Investing options with Japan could pay off again

For nearly a decade, Japan dealt with its collapsing banking system by putting its hands over its ears and singing loudly. Not surprisingly, this strategy didn’t work. But recent reforms have restored Japan’s banks to improve investing options with Japan — and its stock market, as well.

If you decide to go east, however, go through a diversified Pacific fund: As tempting as Japan looks now, there’s no need to confine yourself to one country.

Japan’s stock market has been a 16-year tragedy, punctuated by periods of terror and depression. The Nikkei stock index peaked at 38,916 in December 1989 and fell all the way to 7,608 in April 2004 — an 80 percent drop. That’s the equivalent of the Dow Jones Industrial average falling to 2,345 from its January 2000 peak of 11,723.

A collapse in Japan’s property market helped propel its stock market and its economy into a vicious, long-term deflationary spiral. Consumer prices fell year after year, conditioning shoppers to postpone purchases. After all, there’s no need to buy a television today if you know it will be cheaper next week.

Japan’s banks were left with fistfuls of bad loans when the property bubble burst. Unlike their U.S. counterparts, who wrote loans off quickly, many Japanese banks held onto the loans, hoping that an economic revival would make borrowers solvent again.

It didn’t. But the government of Prime Minister Junichiro Koizumi, elected in 2001, pressured Japanese banks to clean up bad loans and improve their balance sheets. “It’s taken some time, but they have turned the corner,” says Kurt Umbarger, vice president at T. Rowe Price, the Baltimore fund company.

One sign of the change: Mitsubishi Tokyo Financial Group will take over UFJ Holdings on Saturday, taking the title of world’s largest bank from Citigroup. The new bank will be named Mitsubishi UFJ Financial Group. The company’s stock is up 28 percent this year.

Deflation is still a part of Japan’s economy, but it has moderated. Japanese consumer prices have fallen 0.3 percent the most recent 12 months. Tokyo property prices rose for the first time in 15 years, gaining 0.5 percent the 12 months ended in July, Japan’s Ministry of Land, Infrastructure and Transport reported last week.

The Japanese stock market has soared, as well. The Nikkei has gained 7.5 percent in U.S. dollar terms, vs. a 2.3 percent loss for the Dow Jones industrial average. But that understates the Japanese market’s strength. In Japanese yen, the Nikkei is up 18.5 percent.

There’s plenty of room for more investors to jump in. The Japanese stock market is 22.4 percent of the Morgan Stanley Capital International Europe, Far East and Australasia index, down from 59.8 percent at the end of 1989. Many large international funds have less than 22.4 percent of their assets in Japan. If they want to mirror the performance of the EAFE index, they would have to pour money into Japan. They wouldn’t be alone. Even the locals don’t own a lot of Japanese stocks, says Mark Headley, manager of Matthews Asia Pacific fund. “They have more in U.S. Treasuries than they do in their own stock market,” he says.

Finally, Japanese stock prices are low, relative to earnings — and relative to recent history. For years, Japanese stocks sold at improbably high price-to-earnings ratios. (The P-E ratio, a stock’s price divided by its past 12 months earnings, is a measure of how cheap or expensive a stock is. Lower is cheaper.) Japan’s P-Es are still higher than those in the USA.

Scott Snyder, assistant manager of Icon Asia-Pacific fund, looks at P-E ratios in relation to interest rates. When interest rates are low, stocks are more attractive. By his reckoning, Japan is the second-cheapest Asian market, just behind Taiwan. Japan is the fund’s largest weighting by country.

What could go wrong? Plenty. Japan is extremely dependent on foreign oil, and high oil prices hurt its economy. But Japan has worked hard to conserve energy, Headley says. “You have to give them credit for not driving Humvees.”

And despite recent improvements, Japanese consumers are still feeling pretty low. Japan’s consumer confidence survey was 47.4 in August, meaning that pessimists still outweigh optimists.

If you’re tempted to send your money east, hedge your bets with a diversified Pacific fund. If Japan falters, other Asian markets could cushion the blow. And if Japan does well, the rest of Asia probably will, too.

By John Waggoner

John Waggoner is a personal finance columnist and wrote Investing options with Japan could pay off again – for USA Today. E-mail him at jwaggoner@usatoday.com.