Japan stock outperformance likely to peter out

Foreign investors have been snapping up Japanese shares at the fastest pace in two years, bargain-hunting blue-chips after the market lagged the rest of Asia in 2009, but the buying is unlikely to continue at this rate.

Fund managers are bringing their portfolios closer to neutral on Japan after having been heavily underweight in 2009, pulling funds out of other Asian markets in the past few months. But once the initial rush is over, shares such as tech stocks are still seen in demand as investors target individual growth stories.

Strong earnings at blue-chip technology firms such as Canon are expected to benefit from a broad worldwide recovery. Those companies have slashed costs and have a longer pedigree and stronger business than their emerging Asian peers.

Investors have also put a little more faith in Japan since the yen began to fall in late November, sliding back closer to exporters' assumption of 91 per dollar. Since then, the yen's drop has sparked a broad rally in the exporter-heavy Nikkei average.

But buying Japan remains a more defensive and tactical move. Its economy is suffering from a shrinking population, the highest public debt-to-GDP ratio in the developed world and record deflation, keeping it at a longer-term disadvantage to the rest of Asia.

"We're looking at a relative market here. So even if Japan doesn't plough up, there could be the argument that it won't go down as much either," said Harfun Ven, senior portfolio manager at Robeco in Hong Kong. He is slightly above neutral on Japan.

Valuations have proved tempting. Japan's price-to-book ratio, a valuation gauge which compares a company's share price to its assets, was 1.2 by the end of January, according to Thomson Reuters Datastream and MSCI. That makes it cheaper than the MSCI Asia-Pacific ex-Japan at 2.1, Hong Kong at 1.6 and South Korea at 1.5.

So far, Toyota Motors' escalating vehicle recall is not denting investor interest in other blue-chips even as its shares plunge.

Profit-taking in last year's top-performing markets helped fuel the New Year shift into Japan to the tune of 1.5 trillion yen. That supported the Nikkei last month, helping it to fare slightly better than 2009 stars South Korea and Hong Kong as investor confidence dipped.

The Nikkei hit 15-month highs in early January and as of Thursday had lost 1.8 per cent this year, less than benchmark indexes in South Korea, India, China and Hong Kong.

"There was some profit-taking in Asia, and Japan, on a pure value basis, was just the logical place to come for many investors," said Michael Newman, the head of sales and Japan equity sales at Macquarie Capital Securities (Japan).

The Nikkei ranked near the bottom of the Asian league in 2009, rising just 19 per cent compared with 68 per cent for the MSCI Asia ex-Japan index.

Foreign fund managers shunned it because the global recovery was not solid enough to lure them to its more mature, lower beta stocks, which offer lower returns in the short term than emerging Asia.

Funds began 2010 underweight Japan and in the first week of January alone foreign buying surged to a net 733 billion yen, the biggest weekly purchase since July 2007 - just before the subprime disaster started. Net buying in the first three weeks easily outpaced December's total.

Daily trading volume for big companies on the Tokyo Stock Exchange surged to seven-month peaks in early January, helped by a new high-speed trading system. Market players say hedge funds and commodity trading advisers are now more active.

Macquarie says Japan has outperformed the rest of Asia 15 times since 1994, for periods averaging 154 days. This run has been under way for about two months, so if history is a guide it could stretch into mid-year.

But the appeal of Japan's firms over those of fast-growing emerging Asia, such as greater transparency, is a hard sell.

"To be honest, it's much easier to go for Asian stocks such as China and India," said Pascal Masse, head of investment at Aberdeen Investment Management in Tokyo. "The macro picture is much easier to read, but you have a lot of corporate governance problems you don't have here."

In its favour, Japan leads in new-wave technology for batteries and electric cars. There are also signs many Japanese firms may be starting to turn the corner on growth.

Canon has forecast its first annual profit growth in three years and even Japan's second-largest bank, Mizuho Financial Group, has returned to profit.

Macquarie's top strategy picks include Canon, Nippon Steel, Panasonic and Bridgestone.

"If we can expect a stable currency market, we can expect to see the effect of restructuring by Japanese companies, and we can expect a gradual recovery in global demand for Japanese companies," said Shinichi Ichikawa, chief equity strategist at Credit Suisse, who favours tech shares and banks.

Banks were battered by worries about fund raising in late 2009. Those offerings are now mostly out of the way and the shares look relatively cheap, with a price-to-book of 0.9 compared to 1.3 for industrials, according to StarMine.

A lasting drag is the government's dithering on economic policy, especially as the impact of stimulus spending in other big economies starts to fade.