This Is a Japanese Rally That Will Run for a While, Pros Say


Japanese stocks have been on a scorching run this year, but it's easy to view the gains with some skepticism.

After all, the Japanese market has shown signs of recovering throughout its now decade-long malaise--rallying in 1993, 1994, 1995 and 1997--only to fizzle each time.

What's more, the yen has strengthened considerably relative to the dollar over the last two weeks, threatening the health of Japan's critical export sector.

That has been a major factor in the Nikkei-225 stock index's 5.6% slide over the last week from the 52-week high of 18,532 reached July 19.

But the Nikkei is still up 26% year to date in yen terms and 25% in dollar terms, and indexes of smaller Japanese stocks have racked up even bigger gains.

Does this rally have legs? Managers of some of the best-performing Japanese stock funds say it does--but not because of the Japanese government's much-trumpeted efforts to revive the economy.

Rather, "what we're seeing in Japan right now is a restructuring-driven market," says Seung Kwak, lead manager of the $482-million-asset Japan Fund, which is up 65% over the last 12 months.

Todd Jacobson, associate portfolio manager for the Warburg Pincus Japan Growth fund and the Warburg Pincus Japan Small Company, agrees.

"What distinguishes these past few months from [previous rallies] is that the excitement has been generated not from government policies, but from corporate activity," says Jacobson, whose funds year to date are up 86% and 110.1%, respectively.

143 Companies Make Restructuring Plans

Japanese corporations have begun to do what counterparts in Europe and the U.S. have been doing for quite some time: They're cutting costs by downsizing, exiting unprofitable businesses and merging with one another in hopes of boosting profitability.

Sony, NEC and Mitsubishi Chemical are among the big companies leading the charge. Overall, at least 143 companies announced plans to restructure in the first five months of the year, according to brokerage Morgan Stanley Dean Witter.

Based on the current pace, mergers in Japan this year will represent 4% of Japan's total market capitalization, Jacobson says. Historically, mergers each year have accounted for just 1% of market capitalization.

The Japanese government is encouraging mergers by allowing companies to use their stock as currency to do deals. "That's taken for granted in the U.S., but this will make company stock a fiat currency, which gives Japanese executives another incentive to boost the value of their stock and add shareholder value," Jacobson says.

To be sure, compared with restructuring activity in Europe, Japan is still far behind. And "from a Westerner's point of view, it's a frustratingly slow process still," says Peter Kirkman, manager of the TCW Galileo Japanese Equities fund, which is up more than 60% over the last 12 months.

"But I think the mistake the bears have made in this market is focusing too much on the top-down story [the economy] and not enough on the bottom-up" or corporate reform, he says.

Another difference between this rally and previous false starts: Yields on Japanese government bonds, although above their lows of last fall, still are far below the levels of the early and mid-1990s, when they provided a reasonable alternative to stocks. A 10-year government bond now yields just 1.7%.

As older bonds and long-term bank certificates of deposit mature, many analysts say, Japanese households will have no choice but to invest some of that money in stocks if they want their capital to grow.

All in all, says Jacobson, "in the last few months I've been pounding tables at meetings saying that this [rally] is different from a lot of the previous head-fakes."

Still, he admits, there are roadblocks on Japan's path to recovery, not the least of which is the state of the economy. Though it grew a surprising 1.9% in the first quarter, Jacobson and Kwak expect the economy to contract a bit in the second half of the year.

"The economy is still very fragile," Jacobson says.

Restructurings and Pressure on Economy

Ironically, the very thing that has investors confident about stocks--corporate restructuring--could damage the economy in the short term.

"Restructuring can put downward pressures on an economy," Kirkman says. He notes that Japanese companies walk a fine line between boosting investor confidence (and the long-term health of the economy) by slashing unnecessary jobs, and hurting consumer confidence and spending (and the short-term health of the economy) by cutting jobs too quickly.

Another irony: As foreign investors buy yen to invest in Japanese stocks, they're driving the currency's value up. A stronger yen will make Japanese exports more expensive abroad.

The yen, now at just under 117 to the dollar, is at its strongest level since February.

Fund managers say they aren't too concerned just yet, because the yen has traded in a band of 115 to 125 in recent months. In addition, most Japanese corporate earnings forecasts are based on a yen-dollar rate of about 115.

But "if we approach 110 to the dollar, I think you'll see an increased level of concern," Kirkman says.

There are other risks to Japan's market rally. A broad U.S. market decline, for example, could drag all other markets down with it. Asian market sentiment also is vulnerable to the new war of words between China and Taiwan.

"Having rallied quite a bit year to date, especially if the U.S. market weakens, I think the Japanese market could weaken" near-term, says Kwak.

Taking a longer-term view, Kwak, Kirkman and Jacobson all are stressing diversification in their portfolios now: They're owning a mix of domestic-oriented stocks and export-oriented issues, without stressing dependence on either sector.

For instance, more than 40% of Jacobson's two Warburg Pincus funds' assets are invested in technology-related stocks. They should benefit from rising export orders. But their export dependence also means they're vulnerable to a stronger yen.

To hedge that bet, both of Jacobson's funds have also invested in many companies that rely mostly on the domestic economy.

For instance, both the Warburg Japan Growth and Warburg Japan Small Company funds have a stake in Japanese retailers. Though large department stores in Japan still face major debt problems, analysts say there are opportunities to be found in smaller retailers.

The Japan Fund's Kwak likewise is finding opportunities in blue-chip domestic-oriented companies committed to cutting costs. An example is NTT, Japan's leading phone company and the Japan Fund's top holding.

Meanwhile, although Kwak likes some core tech stocks such as computer servicer Fujitsu Support & Service, he has capped his fund's tech investments at 20% of total assets because of yen concerns.

Which Sectors Show Prospects for Growth

All three managers also own financial services stocks that could actually benefit from the increased economic activity that would support a strong yen. But they are either focusing on regional banks--which tend to have stronger balance sheets than large banks--or on non-bank financial services firms.

For much of this year's rally, smaller growth stocks have been the clear market leaders. The Jasdaq index of OTC stocks, for instance, is up more than 112% year to date. But with that steep rise, these fund managers now believe that other sectors, including large stocks and small value-oriented stocks, look just as good if not better based on their growth prospects relative to their valuations.

"If this rally is a real one, it's going to float all boats," Kwak says.

But could Japanese stocks in general, after recent gains, already be overpriced? The Nikkei index's average price-to-earnings ratio based on estimated 1999 earnings is more than 60--more than double the P/E of U.S. blue chips.

"In the late '80s, the P/Es were high because the 'P' was high," Jacobson says. "Today, P/Es are high because the 'E' is so low." The bet, therefore, is that Japan's earnings recovery will be substantial.

Many Japan bulls point to measures other than P/Es. Based on price-to-sales, price-to-cash flow and price-to-book-value measures, Japanese stocks are still considered cheap relative to European and U.S. counterparts, Kwak argues.



Will It Last?

Japan's Nikkei-225 stock index has surged this year, though its advance still lags that of its last major rally in 1995. Quarterly closes and latest:Monday: 17,491.34

Source: Bridge Information Systems


Japanese Stock Funds: Some Ideas

How four mutual funds that focus on Japanese stocks fared in 1997 and 1998, and their year-to-date total returns. All four have sharply outperformed their peers over the last two years:

Total investment return:


Fund name 1999* 1998 1997 800 number Warburg Pincus Japan Small Co. 110.1% 12.8% -25.4% 927-2874 Warburg Pincus Japan Growth 86.0 1.3 1.5 927-2874 Japan Fund 45.4 24.3 -14.4 535-2726 TCW Galileo Japanese Equities 43.7 31.3 NA 386-3829 Avg. Japan stock fund 44.4 7.3 -15.0


*Through Friday

NA: Not available (fund didn't exist for entire period)

Source: Morningstar Inc.


Times staff writer Paul J. Lim can be reached at

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