Investment: Beware of false dawns in the rising sun market

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ALL EYES in the investment world are on the meeting of the Federal Reserve this week, which will set a new course for interest rates in the next few months. If, as seems likely from all the comments of Alan Greenspan in recent weeks, monetary policy in the United States is now to be tightened, it is likely to lead to a period of drift in both the US and UK stock markets. This is as good a time as any to take a step back and consider the prospects of other markets in the world. Japan, in particular, is the one that seems to have the most promise.

The Tokyo stock market in the 1990s has been an unremitting horror story, proof not only of the trite observation that what goes up must come down, but that the descent from the peaks need not be as profound or as dramatic as it typically is in western stock markets. The remarkable feature of the Japanese market is how steady and remorseless its decline from the peak of 1989 has been.

For a while it looked as if the market had bottomed out in 1995 at around 15,000, but the subsequent recovery proved to be only a prelude to a further decline which took the market down to its all-time low (just under 13,000) in the autumn last year.

Since the start of this year the market has rallied strongly once more and the question is whether this is another false dawn. Underlying this is the issue of whether Japan is finally digging its way out of the financial crisis and economic paralysis it experienced for most of the 1990s. And there are positive signs that the combination of belated structural reforms and repeated economic stimulus packages may at last be having an impact.

Hopes that the Japanese economy might at last be reviving were given a powerful boost with the publication of exceptionally strong first-quarter GDP figures earlier this month. The figures implied that the Japanese economy might be growing at an annual rate of as much as 7 or 8 per cent. In fact, for a number of reasons, it is clear that this figure grossly overstates the strength of the recovery.

The GDP figures are still the first positive surprise that has come out of Japan in ages and any confirmation in the coming months of a real trend in recovery is likely to create a renewed bout of interest in the stock market, especially from foreign investors desperately seeking pockets of value in a world where investment bargains appear thin on the ground.

Barton Biggs, the global strategist at Morgan Stanley Dean Witter says: "In a tremendously overpriced world, Japanese stocks are the only stocks that are really, truly cheap." Such sentiments have been a powerful factor in driving the market this year, with the Nikkei 225 index up 30 per cent. Japan's second-tier market, composed of smaller companies, has done even better. The secondary market index is up more than 60 per cent since the low point last autumn.

Can and should investors try to capitalise on this revival? There are certainly a number of convenient vehicles for doing so. Japan is one of the few leading markets where active managers have shown they can still earn their keep. Several British fund management houses have demonstrated a consistent ability to outperform the Japanese market through the long and painful decline. Three of the best of these are listed in the table. All three funds are rated triple-A by Standard & Poor's Fund Research. The houses mentioned (Baillie Gifford, Schroder and Martin Currie) also offer investment trusts covering Japan. A number of other fund managers, including Newton, Global Asset Management and Fidelity, also offer funds which have successfully outperformed the market over a period of time.

Because the Japanese market has done so badly over the last decade, outperformance needs to be kept in perspective. On a five-year view, most funds are showing negative returns. One of the most striking aspects of the performance figures is in fact how diverse the performance of Japanese funds has been. The latest survey, carried out by Fund Research, shows the top- performing Japanese fund over five years had made a positive return of 9.2 per cent, and the worst has lost investors 83 per cent of their money. The average fund is down 29 per cent. (These figures refer to the period to 1 April this year, and will have improved subsequently.) Smaller companies have done even worse historically, so they are bouncing back from an even lower level.

Clearly, Japan should never be more than a minority component of any investor's portfolio, but if there is any substance in the long-awaited Japanese revival, there are now plenty of value opportunities to be found in the market for those with the skill to pick winners. One of the most encouraging signs reported by fund managers, including Michael Thomas at Martin Currie, is the evidence that an increasing number of Japanese companies are finally beginning to place shareholder interest higher in their priorities. There is still a long way to go before Japan Inc embarks on the kind of corporate restructuring which is common in the UK and US, and becoming more so in Europe.

Shareholder value has never been at the forefront on the average Japanese corporate mindset, but signs of change in response to the seemingly endless economic recession are emerging. This creates an opportunity for investors to buy companies cheap in absolute terms, if there is visible cause for seeing how that value might grow over time.

A subsidiary question for investors is whether those managers who have demonstrated the ability to outperform in a falling market can successfully apply their techniques if or when the market rally persists. Stockpicking ability alone is not enough: calling the currency correctly is another essential prerequisite. A fair amount of the disparity in performance between different funds is the result of the way their managers called the Yen, and how far they opted to hedge their currency exposure. So finding the right Japanese fund is not as straightforward as it might seem.

Anyone who wants to look at the Japanese market should start with a fund run by an experienced Japanese hand (as are the funds listed here). If the Japanese economy genuinely is close to its long-awaited revival, there is no need to worry about having missed the boat.

There is plenty of headroom for the Japanese market to grow, given that its weighting in the world's stock markets has fallen from more than 40 per cent at its peak in 1989 to little more than 11 per cent now. But because of the idiosyncracies of the Japanese market, there will also be plenty of opportunities to make mistakes even in a rising market.