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No crisis passes without opportunities

Thursday 15 November 2007 11:14PM

No crisis in financial history tends to pass without it creating opportunities in places where the attention of the investment community is no longer focused. It seems unlikely that this one will prove to be an exception.

It is true that some of the best opportunities in this case are almost certainly at the eye of the storm, in the banking sector itself. As long as the doubts about the true exposure to write-offs and losses of individual banks remain, the sector itself is likely to remain under a cloud. When banks are trading on yields of 8% and selling on p/es of 8-10 times, as several are, they are by definition discounting an awful lot of future bad news. In many specific cases those fears will prove to be unfounded.

Yet the wider point also remains. One example that bears examination is the Japanese stock market. While other Asian markets have been blazing away all year, Japan has been (yet again) the regional wallflower. The Tokyo market is down year to date, while most other leading markets are still, crisis or no crisis, in positive territory. There is plenty of evidence that overseas investors are finally starting to give up on Japan in frustration at its repeated failure to fulfil the sustained recovery that has been forecast off and on for most of the past decade.

In one small but telling indicator of this growing disillusion, one of the big Swiss banks recently announced the closure of its Japanese country fund, the first time since the mid 1970s, it seems, that it has closed any country fund.  Investor apathy has failed to justify the expense of maintaining the fund. The decision is reminiscent of the way that the big investment banks closed down their mining research departments a few years ago, just as the boom in hard commodities was about to take off.

Discounts on Japanese closed end funds meanwhile remain well above average. The sector experienced proportionately larger than average net outflows over the summer, despite the fact that the Japanese market proved one of the most resilient places to be during the August sell-off. In the nine months to the end of September, seven of the 20 worst performing shares in the London investment trust sector were Japanese funds.   

From a longer term perspective, however, many of the fundamentals of the Japanese stock market look favourable. Despite doubling in the last four years, the main market indices are trading at levels that were last seen in June 1986, 21 years ago, well before the final mania that took the Japanese market to a peak some 2.5 times its current level (the level to which the Chinese market seems to be heading on a comparable basis).

Based on reported profits in the last financial year, the Tokyo market boasts an earnings yield of more than 5.5%, some 4.0% above the yield on ten-year Government bonds.  Next year, on current forecasts, the dividend yield will surpass the bond yield for the first time in years, a traditional buying signal for the equity market. Dividends are growing at twice the rate of earnings, and with the payout ratio at 30%, there is clearly room for dividend growth to continue.

Meanwhile property prices are finally starting to recover, at least in the big cities, and rental yields are rising.  The inflation figures look fragile but are at least marginally positive, and the banking sector is in its best financial health for years – even more so when compared to the wilting leviathans on Wall Street. The yen is cheap, as it has been for several years, while the future of the carry trade, its longstanding prop, is far from assured. 

Yet nobody seems remotely interested in the Japanese market. After years when overseas buying alone has sustained the market through its periodic ups and downs, there have been some indications that domestic investors may finally be beginning to move into the market again, although only the most foolhardy optimist would claim that this is in danger of becoming a permanent trend. The latest worry is that after its longest period of economic expansion since the War, the Japanese economy is set to slow and may even go into recession.

The argument against buying the Japanese market is that there is no obvious catalyst to produce a fundamental repricing of the market.  For value investors, and those with a contrarian style, it was ever thus.  It doesn’t mean that the market might not be a bargain, only that the rationale for a rerating remains unclear – though the lack of clarity is but nothing compared to the fog that has settled over the prospects for individual banks. Japan is worth keeping an eye on.

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