Is Japan Now a Good Bet?

The Japanese economy is expected to rebound sharply in the second half of 2011 and 2012.

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Earlier this year images from the devastating earthquake and tsunami in Japan captured the world's attention. The destruction caused by the tsunami badly damaged a nuclear power plant, and parts of Japan have been suffering from intermittent blackouts ever since. That damage also took its toll on economic growth. In the first quarter of 2011, the Japanese economy shrunk by 3.5 percent. Projections for the second quarter also call for further contraction, but experts are expecting a sharp pickup in growth in the second half of the year and in 2012 as the country rebuilds.

"We're forecasting a very V-shaped recovery in Japan," says Paul Sheard, global chief economist and head of economic research at Nomura Securities in New York. "It's pretty much a done deal that Japan is going to have a short to medium term strong bounce in growth. ... The longer term question is, 'Will this bounce in Japan prove to be the catalyst to put the Japanese economy on a much better growth path?'"

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The disaster triggered an immediate selloff in Japanese stock markets. The Tokyo Stock Price Index (TOPIX) fell almost 20 percent in the days following the tsunami. During periods of extreme uncertainty, investors generally overreact and sell—and this time was no different. "In the panic after the earthquake and the tsunami, it wasn't clear exactly who was most impacted, so investors just headed for the hills and sold pretty indiscriminately," says Martin Jansen, head of international equities at ING Investment Management in New York. "They basically dumped everything and ran for the hills."

Year-to-date, the TOPIX is still in the red, but after the initial selloff, it has actually outperformed the broader indexes in the United States and Europe. Since March 18—exactly a week after the devastating tsunami—the TOPIX is up about 1 percent. Meanwhile, the Bloomberg European 500 Index (a broad measure of European stocks) is down almost 5 percent, and the S&P 500 Index has also lost about 1 percent. That's in part due to the strength of the yen this year. It has gained 5 percent against the dollar and about 7 percent against the struggling euro in the past month as European nations remain mired in a sovereign debt crisis.

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The appreciation of the yen has caught the attention of Japanese leaders. On Thursday and Friday, the Bank of Japan meets, and Sheard says he expects the central bank to pursue more monetary easing, similar to what the Federal Reserve has done in the United States through its two quantitative easing programs, in which it would buy up securities to help push the yen lower. "What Japan really needs is a weaker yen, not a stronger yen," Sheard says. Many of Japan's largest and most successful companies depend on exports (think Honda and Toyota), and a stronger currency makes their goods more expensive abroad, which cuts into the companies' profits.

So what's an investor to make of all this? Japanese stocks remain cheap, says Audrey Kaplan, comanager of the Federated InterContinental Fund (symbol RIMAX). Currently, Kaplan has about 15 percent of the fund's overall portfolio invested in Japanese stocks. "We went to that 15 percent weight [in Japan] right after the earthquake," Kaplan says. "Obviously it was a catastrophe, but in terms of stock markets those are usually very good buying opportunities for long-term investors. In our portfolios, we're thinking a minimum of three to five years forward, and that was a good opportunity to add weight to an attractive part of the world."

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Kaplan believes Japanese stocks are attractive compared to other parts of the world. For instance, one valuation metric she uses is the price-to-cash-flow ratio. Stocks in Japan are trading about 6 times their cash flow, and in the U.S. it's closer to 9 times. Using that measure, Japanese stocks are trading at a discount of 30 percent versus U.S. ones. One stock in particular that Kaplan likes is global auto-parts supplier Sumitomo Electric Industries. "We're particularly looking for Japanese stocks that are positioned for growth throughout the rest of Asia," she says.