Market Comment January 7th 2010

Japanese equities have been the great disappointment of the last 20 years, repeatedly confounding the hopes of those who have looked for an enduring recovery from the relentless downward trend in stock market valuation. What cannot be disputed is that the market is now incontrovertibly cheap on most conventional valuation measures. These comments are from the specialist fund managers Morant Wright in their latest monthly report. (I own shares in one of their funds, their Japanese income investment trust).

£ Returns	Month	2009	Since Inception (23rd May 2003)
‘A’ Shares	+1.8%	-6.5%	+74.6%
‘B’ Shares	+1.8%	-6.0%	+80.3%
TOPIX	+3.3%	-7.2%	+40.7%
Nikkei 225	+7.9%	+4.6%	+65.1%

Sources: Bloomberg and Capita Financial Managers Performance given for accumulation shares

The stock market ended the year on a very positive note with TOPIX up 8.1% in December and the rise in the Nikkei being well into double figures. For the year the capitalisation weighted TOPIX was up 5.6% but the Nikkei rose over 19%, a staggering divergence. This anomaly arises because the Nikkei index gives a greater weighting to highly priced stocks such as various technology names and notably Fast Retailing, which now represents over 6% of the index.

Currency moves were again significant as the yen weakened more than 4% against sterling in December and nearly 14% for the full year following the yen’s extreme rise in 2008.
Currently the economy remains weak with third quarter real GDP revised down dramatically to an annualised rate of 1.3% from the previous estimate of 4.8%. The main reason for the revision was private capital expenditure which now comprises the lowest share of GDP since 1984.

However, a new ¥7.2tn stimulus package was announced early in the month. The emphasis is on job creation and environmental industries through which it is hoped that any risk of a double dip recession will be avoided. In addition, the government unveiled a record budget of ¥92.3tn and also a longer term goal to generate average nominal growth of 3% p.a. over the coming decade.

Responding to government pressure to tackle deflation, the Bank of Japan called an emergency meeting and concluded that it will lend another ¥10tn in order to lower 3 month interest rates. Perhaps more significantly it has subsequently clarified its inflation aims by saying that it will no longer tolerate deflation. This suggests that further measures could be taken to stimulate monetary growth.

Apart from JAL, which continues its fight to avoid bankruptcy, company news was quite upbeat with, for instance, Japan Wool Textile and Noritz both announcing upward revisions for the full year. JAPEX also announced that it has won the rights to co-develop a significant new oilfield in Iraq. Mitsui Sumitomo, Aioi and Nissay Dowa received shareholder approval for their merger, which will now take place in April.

Restructuring also continues to be a strong theme with Nisshinbo and Yamato Holdings both announcing additional efforts to cut costs. Elsewhere M&A activity continues with Volkswagen taking a 20% stake in Suzuki and House Foods buying a stake in a Vietnamese food company. A small MBO was also announced at more than double the share price prior to the news.

As the Financial Times’s last Lex column of the year prophesied, somewhat light-heartedly, the coming decade could be the one where Japanese investors re-embrace equities – a prediction we naturally hope is right! Certainly if deflation can be eradicated then equities will become more attractive. The risks are probably more than priced in as our portfolio trades well below book value and many of our companies have significant cash reserves.

Comment: You can see the recent divergence between the Nikkei and the Topix quite clearly in the chart. These differentials tend to work their way out over time, but the Nikkei has never been the most representative index. Japan continues to lag well behind the performance of the US and other stock markets since the market turned in March 2009.