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SID KLEIN

Saturday, August 09, 2003

The Japanese stock market includes countless equities with clean balance sheets and extraordinary appreciation potential, having declined as much as 90 per cent from 1990 peaks. Many are somewhat higher today, having bottomed three to four years ago, even though markets everywhere collapsed since 2000. The investment in Japanese value equities has succeeded where almost all else has failed.

With price-to-operating earnings, price-to-book and price-to-cash flow ratios at historical lows, the universe of value stocks is vast, allowing for still more selective criteria. My preferred value theme, which focuses on Asia (avoiding Western related-business), exhibited strength during the worst market period since 1974. Precisely what made these stocks risk averse has ignited them, largely since last summer, when foreign fund investment into Japan turned positive, in search of superior safety and value.

In addition to having historically low valuations and their business focus in Asia, the value stocks I look for all share certain characteristics. They are not caught up in cross-holdings (shares that were held by Japanese companies in one another, but were seized by banks and now must be sold off); they are generally not held by foreigners; and they fell as much as 90 per cent since 1990, before bottoming in 1998-2000.

These stocks have been powerful versus the Nikkei 225-stock averagesince 2000, falling much less than the index during periods of market weakness, while out-performing the Nikkei during market rallies.

To illustrate, I constructed a model portfolio on Oct. 7, 2002 , that, through yesterday had gained 42.1 per cent, versus a Nikkei advance of only 7.2 per cent. This was preceded by three years of these types of Japanese value stocks trading sideways or moving higher, even as the Nikkei collapsed 12,000 points. Such strong out-performance tends to precede extraordinary gains.

The seven representative equities of that model portfolio were: Cleanup, Hino Motors, Tsutsunaka Plastics, Shinko Securities, Pioneer, Rohto Pharm and Yurtec. Each possesses some or all of the optimal qualities, while together they underscore the diversity of the extensive list of qualifying equities.

A turnaround in the Nikkei itself would truly add fuel to the fire, of course, as underinvested American and European managers continue to aggressively add Japanese shares. There are several factors poised to fuel such a turnaround.

The resolution of the greatest problems at Japan's banks is now a matter of course. Non-performing loans and excessive public shareholdings (including crossholdings) are being resolved. Having seen the worst, aided by a record collapse in liabilities, write-offs, increased reserves and Bank of Japan share purchases, the situation greatly parallels 1932 New York, where the banks' woes also peaked with the low in the market. (Last year, disclosed bad debt of Japanese banks fell by about 20 per cent, close to the amount of excess public shareholdings that they sold off, to be consistent with new legislation.)

Recognition that the banking crisis has seen the worst should itself ignite spending. The stage is set for this, as 90 per cent of respondents in a Japanese survey last quarter felt that little had been done about banking woes. In short, attitudes have nowhere to go but up; consumers are likely to resume spending once their attitudes toward the banks improve.

Also igniting enormous pent-up consumer demand, major gift-tax reform will unleash hundreds of billions of dollars into the economy, in the form of financial assets from generations of Japanese savers who have amassed about 40 per cent of the world's savings, or nearly $12-trillion (U.S.). This backlog of capital, currently stagnating at zero-per-cent interest rates, will flow to next generations through gifts, instead of having to wait for inheritances, due to changes in tax laws that are slashing taxes on gifts to as little as 20 per cent from 70 per cent. Japan's low birth rate is positive, as savings are passed on to fewer people who are in their investment and spending years.

As money moves out of 0-per-cent deposits and the economy recovers, interest rates and asset prices will increase, driving the yen higher, further benefiting our investment theme. Therefore, unlike the 1990s when Sony (a major exporter) made record highs, while the Nikkei and the yen sank, the stock investment focus today is equities that are mostly unknown outside Asia.

Liquidity indicators today are typical of major market bottoms. There are now 15 months of stock fund inflows. Bank of Japan share repurchases will reduce the float of shares. Corporate share buybacks increase each year.

Corporate costs have been falling more than revenue. Such restructuring profits precede sales recoveries, which in turn inflate the economy. The economy was bullish through 2002, yet the Nikkei kept falling to discount the completion of the banking crisis. Therefore, prices discount much today, as did the level of the Dow at its final low in 1932.

In any event, countless non-Nikkei stocks bottomed three to four years ago. Similarly, most Japanese stocks were falling for two years ahead of the Nikkei's 1990 peak. In 2003, influenced by bank and technology stocks, the unrepresentative Nikkei index finally hit a 20-year low in April at 7,604.

Having fallen precipitously through the 1990s, and now unencumbered by crossholdings or foreign ownership, many equities enjoy strong, undervalued balance sheets. As this last year's gains attest, sizeable profits are achieved by merely moving toward neutral valuation. Triple-digit returns will become more widespread among such Japanese equities, which offer the most impressive risk/reward profile anywhere, thus sustaining long-term portfolio growth.

Sid Klein is an investment adviser at MCA Securities in Montreal. He publishes a monthly market letter at http://www.sidklein.com.

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