Could Japan Become the Gateway to Asia's Emerging-Market Consumers?

Japan: A Gateway to Asia's Emerging-Market Consumers? Although Japan has been viewed as one of the least favorable markets for investing over the last 20 years, there are signs that a shift may be under way that could establish it as the gateway to emerging-market consumers across all of Asia. For patient investors looking for a contrarian play with huge upside potential, a diversified position in high-quality, global Japanese companies could pay off handsomely.

The performance of the Japanese stock market has been dismal for a very long time. Since 2000, the it's down about 41%, while the BRIC emerging markets -- Brazil, Russia, India and China -- are up more than 376%.

But despite the Nikkei's poor overall performance during the last two decades, researchers at T. Rowe Price have found that there were eight periods within the last 12 years that Japanese equities have beaten world markets. The most recent of those periods, which tended to last about six months, ran from November 2009 to June 2010. While most of those outperforming periods have been primarily fueled by currency gains, there is evidence that the next time Japanese markets outperform the world, the gains may be fueled by exports of Japanese products.

Risks and Rewards in the Land of the Rising Sun

The evidence of growth potential shouldn't cause investors to underestimate the risks of choosing to play in Japanese markets today. Neil Hennessy, chairman and chief investment officer of the Hennessy Funds, lists a number of reasons why the Japanese economy continues to struggle and investors continue to shun its stock market.

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"[Japan has] a strong yen, it has huge debt, a very high savings rate, it has an aging population and deflation, there's high turnover in the government at prime minister and it has the highest corporate tax rate around," Hennessy says.

But even amidst all those negatives, Hennessy reminds investors that there are some high-quality Japanese companies that have been able to make profits, and are positioned to capitalize on consumer trends developing in Asia and around the world. "You are investing in global companies that happen to be headquartered in Japan," Hennessy says.

Hennessy says there are a number of themes that offer great opportunities for Japanese companies:

Energy and Infrastructure:
Nuclear power plants and improved transportation systems -- such as bullet trains -- have been major initiatives in Japan that could be exported to other Asian economies.

Clean Energy and Pollution Remediation:
Japan has built a leadership position in developing the next generation of green cars, wind power and energy conservation technology, smart community design, and CO2 emission-reduction technology.

"They are also the one to look to for cleaning up the pollution in China, because they've done it before," Hennessy said.

Japan is still a leader in the production of high-quality electronics, and Hennessy foresees a repeat of its 1970s dominance. Back then, they sold televisions and other electronics to Americans. This time, the growing middle class in China and other Asian nations will be the target consumers.

Japan is way ahead of the rest of the world in robotics, largely due to its continuing worker shortage. Such technology, which can perform tasks that humans cannot, will be in big demand worldwide.

On July 1 of this year, travel restrictions between China and Japan were relaxed. This gives China's middle class of 400 million people a greater ability to engage in "shopping tourism," buying high-quality products in Japan that they cannot get in China.

Nursing Care: Just like in China and the United States, Japan's aging population has made nursing a large and growing part of its economy.

With the great potential of all these themes taking shape, the relevant Japanese stocks are in position to rise rapidly. Campbell Gunn, portfolio manager of the T. Rowe Price Japan Fund (PRJPX) notes that the decades-long battering the Japanese stock market has suffered has left many of its best stocks relatively cheap, making them "deep value" stocks. In particular, many of Japan's largest exporters have attractive valuations, he says.

"They've done a phenomenal job of managing through this financial crisis," Gunn said in a recent investor newsletter. "Profitability is rebounding quite dramatically. When we come out of this, their margins, cash flows, and returns will be higher than ever -- and that's not reflected in their current prices."

Hennessy is already taking advantage of some of those aforementioned themes through the two Japan-focused funds he runs. The Hennessy SPARX Japan (SPARX) and SPARX Japan Smaller Companies Fund (SPJSX) have produced strong positive returns this year. According to Morningstar, SPARX Japan was the top fund in its category this year, up 12.5% as of Nov. 9. Some of its top holdings include Mitsubishi (MSBHY), Keyence (KYCCF) and ASICS (ASCCF).

SPARX Japan Smaller Companies is up 8.9% as of Nov. 9. Some of its largest holdings include Paramount Bed, Toshin Group and Fujitsu General.

Gunn's T. Rowe Price Japan Fund is up 7.3% this year. Some its largest holdings are Honda (HNDAF), Toyota (TM) and Mitsubishi.

Investors can also access the Japanese market through ETFs, including the iShares MSCI Japan Index Fund (EWJ) and the SPDR Russell/Nomura Prime Japan ETF (JPP).

There are still many risks involved in investing in the Japanese market, and some are still cautious. Cosmetics company Avon (AVP) doesn't seem so enthused about the market's growth potential: It decided to sell 75% of its Avon Japan interest to private-equity firm TPG Capital for $90 million on Monday.

But for investors who have been waiting patiently for Japan's markets to experience a sustained growth spurt, there are signs that the time may be near.

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