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Can you profit from Japan's electoral upheaval?

Japan is out of recession and a new government looks likely – but investors should be wary, says Rob Griffin

Japan goes to the polls tomorrow having emerged from its longest recession since the Second World War, but observers are divided as to whether these developments will make the country any more attractive to investors.

The election is widely expected to see the Democratic Party of Japan (DPJ) – led by Yukio Hatoyama – break Prime Minister Taro Aso and his Liberal Democrat Party's almost 50-year stranglehold on power, and then put forward a number of economic and political reforms.

Simon Somerville, manager of the Jupiter Japan Income fund, believes such changes will be another positive step for a country whose economy actually expanded 0.9 per cent in the second quarter of this year. "The DPJ are also committed to raising Japan's disposable income with policies more focused on the domestic economy, targeting themes such as the environment, housing, nursing care and highway tolls," he says.

Andrew Rose, manager of the Schroder Japan Growth fund, agrees. "The short-term market response is likely to be positive based on the prospect of change," he says. "This is likely to reinforce the recent improvement in market sentiment."

However, not everyone is so enthusiastic. While the improvement is an encouraging sign, and puts Japan among the first tranche of nations to pull out of the downturn, many still have their reservations.

The country may be officially out of recession, but that's not a reason to get overly optimistic about the market, maintains Simona Paravani, manager of the HSBC World Selection Portfolio range, who says she is finding better opportunities elsewhere.

"Ongoing weakness in other economic data and the Prime Minister's call for national elections have increased the overall level of uncertainty and dampened hopes of a substantial and robust recovery in equities starting in the near future," she says.

The country is still labouring under a debt equal to around 170 per cent of its GDP and has the burden of an ageing population. Consequently, even those who are positive about its prospects admit Japan is vulnerable to any global economic setbacks.

Bill O'Neill, portfolio strategist for Merrill Lynch Global Wealth Management in EMEA, is sceptical about the prospect of a repeat of the 40 per cent market surge that followed former prime minister Junichiro Koizumi's victory in 2005.

"It's likely that industrial activity will remain lower than pre-Lehman levels for an extended period of time," he says. "Unemployment is still rising, wage growth is extremely weak and government finances are under pressure."

Earnings revisions in Japan have only just started to see significant upgrades, he adds. "Our ranking of major equity markets still sees Japan at the bottom of the pile, based on valuation as well as earnings and price momentum."

Sarah Whitley, portfolio manager for the Baillie Gifford Japan Trust, believes the DPJ is probably likely to emerge victorious. "If there was a DPJ victory it would unify the lower and upper house and, therefore, make passing legislation easier and significant political reform more likely," she points out.

Opinions are mixed, but that is only to be expected with Japan, which has had something of a chequered financial history. Numerous recoveries have been promised but, almost inevitably, they have failed to become reality.

The difficulties of investing in such an environment can be seen from the performance of the IMA Japan sector over the past decade in which the average fund has lost 27 per cent. In contrast, the average Asia Pacific excluding Japan is up 121 per cent.

Only three out of 33 funds – Axa Framlington Japan, Fidelity Institutional Japan and Schroder Tokyo have actually made money during this period, according to figures compiled by Morningstar to 24 August 2009. The worst performer – Newton Japan – has shed a staggering 52 per cent.

However, investors that put their money in the country a year ago would have fared much better with a 5.84 per cent average gain – comfortably ahead of both the UK All Companies and Europe, excluding UK sectors, which both lost around 8 per cent.

So what type of investor is likely to be attracted to Japan? According to Geoff Penrice, a financial adviser with Honister Partners, it is one with a lot of nerve, who believes they can benefit from the rise in economic importance of China. "Japan has had a difficult 25 years since the property crash in the late 1980s and the subsequent banking crisis," he explains. "We have seen huge gyrations in the Japanese stock market with many false dawns followed by collapse."

However, Paul Chesson, managing of the Invesco Perpetual Japan fund, is upbeat about Japan's prospects and points out that the country is still home to some of the world's leading manufacturing companies.

"I'm optimistic about the outlook for returns over the next 12 months and think this is still a very good entry level, as a lot of the recovery in corporate profits that we are going to see over the next couple of years is yet to be factored into markets," he says.

While expecting the election to have an impact on some companies – as a result of policies being introduced – he is not focusing much attention on the outcome, preferring to look at the outlook for individual stocks instead.

"Over the last decade, Japanese companies have got better in terms of their focus on profitability, their increasing willingness to pay out excessive profits to shareholders and improvements in corporate governance – but, in spite of these improvements, stocks have been getting cheaper."

He cites Murata Manufacturing, a major producer of ceramic capacitors, which accounts for 6.6 per cent of his fund's assets under management, as a prime example of a world-class company that is being unfairly hurt.

"It has a very strong balance sheet and profitability track record," he says. "Even after the tech-bubble burst it still had profit margins of 10 per cent, so its consistency over a decade is the envy of any manufacturing company anywhere in the world."

Hugh Young, managing director of Aberdeen Asset Management Asia, agrees the main hope for improvement in Japan rests on exports, but warns the jury is out on whether global trade is reviving or benefiting from an inventory-led bounce.

He also questions whether the ways in which Japanese countries are run have changed enough to make them attractive to investors, even though their balance sheets, and cash flows within certain business types, are strong. "It is very difficult to find companies that are aligned with us as shareholders because corporate governance is less well embedded in Japan than the rest of Asia," he says. "Looking after shareholders still comes way down their list of priorities."

Mark Dampier, head of research at Hargreaves Lansdown, acknowledges that Japan has a lot of problems, but believes it is still possible to make decent returns from the country.

There is little point attaching too much importance to a rise in GDP because it doesn't always equate to profit increases, he says. The goal is to have exposure to companies that are making money irrespective of what is happening in the economy.

"The way I'd play Japan is through funds such as GLG Japan Core Alpha, Neptune Japan Opportunities, and Invesco Perpetual Japan," he says. "They have done well over the past few years as they seem to have understood it far better than anyone else."

The recent performance of the IMA Japan sector reflects the more upbeat view of the country, with each of the 56 funds showing gains for the three months to 24 August. Six of them have recorded double-digit improvements, led by Neptune Japan Opportunities and JPM Japan, which are both up around 16 per cent. The question remains as to whether the uplift is sustainable.

Paul Chesson, at Invesco Perpetual, is optimistic. The main reason the Japanese stock market has underperformed is because it was too expensive, he says, whereas now it has become too cheap relative to the outlook.

A combination of cutting costs – particularly wage bills and inventories – and expectations proving not to be as bad as expected resulted in profits increasing in the early part of this year, even though generally sales fell. "Profits will be recovering for the next three years," he predicts. "We're still at the point where this isn't reflected in prices, but in the first full year of recovery the profit uplift will be spectacular because you are coming from such a low base."

No one is pretending that Japan doesn't have issues with the domestic economy, having been dead in the water for years, adds Chris Taylor, the manager of Neptune Japan Opportunities, but it has potential.

A shift in the structure of the country and its companies, allied with the fact that most people don't have much money invested in Japan, he suggests, may well result in this long-awaited positive uplift.

"For the first time in the best part of 20 years it could be back on a sustained basis because companies are very well positioned," he says. "Everybody has written them off but I think they could spring a surprise over the next few years."