Like much of the rest of the world, the Japanese economy
bounced back strongly following the Lehman Brothers shock in 2008.. Overall
real GDP growth in Japan in 2010 is likely to come in quite strong, around 3.5
per cent. In 2011 however, a slowdown is likely, owing partly to the
rolling-off of government stimulus packages aimed at boosting domestic demand.

Monetary policy in Japan remains highly accommodative. Of
course, interest rates are already at zero, so the Bank of Japan has been
taking additional supportive actions. In October for example, there was a
positive surprise when a 5 trillion yen asset purchase programmed was
initiated. Moreover, there was an even bigger positive surprise in September,
when the Ministry of Finance, via the Bank of Japan, intervened in the currency
market to weaken the yen.

The currency intervention action was especially significant
because it had a really positive impact on market sentiment. Incoming data
around this time was not especially encouraging, with talk in some quarters
about a possible double-dip scenario. The currency intervention greatly
improved sentiment however, because it told the market that the Bank of Japan
would intervene anytime the yen pushed up around the 80 level versus the US dollar.

Although not reflected in the market, the recent performance
of Japanese companies has actually been very good. In particular, companies are
now reaping the rewards of actions to manage costs taken during the credit
crisis and their impact during the subsequent recovery. Although on an
aggregate basis, corporate profits are still below the pre-Lehman peak, this is
partly attributable to the masking impact of the strong yen. In fact, on a US
dollar basis, the Japanese recovery has been a little sharper than that of the
US, and overall corporate profits have now almost returned to pre-Lehman
levels.

Japanese companies have been steadily deleveraging their
balance sheets for many years. The positive effect of this has been an
explosion of free cash flows since 1990. On a free cash flow basis then,
Japanese stock looks very attractive. However, there has been a general
reluctance to step up investment levels in their domestic operations. However,
with Japan’s CAPEX [capital spending] to gross domestic product ratio currently
around an all time low, any increase in capital expenditure in the coming years
may act to offset this concern.

The Japanese market today is cheap on a conventional
price-earning basis and in terms of cyclically-adjusted PE, also known as the
Shiller PE, where Japanese equities are at their cheapest level in the last 40
years.

Of course, people say that Japan is bound to look cheap
relative to the excessive valuations witnessed in the late 80s. However,
today’s value is not only on an adjusted basis compared to its own history, but
also on a global sector-relative basis.

The strength of the yen is an important area of concern for
Japan’s export-orientated economy. The equity market is naturally sensitive to
this issue, but it is worth bearing in mind that in spite of the strength of
the Yen, quite a few of Japan’s export-driven sectors have reached the point
where they are almost at peak profitability.

What this tells us is that, up to now, Japanese corporates
have done a rather good job in terms of adjusting to the stronger currency. For
example, many leading exporters have now shifted their production overseas; in
the case of Honda, around 80 per cent of its cars are now produced overseas.

I believe in the cyclicality of earnings and the mean
reverting nature of valuations. This type of framework works well for a
manufacturing-driven economy like Japan and requires a combination of growth
and value styles as stocks work through the cycle.

When companies are performing well and achieving high
margins, they are often overvalued. They might be targets for a short position,
but investors should be wary of shorting these stocks in the absence of a
catalyst for underperformance. Technology stocks in the late 1990’s were
“overvalued” when trading around 50 times earnings. They went on to become even
more overvalued at around 100 times earnings.

Once the catalyst has triggered the break in fundamentals, a
company will eventually drop to a position where it is trading extremely
cheaply relative to its long-term history and margins are low.

This is where the value approach works best. Investors
should ask “is the business model still intact - will it therefore be able to
return to peak margin levels?” And “is the stock cheap enough to buy?”

As on the way down, the markets will move ahead of the
fundamentals and the growth style takes over and the question becomes “can, and
to what extent, the company beat earnings expectations?”