Can Japan Stage a Comeback?

Fund manager Neil Hennessy talks about why he's confident in the Japanese market.

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Even as the grip of deflation tightens around an already-weak Japanese economy, experts are looking with renewed interest at the perennially slumping Asian giant. In particular, a regime change and expanding trade opportunities are prompting a rare bout of reserved optimism in a market that has been struggling for the past 20 years.

Neil Hennessy, the president of the California-based Hennessy Funds, is among the fund managers who see fresh sparks of light in the Land of the Rising Sun. Earlier this week, Hennessy spoke with U.S. News about his new batch of stocks for the Hennessy Focus 30 fund. He also reflected on his recent acquisition of two funds based in Japan.

Hennessy, who last month picked up the SPARX Japan Fund and the SPARX Japan Smaller Companies Fund, is enthusiastic about the victory of the Democratic Party of Japan, which has indicated that it will look to improve the country's financial relationship with neighboring China. He also sees the Japanese market assuming a growing role in the Indian, Russian, and Brazilian economies. "They want nice products—Japan has them. They also want technology—Japan has it," he says.

Meanwhile, Hennessy predicts increased volatility in emerging economies. "People are going to get smacked in India and China," he says. "They're going to get smacked, and they're going to go for a safe haven. I'd rather be early in Japan than late."

Still, Japan provides plenty of reasons—including deflation, an enormous national debt, and the rising value of the yen—to give investors pause. Deflation has been a particular concern, and in August, prices (excluding those for fresh foods) fell by a record-breaking 2.4 percent. These lower prices can hurt stocks by hamstringing companies' profit margins. At the same time, a more valuable yen makes Japanese exports harder for other countries to afford.

But even as deflationary trends continue, Hennessy sees room for optimism. "How are you going to grow your money in a deflationary environment? It's going to be very tough. So what's going to happen is I think you're going to see people get a lot more interested in the stock market over there," he says.

A devotion to data. If the recession has convinced downtrodden investors of anything, it's that no matter how alluring economists' predictions sound, they can go horribly awry. All this evidence of error has left some wondering if investors would be better off with fund managers who rely as little as possible on subjective evaluations.

To that end, Hennessy is a faithful devotee of historical data. "If emotion enters your investment decision-making process, at some point in time it's going to get ugly," he says. "And emotions have entered. Look at this marketplace; look back to late February and early March. Emotions were so high that the crisis of confidence was something I'd never seen in 30 years."

Hennessy makes his Focus 30 fund picks based solely on data-driven indicators of a stock's performance over the past year. His formula picks up companies that have shown momentum, have price/sales ratios of less than 1.5, and have market caps of between $1 billion and $10 billion. Each year, he divides the fund's assets equally among the top 30 stocks spit out by his screens. The Focus 30, which launched in 2003, has posted an annualized return of around 6 percent over the past five years.

Here are some highlights from this year's Focus 30 list, which was officially released on Thursday:

Like last year's choices, the new picks put about a third of the fund's portfolio in consumer discretionary stocks. In particular, Hennessy highlights companies like Ross Stores and Ball Corp. According to Hennessy, consumers who retooled their shopping styles to slim down during the recession will continue to look for bargain deals even as the economy rebounds.

Also notable is that this year's screen came up empty for utilities companies. Hennessy attributes this to consumers becoming more conscious of their energy use as they look to tighten their belts. This, in turn, cuts down on the companies' profitability. Meanwhile, the portfolio maintains its standard aversion to technology, except in the information-solutions area. Here, Hennessy touts companies like Broadridge Financial Solutions, a New York-based firm that can help businesses increase their efficiency in the wake of layoffs.

But before you swear off human stock pickers, remember that all strategies have potential downsides. Morningstar analyst Greg Brown says that in Hennessy's case, one flaw is that the formula relies entirely on past performance. This could be particularly problematic for the upcoming picks, he says, since market trends in 2008 are believed in many circles to be an aberration.

"Fundamentally, I just don't agree with the strategy. [The] entire investing philosophy is just predicated on 'what happened in the past will happen in the future.' And over and over again, that shows not to be the case," Brown says. "Financial markets are just incredibly evolutionary. They just don't do what they did in the past."