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You can look behind the numbers. Price earnings ratios are not relevant in a market where earnings are severely depressed. But earnings ultimately are driven by sales. And on a price-to-sales ratio basis, the Japanese market is half the price of the U.S. market. What this means is that if they were to price their products to deliver just the same profit margins as the U.S., they would be at half the U.S. p/e ratio. They would be priced at less than 10 times earnings.
Why don't they do this? They are taxed on roughly two-thirds, 65% of corporate earnings. And unlike the United States, they don't keep two financial books, one for the shareholders and one for the IRS. They pay tax exactly on what they report to the shareholders. There is a powerful disincentive to report earnings. There is a powerful incentive to buy world market share and to keep earnings down. So for that reason, the p/e ratio in Japan is not particularly relevant. And the price-to-sales ratio would suggest that market is hugely underrated.
Also common sense tells us the best time to buy a market is when there is blood in the streets and when there is fear and loathing. And what major market in the world better characterizes blood in the streets or fear and loathing than Japan?
MR. WIGNALL: Mexico.
Mr. ARNOTT: I said major.
P&I: Rob, you said Japan was your favorite large market. What's your favorite small market?
MR. ARNOTT: South Africa. Our models suggest the South African markets are priced so as to produce very large returns if they make it through the political land mines that lie ahead. And so one could just gauge the relative likelihood of that occurring.
Favors emerging markets
We also like all of the emerging markets; there are no exceptions to that. We like them to varying extents. We favor Argentina and Indonesia and India at the top of our list; Chile, Mexico and Pakistan at the bottom of our list. But in every case, these markets are in the top two quintiles of attractiveness, particularly after a horrific month like November.
MS. KETTERER: We generally are very optimistic about the international equity markets relative to the U.S. market next year.
Europe and Japan are lagging the U.S. economic cycle; they have yet to recover fully from recession. Interest rates still have room to decline in these economies, which is bullish for stocks. The valuations are simply attractive in the foreign markets. There are several of them - Japan, Italy, Spain, Austria and New Zealand - trading 30% to 40% below their peak levels, which you couldn't say about the U.S. market.
There are another six markets trading 10% to 25% off of their highs. The European markets, as an example, are trading at two times book value vs. something like four for the S&P 500. They also offer investors a significantly higher dividend yield.
Corporate restructuring has just begun to take off in other parts of the world. All of that is awaiting us as investors. To give you an example, this year we have seen the first contested takeovers in companies in Switzerland and Sweden. That will just accelerate.
A modestly stronger dollar next year should help, not harm, U.S. investors who participate in foreign stocks, because they are going to see in those companies accelerated earnings as they become more competitive vs. their U.S. counterparts.
As for markets, we like France, Hong Kong, the Scandinavian markets and Switzerland. France has been miserable this year. But with economic growth perhaps turning up, the franc fort policy should finally be rejected by the government. That would allow the French franc to go down against the German mark, thus interest rates will come down, brightening both prospects.
Hong Kong, as has been pointed out, suffers from a China discount to its valuation.
Hong Kong should be safe
We see no reason China should ever want to harm Hong Kong, because Hong Kong allows China to increase its foreign exchange reserves. China desperately needs foreign exchange. No politician in China who wants to stay in power would harm an asset such as Hong Kong, which would help provide for his nation's needs.
As for least attractive markets, Japan would be our pick. We see the economy still limping ahead next year. The economy will barely manage 2% real GDP growth. The current exchange rate between the yen and its major trading partners leaves many companies at break-even level at best.
What really bothers us most about Japan is that restructuring is very slow to happen. Toyota makes a wonderful example. They have more employees worldwide today than they did at the peak of their auto production in 1991. Yes, the export sector has been the most successful at restructuring, but it still leaves a lot to be desired.
P&I: Christian, you get to bat clean-up on this one.
MR. WIGNALL: There is probably less than meets the eye in the difference between the U.S. and foreign markets in 1995. The fact is the U.S. has some of the most advanced industries.
I believe I saw a number that computers, electronics and software account for over 13% of the market cap in the United States. But Spain has almost nothing in this area, and it's less than 2% of the British stock market capitalization.
A lot of the relative performance of the foreign markets can be attributed to the industry mix. Markets that are full of banks and utilities have done poorly just as those stocks have done poorly in the United States. Markets that have high technology or leading pharmaceutical technology companies have done well. One of the best performing markets this year has been Finland, not because of reindeer and forests, but because Nokia now accounts for, I think, 40% of the stock market capitalization.
Recently Switzerland has been remarkably strong, about 35% of the MSCI Switzerland index is three world-class pharmaceutical companies.
So I am not so sure that foreign markets have to catch up. Their relative performance is very explainable by industry composition. Having said that, there are some extremes in foreign markets that I think we should take advantage of. And many of us already have talked about this.
I think Mexico is very interesting right now. Here is a country that has its budget under control and a very competitive currency today. If you didn't know it was Mexico, you would think it was a screaming buy on the top-down reasons alone.
Another outlier is Japan. The macroeconomic conditions in Europe are very similar to the United States: 2% inflation, modest economic growth. Japan, however, is in outright deflation with a major financial crisis. So there again, if you take the principle of buying blood on the street, perhaps we should be looking at Japan. And no matter how I massage the numbers, turn the paper upside down and cook the books, the numbers are not normal yet. This market still has a very, very low dividend yield.
MR. ARNOTT: Look at the price to sales.
MR. WIGNALL: Well, if your sales are relatively low-value-added products as opposed to software or pharmaceuticals or something, then I would expect you to have a low price-to-sales ratio.
Change needed in Japan
MR. ARNOTT: What they do have to do, and which this severe recession may begin to prod them toward, is move away from employment for life and toward a willingness to accept the notion of competition by way of efficiency