MW-25 -- Japan's Polarizing Markets

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Issue No. 25
Tuesday, April 22, 2003

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Viewpoint: Japan's Polarizing Markets

The Bottom Line:

o While the business community, opposition politicians and the
press claim that the Koizumi administration has been all talk
and no action, in reality Mr. Koizumi has kept his original
promise -- that there would be more pain before any gains
could be realized. Indeed, there has been plenty of pain,
particularly in the stock market.

o While polarization within Japan's economy and financial
markets is becoming increasingly obvious, is this phenomenon
evidence of "creative destruction," or are these instances
merely sidebars to the main scenario? Money Watch believes
that the instances of positive change pointed to by
"optimists" are basically sidebars to the main scenario, which
is one of continued economic deterioration and capital

o These instances are certainly not extensive enough to build a
benchmark-weighted portfolio of Japanese stocks, nor
sufficient enough to support a secular bull market. In other
words, yes, there may be a few interesting "punts" in Japan,
but Japan continues to be the playground of hedge funds,
restructuring funds and private equity.

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Japan's Polarizing Markets
Koizumi delivers on a promise: plenty of pain

The business community, opposition politicians and the media have
turned on the Koizumi administration, claiming that all they have seen
from the self-advertised "great reformer" has been talk. In reality,
prime minister Junichiro Koizumi has kept his original promise -- that
there would be more pain before any gain. He was absolutely right.
There has been plenty of pain, particularly in the stock market. The
Japanese stock market had already been in a tailspin since the
"popping" of the global telecom-media-tech (TMT) bubble, in which, for
a brief moment, it appeared that an IT wave may just be the ticket to
kick-start Japan's moribund economy and stock market.

But the Japanese market reversed all of the fleeting gains seen during
the last stages of the TMT bubble and then some. The Topix, which was
trying to breach 1,800 as the TMT bubble popped, thereafter lost some
35 percent in the sell-off leading up to the whirlwind election of "no
pain, no gain" Koizumi. For a brief moment (from January 2001 to
Koizumi's inauguration as Japan's new prime minister in April), the
Topix rallied, tacking on 81 trillion yen of market capitalization on
the hope that Koizumi just might be the hero that Japan had been
desperately searching for. Alas, Koizumi delivered exactly what he had
promised: more pain before any gains. After April 2001, Japan's stock
market renewed its tailspin, with the angle of descent becoming even

From the peak of the TMT bubble, the Tokyo Stock Exchange's first
section of listed companies has lost 223 trillion yen, or more than
half of the market capitalization that existed at the peak of the TMT
bubble. Moreover, 181.5 trillion yen, or over 80 percent of this
capital destruction, has come during the Koizumi administration. That
is indeed pain. Yet after three years of Koizumi "reforms," Japan is
no closer to the promised land of gains that were supposed to follow
the pain.

Japan's Two-Tiered Markets
The accelerating economic stagnation, price deflation and destruction
of capital in Japan masks megatrend-like shifts in the structure of
the financial markets, individual industries and the economy. Japan's
economy and markets are polarizing to the extent that simple averages
of various indicators are becoming virtually meaningless as
indications of what is actually going on. Japan observers have for
years pointed to the dual nature of Japan's economy, where a
relatively few competitive and global Japanese companies compete in
international markets, while high-cost, highly uncompetitive
domestic-oriented corporations are under siege from imports and a more
open Japanese economy. But these are not the only two-tiered features
of Japan's economy.

The situation of salaried workers in their 30s and 40s who are heavily
indebted with housing mortgages, children's college, car payments,
"stealth" tax increases and other financial burdens contrasts sharply
with young, unmarried twenty-somethings and retired couples living off
their pensions. The senior citizens own the bulk of Japan's 1,380
trillion yen (and falling) personal financial assets and are spending
these savings on enjoying their silver years by going on expensive
trips. The twenty-somethings are keeping the foreign luxury brand
consumer goods makers in business as they use up their parent's
savings. Economically, this is not a healthy situation. In effect, the
twenty-somethings and the silver set are spending savings; not
creating the value-added that contributes to a healthy economy.

In the property markets, nationwide property values and rents continue
to shrink. The declines are sharpest in the metropolitan areas,
particularly Tokyo, and especially in commercial property.
Metropolitan Tokyo commercial property prices are down 81 percent (as
of September 2002) from March 1990 peaks and are 53 percent below
March 1985 levels as the property bubble was just beginning to form.
Increasingly, property is being priced on the basis of discounted
future cash flows, i.e., the revenue-producing potential of the
property, not simply because prices "are expected to go up." Rents
also vary dramatically between modern new buildings with larger usable
office space, and smaller/older buildings, even if both are standing
side by side.

Space in smaller, older and inconvenient buildings is becoming
virtually unrentable. To the extent that the "ever-rising property
prices" myth has been dispelled, the polarization of property prices
is healthy. However, to the extent that property values formed the
basis of much of the recoverable value of bank loans and provided an
unrealized asset-value cushion for companies, it is only exacerbating
Japan's bad debt problem.

Even the perception of the threat posed by falling stock prices has
polarized. Japan's three major business lobbies, led by Keidanren,
continue to ring the alarm bells about falling stock prices, while the
government is more sanguine, believing that the most delicate period
-- the end of the financial year -- has already passed.

As the voting public has little money in stocks, the public outcry
from falling stocks is faintly heard. In 1998, when there was no
financial system safety net, falling stock prices to this degree could
well have caused bank runs. Now, stock prices are tanking, but the
banking sector is perceived (by perhaps the public and particularly
the government) to be much more stable than it was in 1998.

But the Japanese public and the ruling coalition politicians do not
fully appreciate the huge economic implications of plunging stock
prices. The Bank of Japan continues to provide abundant liquidity,
ultra-low levels of interest rates and is now edging toward bypassing
the financial system with direct purchases of assets. The government
keeps changing the rules to alleviate the pain of falling stock prices
on the financial system and, to a lesser extent, non-financial
corporations. But these "countermeasures" are merely temporarily
treating the symptom instead of addressing the disease. Plunging stock
prices are a barometer of economic health, and as such, are an
indication that the health of the economy continues to deteriorate.

Polarizing Index Valuations
The stock market itself is becoming increasingly two-tiered. One
snapshot view of Japan's stock market, the average forecast
price-earnings ratio for the Nikkei index, would lead one to believe
that Japanese stock prices are still massively over-valued, but that
is not necessarily the case. The valuation gap between the Nikkei,
Topix and the small/mid-cap indexes ・ the Tokyo Stock Exchange (TSE)
second section and Jasdaq -- has grown so large as to be a bit
ridiculous. While the Nikkei is selling at 112x prospective earnings,
the TSE's first section is selling at 52.8x earnings, and the second
section and Jasdaq sell at a mere 18x earnings. The return on equity
for the TSE's second section is 3.5 percent, while it is just under 6
percent for Jasdaq. Moreover, the whole TSE's second section is
trading well below stated book value.

This valuation gap has been reflected in year-to-date performance of
the relative indexes. The Nikkei is down 11.8 percent from the start
of the year; the TSE's first section is down 10.95 percent; and Jasdaq
is down 1.7 percent. The TSE's second section, however, is up by 3.11
percent. This two-tiered market, where the performance of the TSE's
second section and Jasdaq have begun to pull away from the Nikkei and
Topix, began to emerge in 2003 as selling by the domestic corporate
pension funds and the banks began to weigh heavily on larger
market-cap, "blue chip" names in the TSE's second section and the
Nikkei, and these indexes experienced substantial drag from plunging
bank stocks.

Smaller companies are also fairing better because they lack the debt
overhang of their larger peers and tend to trade at very reasonable
valuations, pay higher dividends and offer less potential selling risk
on the upside than their large-cap cousins. Better value and better
stock price performance notwithstanding, many of these companies are
languishing on the stock market, with minimum trading volumes and
less, if any, coverage by sell-side research analysts. Indeed, a
"flight to quality" by investors has them looking at only the largest
firms in any particular sector, even though the irony of this practice
is that the poorer performers have actually been the large-cap, "less
risky" stocks.

A big problem for the large-cap indexes is that market capitalization
of Japan's largest banks is imploding. At the end of March 2002, the
major four bank groups had combined market capitalization of 13.1355
trillion yen, but by April 2003, this had imploded to 5.47 trillion
yen. Conversely, the market cap of all other listed banks was 12.00
trillion yen in March 2002, but 11.477 trillion yen as of April 2003,
and market capitalization actually increased in many of the regional

Contrary to what the government would have you believe, Japan's stock
market is rationally valuing companies. Regionals like Shizuoka Bank
and Yokohama Bank now have larger market capitalization than Sumitomo
Trust, Mizuho Trust, and Mizuho Holding (which does business with 70
percent of Japan's companies and is the main banker for no less than
40 percent) has seen its market capitalization plunge to just above
that of Chiba Bank. Even Mitsubishi Tokyo Financial Group, by far the
strongest bank of the majors, has seen its market capitalization
plunge by 43 percent in the past year. The reason is fairly
straightforward. Investors could care less that Mizuho Financial is
nominally one of the world's largest banks. It's the bank's loan
portfolio and fragile balance sheet that investors are looking at.
Indeed, the major banks' bad-loan clean-up target is looking as
distant as ever as they still have 20 trillion yen in bad loans,
leaving them far behind the government's goal of reducing them to half
that level in two years. The value of a regional like Shizuoka Bank
has held up well because investors appreciate it's cleaner balance
sheet and more focused business.

With the exception of the major banks (and such government-protected
species), the trend in individual industries for the last several
years is for the strong to get stronger, and the weak to get weaker,
in terms of market share, profits and balance sheet health. While the
top sellers and providers of 100 key goods and services have seen
their domestic market shares shrink, according to a survey by the
Nihon Keizai Shimbun, the leading market share losses are attributed
to efforts by firms with the second- and third-largest market shares
who are "trying harder," to quote the famous advertisement as Avis was
challenging Hertz during the 1980s. Meanwhile, the smaller, niche
players are also doing relatively well. It is the middle ground where
the most problems are.

Given a stagnating market, firms that are doing relatively well are
either in the top five in their respective industry category, or they
are excelling in a particular niche (where they are the big fish in a
smaller pond). It is the lower-tier "integrated majors" that are
having the most trouble; they do not have commanding market shares in
a large number of the markets in which they participate, nor do they
have strong franchises in niche markets.

Japanese Stocks: Nuggets Can Still be Found, But ...
The optimists insist that, with legwork and fortitude, investors can
still find hidden "nuggets" in the wasteland of the Japanese stock
market. However, finding these Japan stock nuggets is increasingly
like panning for gold in a well-prospected stream. You can work all
day shoveling gravel for maybe a buck's worth of gold.

But if meaningful change is to begin in Japan, smaller companies stand
to gain more and have more potential upside than their large-cap
peers. These companies will also benefit from funds set up by
foreign-capital efforts to invest in and then revive small Japanese

Private-equity firms have flocked to Japan in the hope of repeating
what happened in the early 1990s in the US, when private-equity firms
rose up to restructure mountains of bad debt and went on to cash out
in the ensuing bull market. For example, Calpers (California Public
Employee's Retirement System) will reportedly be investing $200
million in a fund managed by Wilbur Ross aimed at actively
revitalizing companies. Calpers invests in similar funds in the US and
Europe. In addition, it has tied up with Sparx Management to invest a
similar amount in a "corporate governance" fund targeting Japanese
companies. Since the banking crisis of 1998, foreign investors have
invested billions of dollars into Japan in the hope of scooping up
what will prove to be bargains once Japan begins to pull out of its
decade-long malaise.

Many of the players in private equity remain the same as in the early
1990s, and most buyers of distressed debt are out to buy a security at
40 or 50 cents on the dollar and flip it for 70 cents on the dollar.
Foreign investors are not the only ones with an increasing interest in
Japanese private equity. Japan's pension funds first began investing in
private equity around 1999, but while the average exposure to private
equity investments for US corporate pension funds is around 7 percent
(or 5 percent for Calpers), it was only 1 [percent last year for
Pension Fund Association members. The interest in private equity by
the generally risk-adverse Japanese pension funds, of course, is
better investment returns, recently averaging 8-15 percent per year,
according to Thomson Financial Venture Economics. But since these
investments are still such a small part (much less than 1 percent even
for the larger domestic pension funds leading the way into private
equity) of overall assets under management, the impact on overall
pension fund performance is minimal.

Creative Destruction or Just a Sidebar?
While polarization within Japan's economy and financial markets is
becoming increasingly obvious, is this phenomenon evidence of
"creative destruction" or merely sidebars to the main scenario? From
the top-down perspective, the only evidence of change is that of
continued deterioration. There is no hint of a major turning point in
Japan's malaise in the aggregate market indexes (both falling stock
prices and record low bond yields).

At the micro-level, there are numerous examples to show that positive
change can and does take place. But Money Watch believes these
instances are basically sidebars to the main scenario, which is one of
continued economic deterioration and capital destruction.

Given the across-the-board consolidation in the dollar, investors are
now trying to reduce their dollar-based asset exposure in favor of
other currencies. Yes, it is true that the yen remains firm against
the dollar. But at the current pace of change, it is difficult to
predict that Japan is on the cusp of a major creative-destruction-
driven revival, because the instances of positive change are still too
few in number and too limited in scale to turn the tide of
deterioration. These instances are certainly not extensive enough to
build a benchmark-weighted portfolio of Japanese stocks nor support a
secular bull market.

In other words, yes, there may be a few interesting "punts" in Japan,
but Japan continues to be the playground of hedge funds, restructuring
funds and private equity.

-- Darrel Whitten

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