Biggs: Japan’s Big Undervalued Market

A Bull Hidden In an Enigma
To global investors, Japan continues to be "a riddle wrapped in a mystery inside an enigma." I have been to Japan perhaps 50 times in the last 30 years, but on my most recent trip I was stunned by the atmospheric changes in Tokyo. The city has become one of the most avant-garde places in the world. Prosperity seems to be busting out everywhere, stylish young shoppers swarming the Ginza, and sleek new office buildings and hotels opening. Yet the Japanese economy and stock market stagger along from slump to sluggish recovery.

It's a paradox that's endlessly frustrating to investors. The Nikkei today is at half the level it was 16 years ago. That's not cheap in absolute terms, at 17 times forward earnings, two times book value and a yield of only 1 percent. But on valuation models, relative to interest rates and inflation, it makes Japan the most undervalued big market in the world. Since the Japanese stock-market bubble burst in 1990, Japanese institutions and the public have shown virtually no interest in their own shares. Instead the proverbial "Mrs. Watanabe" is speculating in exotic equity and debt in foreign currencies.

Unfortunately Japan Inc. and its CEOs still don't get it. Dividend-payout ratios, at 20 percent, are less than half that of the rest of the world, and corporate governance is way behind the times. Japanese companies on average earn 10 percent on their equity, versus 17 percent in the United States and Europe. Meanwhile, Japan's population and work force are both shrinking at about 0.3 percent a year. This not only creates an enormous pension-funding problem, but also restricts Japan's long-term GDP growth potential to an uninspiring 1.5 to 2 percent. The government is deliberating, in its own ponderous way, incentives to raise the birthrate, increase immigration, encourage women to work longer and lift the retirement age from 60 to perhaps as high as 70. In the meantime, the demographic time bomb ticks away.

Another issue that many Japanese find particularly troublesome is the swelling national debt. As a percentage of GDP, it is the highest in the industrial world. However, with the 10-year benchmark government bond yielding a mere 1.6 percent, the national debt is owed almost exclusively to Japanese, not foreigners, as America's debt is. It's like a family owing money to itself, rather than to loan sharks.

Japan's current lackluster recovery is heavily dependent on exports and capital spending. Nominal GDP growth is still below the 1997 peak. Despite those fancy new hotels and shops, overall domestic demand has been weak for years, which is to be expected in a country where persistent deflation has made it smart not to buy now, because it will be cheaper later. Although the big cities are booming, much of the rest of the country is struggling with unemployment, deflation and stagnation. The gap between rich and poor in a nation that has prided itself on being middle class has dramatically widened. The Consumer Confidence Index has dipped down again, and 67.6 percent of the public is worried about the future—a record high.

Yet there are changes afoot in this paradoxical nation. For starters, society is modernizing. Maternity benefits are at last becoming mandatory, and the birthrate has turned up. Japan's archaic divorce laws, under which the man got the money and the woman the children, have been changed to split assets evenly. One survey reports that many women are counting the days until the law goes into effect. A wave of divorces will swell the number of households, and the work force.

Business is on the upswing too. Corporate profits are soaring as companies cut fat and run things more efficiently. Management has pledged to raise dividend-payout ratios, and the threat of shareholder activism is making them ever more conscious of the price of their stocks. Takeover laws are being liberalized, allowing raiders access to lush corporate pickings. The banking system has finally been cured of a huge load of nonperforming loans. Unlike the rest of the world, Japan has no residential housing bubble yet. Meanwhile, the commercial real-estate market (which collapsed after a vertical price rise in the 1980s) has finally turned up. Japanese technology, craftsmanship and innovation remain among the best in the world.

Given all this, the Japanese stock market is either a classic value trap or an economic system in which a virtuous circle and a secular bull market are about to begin. All depends on whether old political, economic and financial practices continue to change, and I am inclined to believe they will. After all, the return on equity and replacement cost value of most Japanese companies are a little more than half of similar enterprises in the West. Japan is strategically located in the middle of Asia—the fastest-growing area of the world. I'm betting that stocks in the Land of the Rising Sun will rise again.