Ugly and Unloved

It's intriguing that as Asia leads the recovery of the world economy and as its stock markets power to new highs, Japan, the biggest economy and market in Asia, languishes. If ever there was an equity market that qualified for the legendary "Four U's" (underowned, undervalued, unloved, and ugly), it's Tokyo.

The conventional wisdom of the world's investors is that Japan is a loser. Everyone knows that its politics are a farce of elderly, bungling aristocrats, that its population is aging and declining, and that its economy for two lost decades has been mired in debilitating stagnation and deflation. Twenty years ago, the Nikkei got to within a hair's breadth of 40,000. Today the index is around 9400. In February it fell to a 26-year low. Talk about a secular bear market!

So why be optimistic now? There are a number of reasons. Japan's stock market is dominated not by cheap consumer exports but by industrial-oriented export firms, many of which produce technology-intensive, precision capital equipment (these stocks have average returns three times higher than their global peers). About half of Japan's exports go to Asia, with 20 percent going to China. Asia, led by China, is by far the fastest-growing part of the world, so Japan is bound to benefit from the recovery now underway there.

In fact, Japan is already turning. Exports and the economy collapsed in the fourth quarter of 2008 and through the first quarter of this year, with real GDP falling an astounding 14 percent. Now the economy has stabilized, and, beginning in April, exports—particularly to China and the rest of Asia—have had a strong revival. The economic consensus expects real GDP growth of about 3 percent in the second half of this year. What happens next year remains to be seen, but optimism about the global economy is clearly growing, and sources report Japanese exports to the U.S. and Europe are rebounding. Nomura, the biggest investment bank and broker in Japan, is forecasting corporate profits in Japan will jump 62 percent next year, by far the biggest increase for any major market.

No one has made any money in Japan in what seems like forever. It is often dismissed as a "value trap," with stocks that seem like bargains but go nowhere. Even Nomura, which just released stock-market-performance targets for the end of 2009, has Japan gaining only 3 percent, compared with 18 percent for the rest of the world. For the big money, Japan truly is underowned and unloved. However, it's an interesting anomaly that Japanese retail investors for the first time in many years have been buying into their own market. In the fiscal year ended in March, the number of retail investors trading on Japan's five major exchanges increased by more than 2 million, to a new high of 42 million.

Japan is still a very rich country. It is the world's largest creditor (net foreign assets are 54 percent of GDP), and its household net worth to net income ratio is the highest of any major country. If the Mrs. Watanabes who run family finances in Japan ever got bullish, they could move stock prices big time.

As for value, the overall market is selling at 1.3 times book value (the U.S. is at 2 and Japan once traded at 5 times) and at 50 percent of sales. Because of their stability, I find these are the two best valuation measures for stocks. The dividend yield is about 2 percent. Small- and medium-size stocks in Japan are even cheaper. Corporate governance is improving.

Japan may be at a political tipping point. The country desperately needs change. Since World War II, the sclerotic Liberal Democratic Party (LDP) has run Japan. Economic miracle has become disaster, and people have had enough. Elections have been called for the end of August, and polls suggest a landslide defeat for the LDP, with the Democratic Party of Japan (DPJ) coming to power.

The DPJ is far from perfect, but at least it's a breath of fresh air. Its three major factions agree on civil-service reform, agricultural reform, and worker-protection changes, but disagree on foreign policy. Although they criticize the LDP's stimulus programs for adding to Japan's already massive government debt, they are silent on what to do about the deficit, productivity, and how to end the deflation mentality of "Don't buy now because it will cost less later." For the DPJ to remain in power, it must revive the economy, which will make the stock market happy. Rather than building bridges to nowhere, the DPJ seems inclined to transfer more income directly to households through social support. For example, the gasoline tax might be cut in half and highway tolls eliminated. If the Japanese people could be persuaded to start spending, it could set off a scramble into stocks. How do you invest in Japan? I'm a big believer in index funds and exchange-traded funds (ETFs). The biggest Japan ETF is I Shares MSCI Japan (symbol EWJ).