What were the reasons for you to believe that Japanese stocks were attractive enough to start the research business in 2003?

To be honest I could not have predicted that the Nikkei would bottom in early 2003. However it was as far back as 1992/93 that the ratio of Japanese corporate profits to GDP hit its low point. In the 1990s Japanese corporate profitability saw little absolute improvement, whilst US companies grew revenues and profits significantly. So whilst the fundamental strength of Japanese manufacturing companies was on the mend soon after the Bubble burst, there was still a significant longer term performance differential between the US and Japan,as Japan saw deleverage and deflation (depressing GDP) and the US experienced quite the opposite. In other words financial system disfunction became the main driver for lower Japanese share prices. The bearish tone in Japan was made worse by the bursting of the Internet Bubble in 2000.

In such a difficult environment, the news that Mr.Takenaka had been appointed to the Finance Ministry (September 2002) as well as the Koizumi Cabinet’s economic and fiscal policy (starting in May 2001) indicated to the market (including foreign investors) that reform of the Japanese financial system would eventually translate into an improved overall economic performance.

Looking back, there were many small to medium sized stocks, listed on TSE 2nd Section, which were trading at exceptionally low valuations, and with very high net cash positions. Often these smaller stocks were overlooked by the research departments of the major investment banks, even though many of these companies were in fact industry leaders in their field, with substantial global market share ? in other words an investor was not just getting a cashpile, but a real franchise too.

I still remember Amada (TSE1 6113) looking amazingly cheap. They had announced a historically large loss for the period to March 2003, but the stock was depressed to just 0.3x PBR. A quick calculation showed that they would have to repeat that historic loss for an implausible 16 consecutive years before trading back to a PBR of 1x.At the time I was working on the research sales desk in our London office, and I remember there was one US fund which was relentlessly selling Amada simply because it had dipped below their minimum market cap threshold. So somewhat embarrassingly for me, Amada continued to drop for a further two months after I recommended my clients to buy, although it has since proved to be a very good investment.

Though the market environment remained difficult, the Japaninvest acquired its UK securities license in March 2003, and we opened research department in our Tokyo office the following month. By good fortune our first reports were published just 20 days before the long bear market ended. Our focus from then onwards was on these very undercovered and undervalued mid cap names.

Did the market change from 2003 to 2007?

Let us first look at the macro background; personal consumption has been relatively depressed since 2003, and remains so today. This is the main reason why Japan continues to languish towards the bottom of the OECD growth league table, as it has grown on the back of exports, unlike the US or to a lesser extent, Europe.

In terms of the actual stock market environment it is clear that foreign investors were very underweight Japanese equities in 2003. Now in 2007, they have already sold down many of those positions bought into the recovering market, indicating the end of one investment cycle.

As long as personal consumption remains weak, and the macro outlook is consequentially uncertain, there will be no strong groundswell of buying support from long term institutional investors. The Japanese stock market has therefore disappointed of late.

In my opinion, the market here lacks that stable core of long term active managers that you see elsewhere in developed equity markets. Because Pension Funds and Hedge Funds serve different investor bases, and have difference performance time horizons, they can often act as natural counterweights to each other.Thus in Europe and the US it is often the case that pension funds will absorb selling pressure by hedge funds, which are seeking shorter term returns. The very large purchase lot size of the biggest pension funds means, for example, that they can often only add to core holdings when there is “bad news”. However in Japan the Hedge Fund community was very active during the bull run, but their selling caused one way declines in share prices thereafter in the absence of those investors described above.

The relative lack of longer term institutional money has meant that individual investors continue to own a very high percentage of the TSE (around 30% compared to 26% for foreign investors). This low level of activity by domestic institutions is an important challenge for the Japanese market, that needs to be addressed.

How do foreign investors see Japanese market today?

The Nikkei showed a recovery from the major bottom in April 2003, which extended for the twelve months to April 2004. The index then struggled in a fairly narrow box range for the next eighteen months, as overseas investors grappled with concerns over domestic demand and financial sector reform, before the August 2005 rally which was supported (again) by foreign net buying. As valuations are not compellingly attractive, there is a lack of interest at the moment from foreign buyers. The market after the summer of 2005 was largely supported by buying of large cap exporters, with domestic demand related areas weak. Most recently (in 2007) anxiety over a possible US economic slowdown has increasingly overshadowed sentiment. The extreme weakness of US housing (recent data showed an 8% YoY fall off in sales) and its close correlation to domestic consumption, certainly makes it more difficult to be sanguine about the US consumer as the engine of global growth.

On the other hand, domestic consumption data has continued to look unimpressive, with department store sales, for example, showing YoY declines. There is no clear prospect of an imminent turnaround either.

Meanwhile capital spending, which has supported the domestic economy, may start to falter. Capacity utilization rates seem to have peaked in late 2005, and to have moved sideways since then, suggesting that demand growth and capacity add are now in balance. The most recent BoJ Tankan survey shows that this fact is not lost on the corporate sector, and Japanese companies are now scaling back their spending plans. Historically capex has weakened as the profit cycle tips over, and this time around there is likely to be additional damage to overall growth and profitability given the historically high weighting of capex in recent GDP contribution terms.

Notwithstanding these external demand related concerns, there are also some positive incentives in our view:

1. The price of services (as measured by the CSPI) appears to have lagged the price of goods (as measured by the CGPI) over the longer term, so there is room for a catch up.
   
2. Bank lending, although unimpressive in aggregate, seems well supported on the housing loan side, suggesting a firm outlook for residential fixed investment.
   
3. Land prices should see continued steady rises, provided that the Government avoids the temptation to impose restrictions on property lending, as overall land prices (outside prime areas) remain low compared with the bubble 15 years ago.
   
4. Consumption amongst baby boomers in the 50+ bracket may now pick up, as the recent economic recovery has eased their perceived asset / liability burden (ie their dissolute grandson now has his first job, their house has finally started rising in value again, they enjoy for the first time in years some yield on their savings, and may have seen a windfall on overseas investments, both in local currency terms and adjusted back into yen).

These factors should start to increase in relative importance, encouraging overseas buyers back in to the stock market, and helping the market to pick up from recent lows.

In the meantime Japaninvest will focus on what we think are the following interesting themes.

1. Improvement in the payout ratio (dividend growth).
   
2. Acceleration in domestic M＆A transactions (spurred by recent triangular merger legislation etc.)
   
3. Further financial sector reorganization, bring greater competition to the tertiary financial services sector.
   
4. Fiscal reform of local government.

We think that overseas investors are only giving partial credit to these developments and that there is room for positive surprises from these factors.

What is the attractiveness of Japanese market if compared with US or European equities?

Looking at Japan’s relative performance against the US S＆P from June 2005 to April 2006, you will see that Japan outperformed, but that has since corrected. So although foreign investors continue to buy Japanese equities, they are far more active overseas.

In the US the economic outlook has been clouded by the rapid deceleration of the housing market and future prospects are now much more uncertain. As US property has been fuelled by lending on increasingly speculative loan to value ratios, and accompanied until recently by significant equity withdrawal, any further unexpected interest rate increase would quickly impact on both house sales and consumption. Indeed it is probably still too early to be sure that the falls in both housing starts and prices will not produce an unexpectedly sharp overall slowdown, as the effects start to work their way through the economy.

Given this US uncertainty perhaps the relative attraction of Japan may start to increase. In fact the recent uptick in the performance of Nomura (8604) against TEPCO (9501) after a prolonged correction would seem to indicate that the Japanese market may be set for some improvement from here in the relatively near future.

How do you see foreign investor's activity in 2007?

If the current low interest rate environment remains unchanged, then rate sensitive investors (such as buyout funds) will continue to be active acquirers of Japanese assets. However were interest rates to normalize more rapidly, squeezing profits, their activity would quickly slow down.On the other hand more conventional long only investors such as pension funds may well start to increase their Japanese exposure once again, for the positive reasons listed above. They would be powerfully incentivised by any sustained improvement in the payout ratio.On balance, the external demand risks appear quite clear & are to some extent discounted, as is the ongoing disappointment on consumption.The longer term and potentially significant positives seem less widely acknowledged.

Interviewer: Takashi Nishibori, Editor in Chief, TokyoIPO

Mr. Mark Burges Watson

He has been engaged in broking business for Japanese stocks for over 17 years at BZW Securities (UK) and JP Morgan Securities (UK) following his graduation from CambridgeUniversity in 1989. He was appointed as Chief Operating Officer (COO) of Japaninvest Group plc in December 2005, after he joined Japaninvest Holdings (presently Japaninvest Group plc) in March 2003.