Buy Japan's Exporters

By Daniel Kadlec

Japanese stocks have put a world of hurt on intrepid investors who dared to call that market's bottom at any time in the past decade. Now with the Japanese economy seemingly bent on a fourth recession since 1990, few are inclined to try again. And that's a shame. With the yen near record lows and the U.S. economy headed into recovery, the stocks of some Japanese exporters are looking attractive.

Viewed more broadly, a lot of good things have happened in Japan in the past couple of years--finally. Hundreds of companies like Nissan and Sega have taken Western-style restructuring to heart. The government is letting more companies fall under foreign control, including top financial institutions like Shinsei Bank and consumer-electronics maker Denon. U.S. firms have surpassed mighty Nomura Securities in domestic stock underwriting and merger advice. Corporate bankruptcies are more frequent, as are takeovers--sorely needed to clear away deadwood and reinvigorate competition.

Plenty of issues remain. Japan's banks have $1 trillion in bad loans on their books, and there is no comprehensive plan for dealing with the mess. The slumping economy will push earnings down 20% or so this year, and a deflationary spiral is keeping just about everyone from making any meaningful investment in the stock market. So prices keep drifting lower. Amazingly, the bellwether Nikkei stock average is now at levels first reached in 1984, down 73% from the 1989 peak of 38,916.

Any day the Nikkei could slip below the Dow Jones industrial average for the first time in 44 years--a historic crossroads that drives home just how brutal Japan's 12-year bear market has been and how thoroughly economies can change. At the Nikkei peak the Dow was at just 2,753, trailing its Pacific rival by an astounding 36,163 points. Now, as the Nikkei sheds fur like a sheepdog in spring, the unthinkable is coming to pass: parity. The two trade near 10,000.

What's going to stop the Nikkei plunge? At some point its value stocks will become too attractive to ignore. Japanese stocks are now two-thirds cheaper than U.S. stocks, based on price-to-sales (0.5 vs. 1.5) and price-to-book (1.5 vs. 3.3) ratios. Because earnings are so depressed, the price-to-earnings ratio on many stocks seems high--in the 20s or 30s. Still, some believe that the Japanese market represents the best deep-value play in a generation. For that reason Cyril Moulle-Berteaux, who runs an institutional fund for Morgan Stanley, has his most aggressive stock allocation in Japan. "Everybody who's had money to pull out of Japan has already done so," he says, noting that Japan is not just cheap but a low-risk contrarian bet.

A relatively safe route into Japan is blue-chip Japanese exporters, which, while not dirt cheap, stand to benefit from renewed buying among U.S. customers and a continuing slide in the yen. David Bowers, chief international strategist at Merrill Lynch, likes the copier company Canon, where 84% of sales are outside Japan, and consumer electronics giant Pioneer, where 64% of sales are outside Japan. Also on his list is Nissan, which has been aggressively investing in new production technologies. All three stocks trade in the U.S. as American Depositary Receipts.

The deepest values tend to be small- and mid-cap businesses that trade only in Japan but are available through most U.S. brokers. That's where Charles de Vaulx, co-manager of the First Eagle Sogen Global fund, has been mining. "Our bullishness on Japan rests on the extremely low valuations," he says. He likes the bicycle-parts maker Shimano, which has cash on its balance sheet equal to a third of its market value and has strong exports to boot. Other favorites include construction company Okumura, machinery company Aida Engineering and textiles firm Sotoh--all of which are profitable or break-even and trade at less than the value of cash on their books. Other solid funds with this kind of exposure include Fidelity Japan Smaller Companies and Credit Suisse Japan Small Cap.

As with all value investing, you'll have to wait until others see what you see for the payoff. But that time may come faster than you think.