There seems to be a great deal of uncertainty in the investment management and plan sponsor communities about how to handle the Japanese market.
At 41% of the Morgan Stanley Capital International Europe Australasia Far East Index, Japan cannot be ignored. But an index weighting can invite second-guessing and sanity checks by clients or boards. The solution is to focus on the areas of the Japanese market that represent the "new Japan," growing companies that will benefit from the structural changes going on within the country.
We believe the situation in Japan is analogous to what many investors went through in the United States following the 1973-'74 bear market. Seeing renewed growth, many of us went right back to the "Nifty 50" growth stocks. What we missed is that many of those companies were the growth stocks of the past - that is, they were still fully priced relative to their future growth. This trap can be avoided in Japan by focusing on the new growth stocks in parts of the economy that are growing in spite of the current gloomy picture.
Japan is, in many ways, still suffering from the aftermath of the bubble economy of 1986-'89 and is undergoing major economic and social structural changes. Although the economy is believed to have bottomed out in the early part of this year, there is no definite sign of recovery yet.
The combination of numerous cuts in the discount rate and three economic stimulative packages representing 30.5 trillion ($290 billion), soon to be joined by another 15 trillion ($142 billion), have done little more than support sideway movement in the economy. Real gross domestic product is now expected to be flat in the fiscal year that ends this month, followed by slow growth of around 2% in the next fiscal year. It appears, therefore, Japan will be hard-pressed to find additional growth in either the traditional export or capital spending areas. There is no alternative but to stimulate consumption, and the new coalition government is moving in the right direction by promising to eliminate thousands of regulations and tariffs and cut personal taxes.
On a macro basis, signs of growth are still mixed in the United States and difficult to locate in Europe, particularly in the United Kingdom, Germany and France. Even so, all of those stock markets recently hit historic highs, supported by low interest rates, expectations of improving corporate profits growth and successful restructuring for rationalization and improved productivity.
In Japan, stock prices also have been supported by low interest rates, but the market is still some 50% below its 1989 high.
What makes Japan different is that profits among First Section stocks are still deteriorating, and the perceived rebound has been delayed. Secondly, corporate restructuring should take much longer than in the United States or Europe, because the lifetime employment system makes it difficult for Japanese companies to make drastic cuts. Thirdly, there will continue to be selling pressure on large-cap issues in the First Section from banks acting to offset losses on their underperforming loans, and corporations reducing their cross-holdings.
The combination of these various effects easily could keep the large-cap indexes within a narrow range until restructuring in major companies is completed and the market can anticipate the resumption of profit growth.
The good news is that the lowest interest rates in post-war history prevail. The official discount rate has been lowered to 1.75%, the seventh cut since August 1990. Japan's benchmark interbank rate and three-month certificate of deposit rates are at record lows. Volume in the call money market is currently at an abnormally high level of 43 trillion ($410 billion), which is more than 8% of nominal gross national product.
The percentage of bond holdings in life insurance company general accounts, representing $1.5 trillion, is up to 19.3%, close to the historical peak in August 1987. This compares to an average percentage of 11.7% since 1970. For tokkin and fund trusts (combined assets of $240 billion), bond holdings account for 27.3% of the total assets, up seven percentage points from a year ago. Money market funds, yielding around 2.5%, stand at 10.8 trillion ($103 billion), nearly double from a year ago. There is a strong possibility at least some of these assets will find their way into the stock market.
While cash flows from the above sources will limit the downside risk in the market overall, buying interests will be focused mainly on companies with good profit growth. In contrast to the more than 20% decline forecast for major companies in the current fiscal year ending March 31, profits of Japanese over-the-counter companies are expected to increase 10%, followed by further gains of 15% in the fiscal year ending March 1995. In fact, there have been many recent downward revisions in profits for the current year from major companies, while quite a few smaller companies have been raising their profit forecasts. Foreign institutions in particular have become aggressive buyers of smaller companies with their net purchases in the OTC market amounting to $1.2 billion in 1993, six times larger than in 1992. Japanese life insurance companies and domestic unit trusts also are showing interest, leading one to believe this recent strength in the OTC market and other smaller company issues is not temporary, and the area of the market is beginning to mature into a significant opportunity.
This opportunity is expanding quite nicely. The Japanese Market Statistics table shows some basic statistics on the Tokyo Stock Exchange First Section, Second Section and the OTC markets. Although the latter two are small in relative market size, they are expanding rapidly as many companies go public. In December 1991, when the investment environment was deteriorating, new listings were completely suspended. In May 1992, one company per week was allowed to go public, and this was expanded to two companies per week in January 1993. Now, five per week can go public. Currently, more than 200 companies are in the queue to go public and some 1,000 are expected to offer their shares to the public by 2000, when the OTC market is projected to be at more than $400 billion in capitalization.
While net purchases in OTC companies, for example, by Japanese financial institutions, investment trusts and foreigners will be more than four times what they were in 1992, it is difficult to make a general statement with respect to the liquidity of individual companies. Companies like Aoyama Trading have recently been experiencing trading days in the 230,000 to 360,000 share range while Autobacs Seven trades around one-quarter of that share level. Because both large and small companies are difficult to sell on days when the market is broadly falling, it is important to have strong local representation on the trading side.
Smaller companies appear to represent the best values in the Japanese market. Looking at the price/earnings multiples of companies that have positive earnings, the TSE First Section is selling at 59 times, while the Second Section is selling at 52 times and the OTC, 43 times. While all of these multiples look high, it is important to remember the price/cash flow ratio of the market as measured by Morgan Stanley Capital International is 11 and the price/book value is 2.25, both in line with global indexes.
A large number of small growing companies are becoming leaders within their respective industry groups. The commitment to deregulation espoused by current Japanese leadership will further benefit these successful firms.
The Major Japanese Industries table shows the retail/trading and service sectors combined account for 40% of the OTC market but only 9% of the TSE First Section. Using the retail sector as an example, many companies will benefit from further deregulation of the Large Scale Retail Law. This law regulates stores with floor space in excess of 500 square meters.
To open a retail outlet requires 26 different types of licenses, based on 12 different laws, making it necessary to fill out 75 application forms of at least 340 pages. This law was revised in May 1991 to limit the waiting period to 1.5 years and further reduced to one year in 1992. A further reduction should come soon.
This is a great benefit to companies like Autobacs Seven, an auto parts and accessories retailer that is opening 25 to 30 new stores annually and will expand to 500 outlets by 1999. The company has trebled its profits for the past three years and should continue with 15% to 20% annual growth rate in the future. Another example is Aoyama Trading, a Hiroshima men's clothing retailer that has grown by more than 30% a year on both sales and profits during the past four years and is opening 80 stores annually.
These examples suggest that today we are dealing with a market in Japan that needs to be approached from a micro rather than macro view. Investors with local expertise will be able to search beyond the traditional institutional universes to identify the best growth and investment opportunities. The resultant superior stock selection will permit greater flexibility with respect to the country weighting decision.
Hideo Shiozumi is president, Shiozumi Investment Ltd., Hong Kong, and William L. Green is executive vice president, RCB International Inc., Stamford, Conn.