MW-62 -- Small Caps: Where Doing Your Homework Pays Off

J@pan Inc Magazine Presents:
Weekly Financial Commentary from Tokyo

Issue No. 62
Tuesday, February 3, 2004

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++ Viewpoint: Small Caps: Where Doing Your Homework Pays Off

The Bottom Line:

o The US GDP slowed in the fourth quarter to half of the third
quarter's torrid pace, but more unsettling to US equities was
the hint that the US Federal Reserve is debating when to shift
monetary policy gears. As Money Watch has pointed out several
times in the past, shifting monetary policy gears will mean an
interim correction as far as stocks are concerned. But the
Fed has been careful to point out that it will be "patient,"
i.e., careful not to change gears prematurely.

o Ironically, the US dollar痴 short-term reversal is spooking
the equity market because of American dependence on Asian
government purchases of US treasuries to keep a lid on US
interest rates in the face of ballooning twin deficits. While
everyone ostensibly wants a stable US dollar, dollar stability
also implies a reduced need for Asian governments to intervene
in the currency market, and therefore, reduced purchases of US

o While global sell-side strategists have recently become even
more bullish on Japan, the Topix has basically trended flat so
far in 2004, hobbled by strong yen concerns, cross-holding
unwindings and market jitters regarding the signals the Fed is
trying to send the markets.

o The leading Topix sectors in 2004 -- the basic materials and
banking sectors -- have now gone into consolidation to be
replaced by those sectors mainly left on the sidelines during
the 2004 rally. Real estate has rallied on hints of firmer
property prices, and Japan痴 IT sector has perked up given the
recent IT sector market leadership in the US as well as the
global indexes. But given the market jitters surrounding
efforts to cap the euro痴 rise and Fed signals on future
policy moves, the Topix could remain heavy on the upside for
the time being.

o The Jasdaq, however, is not so fettered and is much better
supported by active individual trading through online
brokerages. It has already bounced back from the individual
investor sell-off in the third quarter of last year and could
well lead the next rise in the Japanese market, just as it did
in last year's rally. Current pricing in Japan's emerging
stock markets (the second section of the Tokyo Stock Exchange,
Jasdaq and TSE Mothers) is much more of a "seat of the pants"
affair than the first section of the TSE. This means there is
ample potential for excess returns provided that you do your
homework. Pricing anomalies abound on the TSE 2 and Jasdaq
because of: a) under-coverage by the sell-side, b) continued
growth in new listings where coverage is essentially dropped
after the first year, and c) trading more dominated by
individual investors and punters based on limited financial
analysis of each company.

o Screening for deep value stocks in Japan produced the usual
suspects -- companies languishing under the thumb of a
majority owner parent company or deeply indebted companies
that were alive simply because their main banks did not want
to have to take write-downs on their loans. Investing in such
deep-value stocks was a waste of time, because webs of
cross-holdings protected such firms from takeovers. That has
now changed. In 2003, there were 52 cases of takeover bids in
Japan, for a total purchase price of 1.74 trillion yen. Such
"value" transactions are beginning to change the market value
of underutilized assets in Japan.

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++ Viewpoint: Small Caps: Where Doing Your Homework Pays Off

US GDP growth in the fourth quarter undershot market expectations
somewhat, recording 4-percent growth versus a torrid 8.2-percent
increase in the third quarter, with essentially all GDP components
slowing. Full 2003 growth was 3.1 percent, the fastest since 2000, and
the general perception is that the US economic recovery is becoming
more balanced. Of concern to Japanese exporters, however, is the fact
that US personal consumption (core personal consumption expenditure
price index) increased at an annual rate of only 0.7 percent in the
fourth quarter, the lowest quarterly gain since 1962, and just 1.2
percent for the year, which matches a 38-year low.

On the other hand, exports grew at the fastest pace in seven years in
the fourth quarter, aided by the weaker US dollar. The good news is
that the more modest GDP growth number helps to allay the markets'
fears of a change in direction in US monetary policy. The Fed spooked
the markets following the Federal Open Market Committee meeting on the
27th and 28th of January by dropping its mention of "a considerable
period of time" in its comments. Traders took this to mean that the
Fed is preparing the markets for an eventual change in its ultra-
loose monetary policy.

The sharp reactions to any hint of a change in the Fed's monetary
policy indicates that investors have already discounted high
expectations on the Fed's keeping its loose monetary policy "for a
considerable period of time." Despite dropping its "considerable
period" wording, the Fed is still insisting that it can afford to be
"patient" about changing gears on monetary policy.

Dollar Rebound a Double-Edged Sword
There has been much hand wringing about the dollar's depreciation and
what it potentially means for investments in US assets. Verbal
intervention by euro monetary authorities, the Fed's hint that it
would like a freer hand with monetary policy and continued massive
intervention by the Bank of Japan have acted to put a floor under the
US dollar.

Discounting the expectation that a rate hike in the US could be
brought forward, investors have started to move money out of the euro
and back to the US dollar. Everyone ostensibly wants a stable dollar.
Ironically, the rebound in the dollar is being taken negatively in the
US bond and equity markets. It has also mirrored a sell-off in gold.
The US dollar index has bounced off an 84.80 low recently, after
plunging 29 percent since January 2002. It is now bumping up against
its 50-day moving average, which is still falling. On a weekly basis,
the dollar index is still in oversold territory versus its 40-week
moving average and could easily stage a rally of 9-10 percent and
still remain firmly in the clutches of a bear market.

The flip side of the US dollar -- gold -- has stopped its solid rising
trend since last April, a run in which it tacked on $100 an ounce of
value. Gold future prices have sunk below their 50-day moving average,
and on a weekly basis could fall to $380 before finding support at the
40-week moving average, which is presently at $377.6. This would
represent a 12-percent consolidation from recent highs of $431.5 per
ounce. While this interim reversal is happening, the US stock and bond
markets are not likely to take it well, as the shift from an excess-
liquidity-driven market to a fundamentals (earnings) driven one
capable of absorbing higher interest rates always involves an interim

A large factor in the ability of the Fed to keep US rates in check
despite soaring twin budget deficits has been massive purchases of US
treasuries by Asian central governments, especially Japan. It makes
investors nervous to consider the implications of a more stable dollar
because the Asian governments will feel less compelled to maintain
their current pace of purchases of US debt. Also, the US trade deficit
of $550 billion a year ($46 billion a month) and the projected budget
deficit of $477 billion ($40 billion a month) won't go away if the
dollar rallies. Investors are concerned about: a) possible shifts in
the inflow of foreign central bank funds into the US treasury market,
and b) possible shifts in Fed monetary policy.

Consequently, Nasdaq is headed for support at its 50-day
moving average of 2,007.5, which would represent a correction of
7 percent -・the first real correction since a mid-December low of
1,887.5. If the Fed miscues in its current dialogue with the financial
markets, or there is some indication that Asian central banks are less
willing to purchase US treasuries, Nasdaq could easily correct 12
percent from current levels to its 40-week moving average of 1,814.3.

Sectors that Will Take the Brunt of the Interim Correction
The US sectors that have so far and could continue taking the brunt of
this interim correction are the ones that rallied substantially while
the tech and telecom stocks were languishing -- basic industry stocks,
which have been the most favorably supported by the excess liquidity
that has been driving the stock market recovery from the trough in the
first quarter of 2003.

High-flying basic materials companies like Freeport McMoran Copper and
Gold (FCX), which surged 4.7-fold from late 2002, have already sold
off 22 percent and have broken down below their 40-week moving
averages, indicating that the correction will be more than just a
short-term (a few weeks) one. The profit-taking in the junior gold
stocks could be even more substantial.

Conversely, the gaining sectors are starting to look very familiar to
those sectors that were soaring during the IT boom. In particular,
communications technology and wireless communications have finally
come to life, along with other IT sectors.

Global strategists at some of the major investment banks have recently
become even more bullish on Japan. While Money Watch turned bullish in
November after pointing to an interim market correction last October
(Money Watch No. 53, "The Bloom is Off the Boom" -- link provided
below), we find it difficult to build a scenario whereby the Japan
market continues to rally in the face of an extended correction in US
equities. For the world's developed equity markets where global funds
can come and go as they please, there is effectively no international
diversification benefit, leaving only the relative strength of the
currencies as the main factor in incremental returns. A rally in the
US market means rallies to varying degrees in all other developed
equity markets. Vice versa, a correction in the US market means
increased investor caution regarding the other developed equity
markets. Thus, if what we are seeing in the US market is the beginning
of an interim correction brought about by a shift in the main driver
of equities from liquidity to earnings fundamentals, then the
Japanese, the European and other developed markets are in for the same
fate to varying degrees.

However, continued "patience" on the part of the Fed regarding US
monetary policy will buy additional time and hopefully limit the
current correction to a short-term speed adjustment. At the beginning
of the year, the operating assumption was that the Fed would not shift
gears on monetary policy before the presidential elections.

A more stable (if only temporary) US dollar would ostensibly be a
windfall to Japan's export-oriented blue chips, but could be offset by
significant instability in the US stock market. Moreover, the obvious
weakness in US consumption has ominous implications for Japanese
companies that sell a significant amount of consumer goods products in
the US. With profit margins already squeezed by the strong yen, weak
consumer demand in the US would exacerbate this with weaker sales
volumes, creating a double negative for profits.

In addition, the profit-taking being seen in the US basic materials
sectors is also evident in Japan. The Topix iron/steel sector is off
1.3 percent over the past month, and metal products are off 0.4
percent. Individual companies like Sumitomo Metal Mining (code: 5713)
are off 16 percent from recent highs and are beginning to sink below
their 13-week moving averages. The list of top gainers during January
consists essentially of late-coming sectors left out of the first
stages of the rally, while the Topix has been essentially flat (+0.4

The earnings results announced by Sony (6758) sent mixed signals to
investors. The negative surprise of the third quarter was followed by
the "good news, bad news" of the fourth quarter. The earnings results
of other majors, while better, were also less than impressive. The
reported profits of Toshiba (6502), NEC (6701) and Fujitsu (6702)
are all largely dependent on their semiconductor operations. When they
are good, profits rebound. When they are bad, profits implode in a
manner similar to a typical basic materials company merely riding the
waves of industry cycles -- in this case, the silicon cycle.

Toshiba, which should have been enjoying strong demand for digital
consumer electronic products, continues struggling with its PC and
peripherals business, where it expects to report a 26.5-billion-yen
deficit. The combined profits of all three of these companies are 47
billion yen, while Canon (7751) alone produces operating profits of
over 45 billion yen. Thus it is not surprising that the market
capitalization of these three companies combined is more than 4.4
trillion yen, while Canon's is 4.9 trillion yen.

But strong yen fears and excess supply from domestic cross-holding
unwindings have hardly fazed the smaller companies. The TSE second
section has risen 6.8 percent in January, while Jasdaq has surged 7.7
percent. Jasdaq more than doubled last year, corrected over 20 percent
in October-December and has been on the rebound in 2004. A lot of the
third-quarter correction in Japanese stock prices last year was
individual investors taking profits (and their lumps) on trades gone
bad and clearance of their margin positions.

The move of Jasdaq痴 biggest and brightest star, Yahoo Japan (4689),
to the TSE first section also had an impact, but Jasdaq stocks have
bounced back. Individual investors trading on the Internet like
Jasdaq because of the higher volatility of stock prices. One example,
Fields, has seen its stock price plunge 68 percent only to see it
rebound 93 percent just as rapidly as it went down. It gives an
indication of how volatile these stocks can be. In relative terms,
however, the market capitalization of these stocks is not small, so
"small caps" is a misnomer. Indeed, the market cap of Jasdaq痴
largest companies is larger than most of the TSE second section
stocks and indeed many of the first section listings as well.

As Topix waffles because of a) an unstable US dollar, b) shifting
investor perceptions regarding US interest rates, and c) cross-holding
unwindings by large financial institutions, prices on Jasdaq should
continue to be well-supported by active individual investor trading.

Talking to fund managers who have survived the Heisei Malaise in Japan
provides interesting insight and useful adages. One rule of thumb is:
"Sell a stock when the company builds a new headquarters." Money Watch
has had personal experience with this adage with Olympus (7733), NEC
(6701) and Toshiba (6502). Indeed, NEC and Toshiba have yet to recover
the glory they enjoyed at the time their headquarter buildings were
built in the late 1980s. Another is: "Sell when your file of broker
reports on the stock becomes substantially thicker than your other

Japan's 200 largest companies in terms of stock market capitalization
and revenues/assets dominate the print and online media in terms of
information flow. They also can afford to spend the most money on
investor relations, disclosure, and corporate social responsibility.
Moreover, most of the major investment banks and research houses
provide investment research on them, because they: a) are benchmarks
for the industries they represent, b) have the most potential
investment banking business, and c) occupy the largest position in
holdings of Japanese equities by domestic and foreign investing
institutions. Consequently, given the amount of publicly available
information about these companies, the incremental value-added of
doing additional research on such companies is marginalized by the
amount of research and information already available. Moreover, it is
also likely that these companies are the most "fairly valued" among
Japan's listed companies. Thus the "alpha" (excess) returns available
from additional research on these stocks is limited. For a large
pension fund simply wanting to match the market capitalization-
weighted return of the market as a whole, that's fine.

But what is the real object of investing in equities? To Money Watch,
it is to produce excess returns commensurate with the risk incurred.
There are over 3,600 companies listed in Japan, and the number is
growing daily. Effectively, decreasing portions of Japan's listed
companies are being systematically covered by the "sell side." They
are either too small or their business models are not of interest to
the sell side.

This leaves plenty of scope for investors willing to do their homework
in terms of doing research on under-covered stocks in Japan. Examples
of gross mispricing in Japan痴 small markets abound.

Historically, screening for deep value stocks in Japan produces the
usual suspects -- companies that were languishing under the thumb of a
majority owner parent company, or deeply indebted companies that were
alive simply because their main banks did not want to have to take
write-downs on their loans. Earlier attempts by outsiders to force
change at these companies were futile because of the web of
cross-holdings and a general "circling of the wagons" when unfriendly
takeovers were attempted. Money Watch remembers two in particular. In
the early 1980s, a Hong Kong investor attempted to gain a majority
holding in Katakura Kogyo. When it was discovered who was buying
Katakura痴 stock, the Japanese brokerage companies in the end simply
refused to accept buy orders from the individual in Katakura痴 stock.
Another was the infamous Boone Pickens purchase of Koito Seisakusho, a
Toyota keiretsu company. Boone was also rebuffed.

This has now changed. In 2003, there were 52 cases of takeover bids
for Japanese companies, for a total value of 1.74 trillion yen. Some
of them were the targets of "recovery" funds; others were the result
of management buyouts; others arose from companies restructuring their
business groups; and some were the result of direct investment by
foreign firms trying to gain a foothold in the Japanese market.

Some examples included:

a) Foreign direct investment by foreign firms looking for a foothold
in Japan. Mars, a major US manufacturer of food and pet-care products,
spent 23.6 billion yen in acquiring Nippon Conlux, one of Japan's
leading producers of coin mechanisms and note validators. Nippon
Conlux has developed Japan's first general-purpose note validator and
the world's first LSI-mounted coin mechanism. UK food retailer Tesco
paid 31.0 billion yen to acquire C Two-Network. The friendly
takeover of all 78 supermarkets of C Two-Network gave Britain's
largest retailer a jumpstart in the Japan market.

b) New York-based Cerberus Group formed an alliance with Germany's
Hypovereins Bank and GE Capital to pay 103.1 billion yen for a
majority interest in Aozora Bank, which was on the block again after
Softbank found that the restructuring of the bank was too big a task
for it to handle. Cerberus already held a 12-percent share in Aozora,
the former Nippon Credit Bank, and was the fourth largest shareholder.
Interestingly, Cerebus had to compete with Sumitomo Mitsui Bank for
the right to buy out Softbank's 49 percent and had to overcome
management resistance to being sold to a foreign capital-affiliated
group. In an unprecedented move in the Japanese banking industry,
Cerberus chose Hirokazu Mizukami, a senior Sumitomo Trust & Banking
Co. official, as its new president. Such uncharacteristic headhunting
from a rival bank is a result of Cerebus痴 relentless determination to
ensure a return on its investment.

c) Ripplewood Holdings continues to expand its exposure in Japan and
is overcoming initial domestic aversion to the group as a buyout fund.
It paid 4.2 billion yen for Asahi Tec (5606), a major producer of cast
iron, cast aluminum and aluminum wheel products. The deal was
ostensibly amicable M&A, with Asahi Tec announcing its approval of the
takeover bid and previous holders such as NGK Insulators tending their

d) Kito was acquired by the Carlyle Group for 4 billion yen, then
delisted so the group could concentrate on turning the company around.

e) The newest foreign player to make a splash is Steel Partners, which
is buying Yushiro Chemical Industry (5013) and Sotoh (3571). The Sotoh
purchases has becoming a contested bid, with Steel Partners raising
its bid price on January 26 in response to a rival bid by Daiwa
Securities・Group痴 NIF Ventures.

Japanese investors have long had a fixation on "growth" for small-cap
companies, which unfortunately in many cases turns out to be a myth.
Japanese companies continue to list on Jasdaq and Mothers in
increasing numbers. But there is much chafe with the wheat in these
new listings. Japanese institutional investors have long shunned most
small-cap and even mid-cap stocks with market capitalizations below
40-50 billion yen because of liquidity risk.

Thus the Heisei Malaise has produced growing numbers of companies with
shrinking market capitalization that are being ignored by the
sell-side and most of the buy-side companies that are often in "old
economy" sectors like textiles, food and real estate -- where the myth
of growth has long since evaporated. But there are now new pools of
money backed by an investment strategy of finding companies with
under-utilized assets that can be better deployed with better
management or a change in business model. With continued unwinding of
cross-holdings by Japan痴 domestic institutions, companies with ample
cash, liquid assets and big unrealized profits on property or other
assets are now easy targets for buyout funds using other people痴
capital for the buyout.

NIF, for example, intends to borrow about 17 billion yen from Mizuho
and Shinsei banks for the Sotoh bid and to repay the loans after
acquiring Sotoh with Sotoh痴 own cash reserves. In other words, a
Japanese investor is attempting to take over a company using a
leveraged buyout strategy.

For Japanese banks and other financial institutions, this is
potentially a lucrative source of new loan growth, along with new
syndicated loan formats for larger projects.

-- Darrel Whitten

Money Watch No. 53

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Written by Darrel Whitten

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