Internet Stocks -- When Is the Nijikai?

Many investors agree that the recent correction in tech stock prices globally was welcome. There is now a focus on quality and profitability, and the idea that Internet-related stocks are exempt from traditional valuation models is being more widely questioned.

Both Japanese and foreign investors have been eager to snap up anything dot-co-dot-jp, with the view that the world's second-largest economy is still in the Wild West days that the US Internet economy was in a few years ago. The fervor has also been fueled by the introduction of two new startup-friendly stock exchanges, the Tokyo Stock Exchange's Mothers (Market of High-Growth and Emerging Stocks) and Nasdaq Japan. The performance of some of the newly listed Internet-related stocks on Mothers, however, has been less than stellar. And as seen in the following table, almost all of the recent Internet IPOs in Japan are still sitting below their opening prices.

As an individual investor, it's likely that you did not have a chance to participate in the IPOs anyway. As is typically the case with Japanese IPOs, only a limited number of shares are made available, targeted at institutional investors and at institutional-level prices. But these stocks may become more affordable to retail investors as Japanese companies seek more liquidity by splitting stocks and lowering their minimum trading lot sizes. Other options for the individual include participating through the trading of American Depositary Receipts (ADRs), generally with more palatable lot sizes and prices than the underlying Japanese stocks, or indirectly through the holdings of Japan mutual funds. Investors of actively managed funds (as opposed to index funds) may want to pay mind to funds' holdings, as last year's high-flyers like Warburg Pincus' Japan funds have been this year's deadbeats due to major stakes in depreciated stocks like Softbank, Hikari Tsushin, and Sony.

The supply of Internet plays in Japan is still limited not just in terms of the number of shares, but also in the number of companies, further putting a premium on share prices. As more players enter the public markets, we can expect a bit more selectivity. While we can still count the number of Internet-related stocks on two hands, let's take a look at some of them.

No other stock is more synonymous with Japan's Internet than software distributor and publisher Softbank Corp. (9984 or SFTBF), an investor in many Internet ventures, including Yahoo and Yahoo Japan, E*Trade Japan, and Morningstar Japan. Softbank president Masayoshi Son has expressly set the focus of his company on the Internet, seeking to create a vertical portfolio of e-commerce cross holdings, especially in the financial services arena. Also, as one of the founding partners of Nasdaq Japan, Softbank will remain a major force in shaping Japan's New Economy.

Following in the footsteps of Softbank is Hikari Tsushin (9435), a leading mobile phone agent and an Internet investment company. Accusations against president Yasumitsu Shigeta of dubious business practices and a surprise announcement of first-time operating losses caused Kabutocho (Tokyo financial district) to lose confidence in his management. While it has sold off many of its investments, Hikari is still sitting on a bundle of Internet investments from which a homerun could theoretically emerge. Hikari may still be a gamble as a Japan Internet play, but its battered share price may be attractive to optimistic bargain hunters.

Advertising-supported portal Yahoo Japan (4689) and Japan's best-known online shopping mall Rakuten (4755) are two Internet B-to-C pure plays. And, perhaps rare for pure-plays, they are both profitable companies. Yahoo Japan also has the claim-to-fame of being the first million-dollar Japanese stock, when its shares reached a record $100 million in late January. Rakuten derives the bulk of its income from fees charged to its tenants, with online advertising representing only 13 percent of revenues. Some investors have recently shifted their holdings away from Yahoo Japan and toward Rakuten.

While not pure-plays, Internet-related service firms also look forward to a climb in Net usage in Japan. Hikari Tsushin affiliate Crayfish (4747 or CRFH) offers email hosting to small and medium-sized businesses, and Livin' on the Edge (4753) provides Web development services. Neither of these make for particularly exciting talk. Internet advertising agent Cyber Agent (4751) and its 26-year-old founder are the media's favorite success story on Japan's new breed of young Internet entrepreneurs. Homegrown early-mover Cyber Agent will face competition from foreign comers like ValueClick Japan (4759) and DoubleClick, as well as inevitable downward pressure on banner click commission fees.

In the infrastructure arena, there are Internet service providers like Internet Research Institute (IRI), Internet Initiative Japan (IIJ), and interQ.

IRI (4741), the first company to list on Mothers, and IIJ (IIJI), listed on Nasdaq but not in Japan, both target large business customers with services such as data, Web, and application hosting. interQ (9449), unique in providing pay-as-you-go "Dial Q2" (equivalent to 1-900 numbers in the US) Internet access, is moving toward subscription-based services. However, with over 3,000 ISPs in Japan, there will be consolidation in this crowded industry and a shifting focus on corporate customers.

Liquid Audio Japan (4740), still in the red like its US counterpart, provides software technology and Web services to deliver music over the Internet with copy protection. While this technology is attractive to the very vocal (no pun intended) recording industry, it's as frustrating to consumers as DVD players restricted from playing overseas DVDs. I place my bets on the consumers rather than the recording industry.

Japan's globally recognized electronic blue chips, whose revenues still come mostly from manufacturing (not necessarily a bad thing), have all come up with Internet strategies so as not to be left out of the revolution. Fujitsu (6702 or FJTSY) and NEC (6701 or NIPNY) both plan to expand the subscription base of their respective ISPs, @nifty and Biglobe. Hitachi (6501 or HIT) and Toshiba (6502), who do not operate ISPs, announced new Internet strategy plans late in the game this April. Hitachi will leverage data centers as the infrastructure for e-commerce, and Toshiba will focus on Internet-related services for mobile devices. Matsushita (6752 or MC), more familiar to consumers by product brands such as Panasonic and National, is pushing its home network concept to digitally link home appliances. Sony (6758 or SNE) sells its Internet-compatible PlayStation2 below cost and operates its ISP So-net as part of its vision for creating a high-speed network allowing users to download games and music over the Internet.

Finally, while telecom behemoth Nippon Telegraph & Telephone (9432 or NTT) stands to benefit from rising Internet usage in Japan, I view NTT not as an Internet stock but as the anti-Internet stock. With its stubborn refusal to offer less expensive Internet access over its fixed lines, NTT is the biggest barrier to growth in Japan's Internet economy. Its wireless spin-off NTT DoCoMo (9437 or NTDMY), on the other hand, enviably boasts the world's largest single mobile phone subscription base. Yet, as NTT gradually loses its monopoly advantages, NTT as well as its subsidiaries face agile competition to which it may be slow to respond.

For those who didn't get in early on the Internet boom in the US, Japan offers opportunities to participate in an Internet economy that has not yet matured. While getting in may be expensive, the upside potential may be just as high. If you haven't gotten burned yet on tech stocks, remember that besides choosing quality stocks (easier said than done), diversification is key to reducing risk. I believe that over the long term Japan is still in the beginnings of a bull market, so tech stocks should only be one part of your Japan portfolio.