Veryan Allen's Market Outlook

Back to Contents of Issue: May 2001

An executive summary of where the markets have been, where they're heading, and how to invest in them.

by Veryan Allen

Frankly, no one knows where the Japanese stock market will be in a year or 10 years. What is practically certain is continued volatility and a vast supply of buying and selling opportunities. Some of the potential negatives include:

Possibility of recession
A deep, global recession is possible. Japan, already weak, is an export-driven economy, and may be particularly affected.

Bad debt
It is curious how authorities always overestimate tunnel, bridge, road, and airport usage, yet routinely underestimate the bad debt situation and the efforts required to remedy it.

Overvaluation of corporate large caps
Continued overvaluation of Japan "name" large caps will be a problem. Even at current low levels, many famous Japanese companies trade at far higher multiples than comparable ones overseas. In the age of information and free capital flow, is this sustainable?

Index re-weightings
Passive index funds will likely withdraw $70 billion from Japan as the indices adjust to reflect the actual amount of floating stock.

Corporate governance
In Japan, corporate governance and investor protection remain at very low levels compared to other major markets. Political, systemic, and lack of disclosure problems remain significant risks in Japan.

But there are some potential positives as well. Bull markets begin at the point of maximum pessimism. Also, foreign money has been leaving -- and foreign money has rarely been correct on Japan. Keep your eye on:

Public mood
Public resistance to bailouts and use of public money to rescue floundering industries might allow the market to reach its own true level and eliminate the weak companies that have been propped up for years.

Technological edge
Japan continues to have globally dominant companies in many crucial technological areas, including wireless, robotics, miniaturization, and manufacturing.

Savings rate
Japan has the largest savings and a higher personal net worth per capita than any other large country -- including the US.

SME undervaluations
Many companies, particularly small and medium enterprises, trade below the book value of their assets. Legislative changes and freer capital flows may allow SMEs' true value to be realized.

Look for the following legislative changes that stand to affect trading in Japan. There are many proposals on the legislative drawing boards that could affect the markets in the future. Changes in accounting procedures, for instance, have already been enacted (see "Less Share Sharing," page 67, April 2001), and this is contributing to the unraveling of long-time corporate cross holdings. Note that with the political uncertainty in Japan, it is not absolutely certain which of the proposals mentioned here will actually become law.

Share buy-back
Japanese companies will be allowed to buy back their own shares, presently prohibited except in certain cases.

Stock options
Procedures for issuing stock options will be simplified.

Tax changes
We should see renewed efforts to reduce the capital gains tax.

Stock splits
The minimum net asset value restriction is due to be revised.

Tracking stocks
Should be allowed. These are attractive for companies who have undervalued business units but wish to maintain control of the subsidiary.

Introduction of 401K-style savings
This defined-contribution pension scheme has already been heavily watered down; its only similarity with the US 401K plan is the name. Foreign and domestic mutual fund companies are desperately hoping that this will lead to a flood of investment in the stock market, but just as the Post Office savings account rollover plan led to no such migration, it's doubtful the introduction of 401K will do so.

There are as many diagnoses for the Internet crash as there are bankrupt companies. Nevertheless, here are a few investment lessons well-illustrated by the events of the last few years.

• Inefficiency, irrationality, and psychology determine market movements. They have done so for the past 300 years and will continue to for the next 300. The madness of crowds will never disappear.

• Investors must retain an open mind and flexibility. Boom or bust, be long or short -- and be ready to change investment stance immediately if market conditions warrant.

• Profits and valuation actually do matter. Cash and cash flow are king.

• An IPO is the end of the beginning, not the end in itself. The real work starts after the IPO. The barriers to Japanese IPOs were too high pre-1999, and now they are too low.

• Most venture capitalists are not as smart as everyone thought they were. Never confuse brains with a bull market.

• Stock options and management incentives are not the panacea everyone thought. Nothing will save a bad business. Don't throw good money after bad.

• There are no defensive tech stocks. The unprofitable Net stocks crashed, but many blue chips like Sony or NTT DoCoMo went down by over 50 percent as well.

• The more influential the economist or stock analyst, or the more prestigious their firm, the safer you are in doing the opposite of what they recommend. Japan is always receiving free advice on how to turn thing around, and this "advice" is probably worth less than the price paid.

The digerati on both sides of the Pacific were very keen on the notion of separating the Net side of a company from its old-economy counterpart. They were wrong. A company can no more separate its Internet efforts from the rest of its original business than it can isolate its telephones. There is no e-business, there is just business, and business will continue to be conducted face to face, by smoke signals, by homing pigeon, by phone, by fax, and -- yes -- by the Internet. The Net is simply another step on the technological evolutionary scale. Companies that fully integrate the Internet into their operations will thrive; companies that don't or are solely Net-based will perish.

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