Japan's big chance

PORTFOLIO POINT: The devastating Tōhoku earthquake has shaken-up Japan’s sclerotic political and economic system as much as the surrounding landscape. As the danger of nuclear fallout recedes, this could represent the dawn of a new era.

There’s a widespread belief that the Chinese word for crisis comprises two characters: danger and opportunity. That may be debatable as far as Mandarin linguistics is concerned, but it may as well be true for Japanese; right now, the post-earthquake crisis is also looking to be composed of two characteristics: danger and opportunity.

As the dust settles on the devastating Tōhoku earthquake and Sendai tsunami, markets remain bearish on the Japanese economy with indications that the disaster will cost as much as ¥25 trillion or $US307 billion. (In what could be described as good news, an erroneous estimate of radiation levels found in water samples from Fukushima was revised down from 10 million to 100,000 times normal.)

And despite the Nikkei 225 rebounding to reclaim exactly half the 25% plunge after a massive injection of liquidity by the G7 and Warren Buffets claim that it’s a buying opportunity, worries persist that Japan will find it difficult to meet initial estimates of a quick economic rebound in the manner of the Kobe earthquake a decade and a half before.

Yet these worries fail to take into account a more subtle, but nonetheless profound shift in Japan's economic, political and societal fabric.

Since the crash of 1989, Japan has been in a 20-year financial and economic slump of no precedence in the modern developed world. The cause of this slump – a massive bubble in property, shares and commercial debt – is well understood, but it's less understood why the slump has taken so long to get out of. The widely quoted Nikkei 225 index of major Japanese stocks, for instance, is less than one-third of the level it was at the height of the late 1980s bubble.

Some of the better explanations point to Japan's risk-averse business culture, its conglomerate-dominated economy and its lethargic government. Japan has had five prime ministers in as many years but the real power rests with unelected bureaucrats, many of whom are still holding positions they did in the 1980s. Japan also hosts some of the world's most innovative companies, whose technology is years ahead of anyone else, yet it is also one of the world's most distinctly un-entrepreneurial nations. The country has had a functioning democracy since 1945 in a region long dominated by dictators and oligarchs, yet the conservative Liberal Democratic Party (LDP) has run the country for almost 55 of the past 57 years.

The recent earthquake and tsunami is the world's costliest natural disaster in nominal terms in almost 50 years and is Japan's greatest crisis since the Second World War. Yet, like the war, out of the current tragedy Japan has the opportunity to chart a new direction as it has also done countless times throughout its long history when major disaster has struck. Like other recent natural disasters, the earthquake is expected to reduce Japanese GDP by 0.5% over the short term and add another 1-2% during the rebuilding process.

But whereas some disasters ushered in periods of instability – the Great Kanto Earthquake of 1923, in which 143,000 perished, for example, heralded an era of imperialism and xenophobia – the early reaction to the current earthquake is more promising.

Prime Minister Naoto Kan, like US President Barack Obama a former civil activist, has called on Japan to pull together and rebuild the region north of Tokyo most affected. And also like Obama, Kan – a member of the Democratic Party of Japan (DPJ) – has signalled deep changes to how Japan manages its economy and energy needs in future.

But while Kan and his government have faced resistance from the country's massive vested interests since coming to power in 2009, the crisis gives him the mandate Japan requires to reform. Though faced with government debt at 225% of GDP, a declining population that peaked in 2004 (and now has a median age of 45) and a declining savings rate, Kan is unlikely to let this crisis go to waste.

After all, the direction the government and Japanese society takes will determine whether the country stagnates further or rises once again from the ashes to become one of the world's most innovative, creative and outstanding economies.

I'm of the belief that we could soon see the beginnings of a Japanese renaissance. While continued nuclear uncertainty will suppress stocks in the short term, in the long term Japan could become one of the better places to invest your money if the problems with at Fukushima are contained.

While the country does face huge challenges, it also has huge opportunities to address them and thus reap the immediate financial rewards that are no longer available in other developed markets.

The demographic crisis could be turned on its head through greater and permanent immigration quotas, something the country has avoided till now. The fiscal debt crisis could be solved through privatisations and welfare-cuts that the rest of the developed world performed decades ago. The lack of entrepreneurship could be solved à la Singapore, via concerted efforts at legal, banking and educational reform.

Should these reforms take place, investors and believers in Japan have the opportunity to ride a wave similar to that experienced in Australia, Britain and America following their periods of deregulation. And while the experience would certainly not be painless, Japan would come out stronger for it, just as it did in the wake of the Second World War after defying expectations to become one of the world's best-performing economies.

Japan is already running bigger trade surpluses to its Asian neighbours despite a strong yen, which proves that consumers for its world-class products are not being swayed by cheaper substitutes from China, Korea or Taiwan. In the post-carbon economy, Japanese firms lead the world despite the set-back to the nuclear industry that Fukushima will hold and recent problems with quality control at Toyota.

Like a coiled spring, Japan's economic machine is waiting for a trigger to rebound from years of deflation, stagnation and backwards government policy. That spring could also prove to be resilient in the long term to the threat of higher food and fuel costs that many less-developed Asian nations now face.

Unlike China, which has witnessed two decades of spectacular economic growth, investing in Japan is certainly a contrarian strategy, but contrarian strategies can often provide the best performance over the long term. Investing in Japan directly could also put a hedge in your portfolio for when the economy of China (and hence Australia) inevitably slows down.

Based on common value indicators like the rolling 10-year Shiller price/earnings (P/E) multiple, Japan is also a relative bargain, with the country's stocks trading at a 16 times earnings multiple, the lowest level since the late 1970s.

Citi analysts have also noted that based on a conventional 12-month forward P/E average, Japanese stocks are trading at a discount to global P/E levels for the first time in recent history. By contrast, when the Kobe earthquake occurred, Japanese stocks traded at an average forward P/E of more than three times global levels.

Analysts at Société Générale, meanwhile, have put out a 10,800-point target for the Nikkei, suggesting a rise of 1200 points or 12.4% from its present level. In contrast to the investment bank's normally bearish calls on macroeconomics, SocGen says that Japanese stocks are still pricing in an Armageddon scenario that is hardly likely to pass.

Australian retail investors seeking exposure to Japan have traditionally done so via managed funds or companies in the coal and natural gas sectors, some of which Tim Treadgold discussed a fortnight ago (click here).

Other common ASX-listed exposures have been gaming machine maker Aristocrat Leisure (ALL), former Babcock satellite Astro Japan Property Group (AJA), fellow property investor Galileo Japan Trust (GJT) and healthcare companies such as Biota Holdings (BTA), Cellestis (CST) and ResMed Inc (RMD). Companies linked to the fortunes of the international tourism market such as Qantas Airways (QAN) and Crown Limited (CWN) have also been seen to be proxies for Japan.

But with the range of exchange traded funds (ETFs) now available, an exposure to the Nikkei index is a lot more straightforward and achievable than through individual companies which, especially in the resources sector, have exposure to other countries as well. iShares MSCI Japan ETF (IJP) is the most direct example. Like all ETFs, however, IJP is only a proxy for the market and in times of extreme volatility its correlation to the underlying index can widen producing what is known in the industry as “tracking error”.

That said, iShares’ IJP has not had the same issues of other Japan-linked ETFs offshore, such as the London-listed Lyxor Japan Topix ETF, which failed to post bid and offer prices for a period of four hours on March 15, which is not a scenario investors want to find themselves in when they are looking to get out.

The ASX-listed IJP has an average global daily trading volume of $2.034 million and a market capitalisation of $8.384 billion. Indeed, if it were a company it would be bigger than QR National, Transurban, WorleyParsons or Insurance Australia Group.

While of course many economies will grow after a natural disaster in terms of raw GDP numbers, as Shane Oliver pointed out in Eureka Report on March 14 (click here), one needn't invoke Frederic Bastiat's “fallacy of the broken window” to see that Japan could come out of this disaster in many ways better than it entered it.

Although Japan still faces a massive reconstruction task, the effects of a severe pause in production, a nuclear crisis and the threat of higher oil prices, it does have potential for real and lasting change. That potential, notwithstanding the world's many problems, deserves some consideration in your portfolio this year and in the long-term.