Active Investing in Japan

A longtime shareholding on mine, Internet Initiative Japan (IIJI) (JP: 3774), is having its Annual Shareholder Meeting this Friday in Tokyo. I urge all ADR and Ordinary shareholders to submit their votes as soon as possible, but not later than this Thursday, 10:00 AM Eastern (NY) for ADR holders, or by Thursday, 11:59  PM Japan Standard Time for Ordinary shareholders. Also, please see my previous article detailing my activist work to-date with IIJ.

IIJ hit another 20-month high overnight in Tokyo, up 1.3% to ¥276,900 (ADR equiv. $7.65 at $1/¥90.5), although it traded as high as ¥288,900 in the afternoon session before giving back a good chunk of the gains into the market’s weak close. While IIJ’s stock has had a strong year, I remain convinced that its shares are still undervalued, due in some respects to management’s misuse of capital and the Board of Directors’ failure to unlock value, and in other respects primarily because of overly restrained IT spending in Japan. continue reading…

Interesting developments in the Nikkei ahead of the parliamentary election at the end of this month, which at this point looks as if it will finally bring an end to LDP rule. A foreign exchange rate of $1/¥94 would have been practically inconceivable prior to the “Lehman shock” (as the Japanese refer to the genesis of the financial crisis), let alone a stock market rally. And now, ahead of what appears to be a DPJ (opposition party) that will let the yen appreciate and focus more on domestic demand (rightfully so), the stock indices are showing no fear of the yen.

A sustained rally in conjunction with even more yen appreciation bodes especially well for the domestic-oriented stocks, of which there are plenty — many that still have saliva-inducing valuations. However, exporters remain the headline grabbers, and it is not clear just how much yen strength can or will be tolerated (one suggestion is ¥87 is the trip wire, a level reached early this year, and a level not seen previously since the mid-90s). That being said, again what makes this all very interesting is that although the strong yen makes Japanese exports less competitive (great instead for instance, for South Korea (EWY: 49.05 +0.10%), it does allow them to invest more in production overseas, a win-win for the Japanese and local FDI recipient economies.

What worries me though is the pace of reform(s) versus expectations, assuming a DPJ victory. Meantime, there is no debating the fragility of the domestic/global economy and the recovery thus far in equities. Domestic and overseas investors are very fickle and just as quickly as money has been flowing in, it can reverse course equally as quickly. The seemingly conservative, opportunistic play would be to go long the yen (FXY: 114.60 +0.51%). The DPJ’s financial advisors (and by extension, one of them possibly being tapped as finance minister) have already gone public saying they don’t intend to intervene in forex, except in extraordinary cases. Another play would be to look at the smaller-cap funds like (DFJ: 39.98 -0.65%) and (JSC: 38.95 -0.97%), but unfortunately, these are not very liquid and are quite fragmented. Time-permitting I will look at posting some specific stock picks.

At the time of publishing, the author does not own any long/short positions in the funds mentioned.

Pricey, and Japanese stocks, are typically not heard together in the same sentence. However, since last September’s market rout, earnings have deteriorated to the point that the Nikkei 225 is trading at over 175x forward earnings; 10.1x on a trailing basis. No doubt the ratio will swell some more, potentially going negative for a quarter, before it begins to ease. For some time now, I have believed that Japanese stocks are being priced fairly by the market. Still, it remains true that money managers the world over see deep value in Japan.

In order to prevent this article from getting long winded I will summarize my position as follows: (1) Recent trading has been ostensibly positive given the strong rally in percentage terms off the bottom, but the action has been quite thin; which leads me to point (2) in that the 9,000 level has proven pretty elusive due it being right about the middle point of last year’s finish and this year’s high (remember the N225 flirted with 6,000 a month ago); and (3) buying up headline exporters and bank stocks is the easy and obvious way to play, but lack of participation and depth in this rally will surely create a situation of more range bound trading between 7,000 and 9,000. Therefore, with all eyes on the U.S., and with the country’s financial magicians seemingly running out of rabbits, I would exercise caution at current levels. Aside from media cheerleading, last check the economic negatives far outweighed the positives.

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About a year ago today, I published a weekly Nikkei outlook discussing whether the Nikkei was headed to 13,000 or back to 12,000. Suffice to say that much has happened since then. At the start of the new fiscal year today, the range in question is broader, 7,000 – 9,000, but obviously it is not any better (unless one has profited on the short side or had a timely exit). At any rate, investors might be excited since March was a particularly good month for equities.

The Nikkei 225 gave back 500+ points in the last two sessions of March, but the usual claims of year-end window-dressing were audible, since the N225 still managed to gain more than 11% for the month — the ascent was upwards of 18% through last Friday. The 11.4% return tied 1999 for the best March performance since at least 1991. That’s history. So what can we expect for April?

The last two Aprils have produced gains of 9.4% (2008) and 2.2% (2007) for the Nikkei 225. Both of those followed losses of approximately 1% in March. The last positive March in 2006 (7%) was followed by a 2.5% decline in April. Of bigger concern is the fact that the ensuing April to December periods for each of the past three years have been rather brutal: -31% (2008), -11.5% (2007), and +1% (2006). For those looking for a trade or a glimmer of hope, note that the N225 has closed higher two-thirds of the time in April over the past 18 years. However, the first day of trading is no indicator for the remainder of the month since up/down days are split 50:50. Lastly, know that the average monthly gain for April in the past 18 years is 1.3% and the median gain is 2.2%. By the way, the 11% March performance in 1999 was followed by a gain of more than 2% in April.

My assessment of Japanese equities in light of the domestic and global economy is still primarily negative. I continue to be of the opinion that the current trading level of the N225 reflects fair value. A simple way to play may be to consider the low-7,000 level as an area of support and a buying point, and the approach to 9,000 as an area of resistance and thus a selling point. Remember that the N225 closed the year in 2008 at 8,859. The 52-week low was back in late October at 6,994, but most recently on March 10, the Nikkei flirted with the 6,000 level again when it closed at 7,054. Keep in mind that the N225 is now down only 10% for the calendar year thanks to the March rally.

While it goes without saying that stocks are a “leading indicator” and will recover before the broader economy, the best thing to do is to be realistic. No need whatsoever to rush into equities. There are too many lingering uncertainties and the potential for even more doom and gloom. With all eyes seemingly on the U.S. (after all we got everyone into this mess), don’t put much faith in the longer-term efficacy of tweaking mark-to-market valuation or public-private investment schemes that rely on the “goodwill” of banks. Too many ifs would have to be realized before a meaningful amount of confidence could be restored and sustained.

*This article may be reproduced only with the author’s prior consent.