Why Japan is back on the radar

Japan could be described as full of Eastern promise as every few years it seems to promise great riches for investors. But invariably the promises are exposed as empty.

While Western markets have suffered from one lost decade, Japan is coming to the end of its second one: its stockmarket is only worth around a quarter of the value it was at the end of the 1980s. And while there have been occasional rallies - 2005 was a good year - these have quickly petered out.

The past few months have run according to a familiar pattern: the Topix index has risen 12% since its December low, while the UK and US markets are up 3%.

Investor interest is also rising: a survey of institutional investors' opinion showed a quarter of them view Japan as the most undervalued market and they will invest more.

Paul Chesson, manager of Invesco Perpetual Japan, thinks they would be right to do so. He is 'very optimistic' about Japan and expects a big bounce in corporate profits over the next year.

He thinks profits could rise by between 50 and 60% in the year to March 2011 - Japanese companies virtually all have the same year-end - with a decent rise expected the year after that.

"It's a combination of steady improvement in the global economy and cost-cutting by Japanese companies," says Chesson.

That would follow the pattern seen in previous recoveries: Chesson points to the sharp recovery in corporate Japan's profits that followed the last economic trough in 2003-04. "The trough this time has been deeper so the recovery should be sharper," he says.

Chris Taylor, manager of Neptune Japan Opportunities, is also bullish. He says leading Japanese companies have spent the past two decades building up activities overseas, particularly emerging markets.

As well as obvious global giants such as Sony and Nissan Motor, he cites lesser known companies such as Nidec, which makes motors for consumer products and has 85% of the global market, and Asahi Breweries.

While Japanese shares often look expensive, experts think the market is now good value. Chesson prefers to look at the ratio between share prices and the value of the underlying company's assets.

In Japan, share prices are around 15% above this book value and, he says, the huge balance sheet write-offs over the past two decades mean this figure can be believed. In the UK, the gap is 96% and in the US 115%.

Enthusiasm about shares does not mean enthusiasm about the Japanese economy. "I am not bullish about the Japanese economy; if anything I'm the opposite," says Taylor.

"It is the first OECD economy to actually be shrinking: nominal GDP is back to 1984 levels and the population is shrinking by 1% a year."

Also, Japanese politicians have proved inept at solving the country's problems. Simon Somerville, manager of Jupiter Japan Income, is encouraged by the fact the authorities let Japan Airlines go bust after bailing it out four times.

"That could be the catalyst to unlocking what may be a huge amount of value in the Japanese market."

Spotlight on Invesco Perpetual Japan

There is a wide divergence in the performance of Japanese funds. The best - Neptune Japan Opportunities - would have more than doubled your money over the past five years, while Legg Mason Japan was the worst, losing you 60%.

We are plumping for the second-best performer: Invesco Perpetual Japan. While the fund has been less stellar than the Neptune fund, it has been consistently ahead of its benchmark and fared particularly well during the recent rally.

Manager Paul Chesson favours large global companies in areas such as automotives and electronics.

He is also increasing his focus on domestic financial companies, where he is confident that balance sheet issues - mainly problem loans that had not been written off - have been dealt with, as well as property companies.

The five investment companies specialising in the region stand at high discounts to net asset value, as do the five vehicles that focus on Japanese smaller companies.

Performance has not been as good as the best unit trusts but if you are keen to take advantage ofhigh discounts consider Baillie Gifford Japan. Getting your timing right in Japan is crucial, so be prepared to sell when you have made a decent gain.

This article was originally published in Money Observer - Moneywise's sister publication - in March 2010