The Sun Finally Rises

After more false starts than a cranky 1975 Renault, the Japanese economy is at last firing on all cylinders -- or on five of six, anyway. Japan is growing faster than any large industrialized economy besides the U.S. The benchmark Nikkei 225 index doubled between early 2003 and the end of 2005. It's been a long time coming.

Rise and fall. From the 1960s to the 1980s, Japan was the world's prodigy, with an economic system widely feared and emulated. During the second half of the '80s, Japan was growing at 5% annually, and astounded American analysts were writing books with titles such as Zaibatsu America: How Japanese Firms Are Colonizing Vital U.S. Industries and MITI and the Japanese Miracle. Tokyo real estate went through the roof, and the Nikkei soared from 10,000 to nearly 40,000 in five years. But Japan's industrial might -- long on capacity but short on efficiency -- proved vastly overrated, and a massive bubble, based on overblown property values, finally burst. The stock market went into a protracted collapse. As recently as April 2003, the Nikkei was still down 80% from its high more than 13 years earlier.

With good reason. For the dozen years ending in 2003, the Japanese gross domestic product grew at an average rate of just 1% annually, or less than one-third the American pace. Even worse, Japan began to suffer from persistent deflation, an unusual malady not seen in the U.S. since the Great Depression. Prices were actually falling. When the price of a washing machine, say, drops from $300 to $290, consumers wait before buying to see if it will fall again. When it drops the next month to $280, they keep waiting. Eventually, the appliance store goes broke.

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Throughout the painful era that followed the collapse came brief periods when it looked as if Japan would get back on its feet. But revivals were quickly followed by recessions. When I visited Japan in 2002, I found a country suffering from stagnation but, in the stoic way that marks the nation's culture, unwilling to let on that there was a problem.

My latest visit, in December, found a different Japan. Banks accepted their fates, wrote off bad loans, merged, got leaner. The prime minister, Junichiro Koizumi, instituted serious financial reforms -- including a revamp of the post office, where $3 trillion in consumer savings languished. Managers began to run businesses for their shareholders, and markets became more transparent. "Japan has made great strides," says economist Joel Kurtzman, of the Kurtzman Group, an expert in international investment risk. "There's less corruption and better enforcement."

The economy began to recover in 2003. This time, it didn't falter. Gross domestic product has been growing at about 2.5% for the past two years, and the outlook for 2006 is for more of the same. Deflation is dissipating, and prices are expected to rise next year. Optimism reigns. While I was in Tokyo, the Bank of Japan's index of confidence in the service sector hit its highest level in 13 years. The stores along the trendy Omotesando Dori were jammed with holiday shoppers, and new condos and office buildings were rising in sought-after neighborhoods, such as Roppongi Hills. "The recovery story in Japan, that's for real!" says the enthusiastic Gary Stroik, portfolio manager for WBI Investments, in Little Silver, N.J. So, is it finally time to invest in Japanese stocks again?

Early start. It may be past time for the really big gains, but it's not too late to participate. Even before the economy started to recover, the Japanese market was anticipating the good news. Japan Equity (symbol JEQ), a closed-end large-company fund that trades on the New York Stock Exchange, rose 53% in 2003, and the Nikkei jumped 4,500 points in 2005 alone. Toyota Motor (TM) -- which is by far the largest holding of the leading exchange-traded fund that specializes in Japanese stocks, iShares MSCI Japan Index fund (EWJ) -- has returned 35% over the 12 months to February 1. Japan Smaller Companies fund (JOF), another closed-end, has risen a total of 149% over the past three years.

So "we are a bit more cautious" than a year ago, says Andrew Foster, co-manager of Matthews Asia Pacific fund, which currently has 42% of its assets in Japanese stocks. Because Japanese shares make up 61% of the value of all listed Asian companies, the fund is actually underweighting Japan. Still, the fund's top three holdings are Japanese: Mizuho Financial Group, a brokerage and banking company whose shares have risen 81% in the past year; Sumitomo Trust & Banking, up 65%; and Yamada Denki, an electronics retailer, up 147%.

"The near term is very difficult to read," Foster says. Stocks are getting more expensive. Valuations are up. Sony (SNE) carries a price-earnings ratio of 44. Nomura Holdings (NMR), a brokerage and asset-management firm whose shares rose 35% in the 12 months to February 13, trades at a P/E of 20.

Strong fundamentals. But, after all, Nomura's profits quadrupled in the most recent quarter compared with a year ago. Foster is impressed that Japanese businesses are increasing their revenues in spite of deflation. Meanwhile, profits are rising even faster as Japanese managers cut costs, in part by ending the tradition of lifetime employment. "Broader fundamentals in Japan are strong," says a report from Citigroup Global Wealth Management. "A healthier labor market and higher capital spending have boosted the domestic economy, which along with solid demand from the U.S. and China has bolstered earnings prospects." In fact, investing in Japanese stocks is a great way to tap into the growing economy of China, whose own stocks are famously opaque.Japan, in addition, still "has a long way to go," says Foster. Household balance sheets are stronger than in the U.S. because Japanese families save more and borrow less. But for the Japanese economy to start growing at an American pace again (at a 3% rate or more), consumers will have to start spending.

I'm bullish on Japan, but I'll admit that I didn't make my first purchases until the Livedoor accounting scandal -- involving an alleged fraud scheme at a flashy Internet company -- drove the Japanese market down sharply in January. I figured that was a good entry point. After all, the Nikkei is still more than 20% lower than it was 18 years ago!

I agree with Foster, however, that although it is impossible to tell where the Japanese market will go in the short term, it's a good place for your long-term money.

WBI Investments last year moved most of the accounts it manages more heavily into Japanese stocks. The average client now has 5% of assets in iShares Japan, WBI portfolio manager Stroik's vehicle of preference, which tracks the Morgan Stanley Capital International index for Japan. "That's a pretty big weighting," he says. It could be bigger. Japan's economy is about one-third the size of America's -- and more than twice as big as China's.

Stroik is correct to choose an exchange-traded fund or mutual fund. For most investors, picking individual Japanese stocks, except for the biggest of the big, is hard. The companies are difficult for nonspecialists to analyze.

How to invest. My favorite among the mutual funds is Matthews Japan, which returned an annualized 34% for the three years to February 1 and owns some intriguing companies that are cashing in on domestic growth. These include Ryohin Keikaku, a diversified retailer, and Usen Corp., a music broadcaster and owner of a chain of karaoke restaurants. The only drawback is a yearly expense ratio of 1.3%, compared with 0.6% for the iShares ETF.

I'm also fond of Fidelity Japan, a fund launched in 1962 (although its current manager, Jay Talbot, arrived in 2002). With expenses of 1.4%, it has an annualized return of 33% over three years. For small caps, go with the closed-end that I cited earlier, Japan Smaller Companies, whose net asset value per share rose 40% in 2005.

For investors who are fixated on U.S. stocks, it's not too late to seek a newer world. Just don't expect your shares to jump 40% this year.