Japan Could Be the Best of Both Worlds for Investors

Japanese stock market with American and Japanese flags
Japanese stock market with American and Japanese flags

When it comes to economic stagnation, Japan serves as the poster child for most investors. The phrase "turning Japanese," after all, serves as shorthand for the unrelenting deflationary mire that has gripped the country for decades.

But things may be slowly changing behind the scenes. Japan's exposure to booming economies in the region like China and India may be fueling a resurgence in corporate earnings. That means the poor sentiment surrounding the country may give investors a chance to pick up a highly stable market on the cheap.

Japan's domestic economic woes should be familiar to investors.

A corporate culture based on tenure over merit has stifled generations of younger workers who often scramble from one form of temporary work to the next. During its boom years in the 1980s, the Japanese model was known for its focus on quality and incremental innovation.

Bargains by Comparison

But that image took a major hit when a massive real estate bust set off a deflationary spiral. What was once seen as long-term thinking came to be regarded as a tendency to seek stability at any cost when the lost decade of the 1990s set in.

The reputation for stagnation has taken a toll on the values of Japanese stocks, and some investors now see them as bargains. The Tokyo Stock Price Index, or Topix, trades at a price-to-book value of just 1.1. By comparison, the price-to-book value, which looks at market value versus a company's assets, for the S&P 500 index stands at 2.3.

While investor sentiment remains sour, the earnings picture has started to turn nonetheless. Japan's concentration in the manufacturing of industrial equipment and consumer electronics has played well into the rapid industrialization in Asia. In 2009, for example, China overtook the U.S. as Japan's largest export market.

A slew of big Japanese companies like Sony (SNE) and Hitachi (HIT) have recently announced strong results. Investment bank Goldman Sachs (GS)anticipates earnings to approach the record levels seen in 2007, and stockpiles of cash to continue to mount as well.

Corporate Japan Gets Leaner

The growth comes amid once-again-surging exports. Shipments from Japan jumped 24% in 2010 compared to the prior year, marking the first expansion in three years.

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Corporate Japan also shows signs of getting leaner as competition in the region heats up. Recent mergers in the steel industry are aimed at creating more efficiency and scale to take on global competitors, for example.

Some Wall Street powerhouses have stared to warm up to Japan. Deutsche Bank (DB) predicts that Japanese stocks could gain 20% in the first half of 2011, and Goldman Sachs also sees substantial upside in the year ahead.

Exposure to Japan may have another appeal for investors. While the country benefits from trade with fast-rising emerging markets, it still offers the security of a developed country. Japan provides a way to take advantage of growth in the developing world while also offering the downside protection of a safe-haven.

A Turn for the Better?

Exchange-traded funds like the iShares MSCI Japan Index Fund (EWJ) offer investors cheap, easy ways to take part in the rise of Japanese big-cap stocks.

Thanks to booming emerging markets, a turn for the better may finally be in the offing for the long-suffering Japanese economy. And the prevailing sour sentiment for the time being could present investors with an interesting entry point.

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Originally published