Japanese stocks offer a way to bet on a resurgent China

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By some measures, Japanese stocks are cheaper than they've been in a generation.

The question is when investors will be rewarded for scooping up the apparent bargains.

Hiromichi Tamura, an investment strategist with Nomura Securities Co., argues that Japanese equities are trading at levels low enough to warrant a 14 per cent return by year end. But he cautions that the gains depend on a recovery in China, Japan's largest trading partner.

Given the downward trajectory of recent Chinese indicators, most investors may want to bide their time before buying into Japan. But what is beyond question is that Japanese stocks have become cheap by several yardsticks and an intriguing play on an eventual global recovery.

More adventurous global investors are already dipping their toes into Japanese equities. According to Ministry of Finance data, foreigners purchased more than a $1-billion (U.S.) in Japanese equities last week, ending six weeks of sharp selling.

To be sure, Japanese investments have disappointed global investors since the economic collapse in 1990. The Tokyo Stock Price or Topix index, the country's broadest measure of equity performance, sits almost 75 per cent lower than its peak in December of 1989.

Skeptics voice doubts about the outlook for Japanese companies to improve earnings given the country's high public debt and cooling export markets. They point out the market is already trading for more than 20 times earnings, a relatively high level.

The counter argument is that Japanese stocks have reached levels in terms of their price to book value and dividend yield that have not been seen since well before the nation's bubble years of the 1980s.

Japanese stocks are by far the world's cheapest major market in terms of their book value, a rough measure of what they would fetch in the event of a liquidation. They trade for less than one times book, which is far below their 1.5 average over the past 10 years. In comparison, the S&P 500 in the United States goes for 2.2 times book.

Dividends also indicate Japanese stocks are bargains, according to Ryoji Musha of Musha Research. The Topix is generating a 2.6 per cent dividend yield, more than three times the yield of the government's 10-year bond.

Mr. Musha believes that the yield differential will compel bond investors to move into equities, pushing stocks higher. "This is a positive signal of the same magnitude as the negative signal at the peak of the bubble [in 1989]," he said in a recent interview with the Financial Times.

The Japanese market has staggered this year in the wake of last year's devastating earthquake and slowing global growth. The Topix fell 11 per cent in the second quarter as corporate earnings tumbled almost 20 per cent.

Mr. Tamura believes companies and markets are adjusting to slowing global growth and says the earnings outlook is about to improve.

"We think the latest round of downward [earnings] revisions has run its course," he writes. "We recommend long positions in stocks and sectors for which all the bad news is likely out."

He points to electronics giant Toshiba, robotics and automation leader Fanuc and chemical provider Showa Denko as beaten down stocks that fit the theme.

Still, the outlook for Japan ultimately hinges on a vibrant Chinese economy that can provide a strong market for Japanese products. On Wednesday, Tokyo reported an 8 per cent decline in exports, the latest sign that Chinese government measures to stimulate their economy has not taken effect.

For investors, the silver lining in the crumbling export numbers is the increased likelihood that the Bank of Japan will loosen monetary policy to support the nation's economy.

"We think the BoJ's [neutral] stance could be responsible for holding back the rebound. That said, we think Japanese equities could catch up rapidly with global equities if the BoJ shows signs of easing," said Mr. Tamura.