MW-37 -- Dogs of the Nikkei

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J@pan Inc Magazine Presents:
M O N E Y W A T C H
Commentary on the week's music technology news
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Issue No. 37
Tuesday, July 29, 2003
Tokyo

++ Viewpoint: Dogs of the Nikkei

The Bottom Line:

o The Industrial Revitalization Corp. of Japan (IRCJ) continues
to delay in announcing its first corporate revival candidate,
and the state minister in charge admits that companies and
banks have been less than eager to jump into the corporation's
arms.

o The media was reporting that its first revival candidate may
be a bus company based in Kumamoto. The amount of debt
involved is peanuts. It would take over 330 of such companies
to make a serious dent in the IRCJ's 10 trillion yen of
funding. But the IRCJ's COO has said the agency could only
handle about 20 companies at a time.

o At the pace the IRCJ is going, a year of the five-year mandate
will have passed even before it starts working on its chosen
list of revival candidates, and it would not provide any
significant favorable impact in terms of reducing the mountain
of nonperforming loans or eradicating deflation.

o If it's relatively small peanuts, the banks may just do it
themselves, just as some of the major banks have already
started doing. It is ironic, however, that there was no
movement to revitalize weak borrowers among the banks before
all the government corporate revival initiatives began.

o The "Dogs of the Dow" strategy, which invests in the highest
yielding 10 stocks (or five, known as the "Puppies") at the
end of each year and holds them for a year, is a famous
passive investment strategy in the US that still seems to work
most of the time. Year-to-date, while the US "Dogs" have
under-performed the US indexes, the "Puppies" have been
outperforming the major indexes handily.

o While not as consistent, the "Dogs of the Nikkei" seems to
work most of the time as well, even though the major precept
for the US (i.e., that the Dow 30 stocks are proven blue chips
with strong balance sheets) is more tenuous in Japan's case.
Moreover, if the original 10 "Dogs of the Nikkei" were bought
in 1994 and held to 2003, investors would have lost only 23.6
percent of their capital, compared to a 58.3 percent plunge in
the Nikkei index. Of course, you could have preserved your
capital and even made a decent single-digit return if you had
just bought a Japanese government bond and sat on it for 10
years.

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++ Viewpoint: Dogs of the Nikkei

The government trumpeted the formation of the Industrial
Revitalization Corp. of Japan (IRCJ) as a major solution for Japan痴
deflation problem. Other government agencies such as the Bank of
Japan, the Financial Services Agency (FSA) and even the National Tax
Administration have offered their support for the new organization.

Corporate executives say they are "cautiously optimistic," think tanks
have tentatively estimated an uptick in terms of the IRCJ's impact on
Japan痴 GDP growth, and US Ambassador to Japan Howard Baker has
described the IRCJ a "market-driven" entity to facilitate corporate
restructuring and help reduce Japan's pile of nonperforming loans.

But from the onset, Money Watch has been skeptical, particularly
regarding expectations that the IRCJ can single-handedly conquer
deflation. The IRCJ was actually almost an afterthought to the "hard
landing" Financial Revival Program initiated by Heizo Takenaka soon
after he assumed his post as minister of the FSA. A bill was rushed
through the Diet to form the organization, and those tasked with its
formation have been scrambling to put together the organization
within the promised timeframe.

Despite a funding allocation of 10 trillion yen, the IRCJ痴 COO,
Kazuhiko Toyama, says that the corporation does not want to tackle
more than 20 corporate revival projects at one time because the IRCJ
has a staff of just 120 people. Toyama insists that the IRCJ is "not
in the business of rescuing banks," and he emphasizes that the role of
the body is not to "buy up nonperforming loans." Moreover, it will not
focus on the weaker credits, i.e., those that "are in danger of
bankruptcy." This supposedly is the job of the Resolution and
Collection Corporation (RCC).

The IRCJ instead will be focusing on debts of basically viable
companies that need "special attention." But, ironically, it is
those loans to big borrowers classified as needing "special
attention" that have been the most problematic. This is because
the main banks to such troubled borrowers had tended to classify
these credits as "needing special attention" rather than as "in
danger of bankruptcy" in order to avoid having to take more
stringent loan-loss reserves on their exposure. The fact is that
30 or so of the most troubled borrowers that form the core of
the worst nonperforming loans would ostensibly not be eligible for
revitalization by the IRCJ.

Initially scheduled to announce the first batch of rehabilitation
candidates as early as June, the IRCJ is still looking for its
first corporate "patient." What has been brought to them to date is
small peanuts. The IRCJ would have to revive over 300 such companies
to make a serious dent in its 10 trillion yen funding, and it needs to
help many large firms rebuild their operations if it is to have a
major impact on the economy. Thus the news that the first company that
the IRCJ will reportedly work to revive is a relatively small regional
bus company, Kyushu Industrial Transportation, came as a
disappointment.

Money Watch hopes that the revitalization of Kyushu Industrial
Transportation, if reports are true, will be just a warm up
for the IRCJ. If not, it will have little, if any, impact on the
mountain of nonperforming loans and on eradicating Japan's persistent
inflation.

Competition with Other Agencies?
The IRCJ was not designed to focus on medium- and small-company
revival -- or was it? Ostensibly, the IRCJ has plenty of competition
for the revitalization of medium- and small-sized companies.

METI is launching corporate turnaround committees -- smaller
versions of the IRCJ -- in every prefecture. These committees bring
together accountants, tax specialists and other experts to help
smaller firms put together turnaround plans. But these committees
have no funding source and have to persuade a number of banks to
extend fresh loans to assist the three companies in rebuilding
their operations. The committees can also request help from the
IRCJ if there is a complex web of loan claims on these ailing
firms. In fact, they have already approached the IRCJ regarding
two of them.

The role of the RCC was previously expanded to include corporate
revitalization in cooperation with the Development Bank of Japan. The
bank has poured 100 billion yen into corporate turnaround initiatives
over the past two years. The bank has already supported a total of 37
corporate revival projects in the period running from May 2001 through
June this year, with most of the money coming in the form of
investments in funds set up to rehabilitate ailing companies and loans
to help failed companies stay in business while they restructure.

The Development Bank is already providing 40-50 billion yen to revival
funds that spread out investments among many firms as well as funds
set up to support the restructuring of a single company, such as Daiei
or Seibu Department Stores. Financing assistance to failed companies,
including Mycal, Niigata Engineering and Nagasakiya, apparently
totaled around 40 billion yen.

However, the role played by the Development Bank of Japan in the
area of corporate revival could become even larger as the IRCJ
begins to take on rehabilitation projects.

Since the banks fear that they may be taken to task yet again for
poor management, some of the major banks have decided to do for
themselves what the IRCJ proposes to do. Some of the four major
banking groups are forming their own corporate revitalization
frameworks by tying up with foreign financial institutions, giving
them no incentive to sell loan claims to the IRC if they are not
satisfied with the IRC's purchase prices.

A Sumitomo Mitsui official said, "We've just done by ourselves what
the IRCJ aims to do" in drawing up a revitalization plan for Meisei
Electric. As part of the revitalization plan, the telephone and phone
parts maker issued new shares to institutional investors and major
shareholders, including the Daiwa Securities SMBC group, and/or
struck debt-for-equity deals with them. Meisei Electric also
withdrew from the money-losing telecom equipment business and
restarted operations as a company specializing in aerospace
observer systems.

Another problem is that government affiliated public corporations
have problems waiving outstanding loans. The outstanding loan
balance at government-affiliated financial institutions accounts
for 20 percent of the total figure at all domestic financial
institutions. In some industrial sectors, such as railway
services and steel making, government lenders have made loans
comparable to the amounts extended by their private counterparts.

As the funding for these corporations has traditionally come from the
fiscal investment and loan program (FILP), all loans ostensibly
have to be paid back in full. As a result, they cannot allow debt
waivers in situations other than legal reorganization
proceedings. The Finance Ministry fears that debt waivers by
government-affiliated institutions, unless decided upon in accordance
with clear-cut rules, could lead to moral hazard on the part of the
borrowers or add to the costs of taxpayers.

Public financial institutions could thus prove to be among the
more difficult creditors for the IRCJ to convince. A recent
example was East Japan Ferry, which chose an alternative route to
revival than the IRCJ because of the difficulties in having all
creditors agree to use the IRCJ for a company's rehabilitation.

Bottom-Up: The Dogs of the Dow and the Nikkei
The basic theory of the classic trading system known as "The Dogs
of the Dow" is that the 30 Dow Jones Industrial stocks represent
well-known, mature companies that have strong balance sheets with
sufficient financial strength to ride out the rough spots in
earnings. In December 1993, Barron's claimed that using this
strategy returned 28 percent for 1993, which was two times the overall
gain of the Dow Jones industrial average, two times Nasdaq, four times
the S&P500 and better than 97 percent of all general US equity funds
(including Fidelity's infamous Magellan).

In the 20 years to 1996, the strategy lost money in only three years,
the worst a 7.6-percent drop in 1990. In the 10 years to 1996, it
returned 18.26 percent. The methodology was so trustworthy that asset
managers offered and continue to offer mutual funds based on the
strategy. During the tech bubble of the late 90s, the Dogs of the
Dow strategy was up 28.6 percent in 1996, 22.2 percent in 1997, 10.7
percent in 1998 and 4 percent in 1999. During the difficult bear
market years in 2000 to 2002, the Dogs of the Dow were up 6.4 percent
in 2000, down 4.9 percent in 2001, and down 8.9 percent in 2002; this
basket of stocks significantly outperform the Dow, S&P 500 and Nasdaq.

The "Puppies of the Dow" tries to do the Dogs of the Dow one
better by selecting the five "Dogs" with the lowest stock price.
Proponents (http://www.dogsofthedow.com) claim that investing in the
Puppies of the Dow would have resulted in a 20.9-percent average
annual return since 1973.

Year to date, the simple average return of the Dogs of the Dow
basket (with equal dollar weightings for each stock) has returned
a simple average return of only 5.2 percent, versus a 9.2-percent
return for the Dow Jones average, and a nice 27.4 percent return for
Nasdaq. The Dogs basket has under-performed the US market indexes.
However, the Puppies of the Dow have returned 37.1 percent and handily
outperformed the benchmark US equity indexes.

The Dogs of the Nikkei--A Good Bet Most of the Time
The rally to date in Japan is unusual in that individual
"punters" (i.e., very active semipro investors trading online)
have to a large degree led the rally, first by trading the Jasdaq
stocks and then moving into the low-price "penny" stocks on a
rush of foreign buying and the bailout of Resona Bank. As a
consequence, there has been a noticeable shrinkage in the number
of stocks that had been priced for bankruptcy (i.e., trading
under 100 yen per share). Given the sharp gains in the "penny"
stocks seen of late, Money Watch crunched some numbers to see if the
infamous Dogs of the Dow strategy also works for the Dogs of
the Nikkei.

Using the same methodology (i.e., ranking the 10 stocks with the
highest yield on expected dividends at the end of each fiscal
year and giving each an equal dollar weighting) produced many of
the usual high-yield suspects, particularly Kansai Electric Power
and Chubu Electric Power, as well as a revolving group of "old
Japan" companies, including Toyobo, Toa Gosei, Taisei, Yokohama
Rubber, Toa and Showa Shell, with guest appearances by Sekisui House,
Tomen, Marubeni and even Toshiba (in 1994).

In terms of simple average returns for the 10 Dogs of the
Nikkei since 1994, they have outperformed the Nikkei index on an
annual basis in 1994, 1997, 1998, 2000, 2001 and 2002, or six of the
last 10 years. The "Puppies of the Nikkei" (i.e., the five high yield
stocks with the lowest stock prices) also outperformed the Nikkei in
1999, making the smaller group seven out of 10.

While the Dogs of the Dow are supposed to represent well-known, mature
companies that have strong balance sheets, this is not necessarily so
for the Dogs of the Nikkei, as some have periodically been, at
least in terms of stock price, on the short list for bankruptcy.
Extremely poor growth prospects and in some cases shaky balance
sheets notwithstanding, the Dogs and Puppies also outperform the
Nikkei index on an annual basis the majority of the time.

Even if you bought the original 1994 "Dogs of the Nikkei" stocks
and held them to 2003, you still would have been better off than
the Nikkei average, as the 1994 group of stocks declined by a total
of 23.6 percent during the last 10 years, whereas the Nikkei index has
plunged 58.3 percent.

-- Darrel Whitten

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Written by Darrel Whitten info@asianbusinesswatch.com

Edited by J@pan Inc staff (editors@japaninc.com)

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