The resurrection in Japan is real

While you would expect Japan fund managers to be optimistic about the prospects for this market, a number of other managers who run more diversified funds and are not compelled to invest in Japan are increasing their exposure.

"We see profits rising rapidly over the next 12 months as the economy rebounds from the devastation of the tsunami," says Robert Farago, head of asset allocation at Schroders Private Banking. "An easing of monetary policy that brings a weakening currency will provide an additional boost to a corporate sector that has proved adept at cutting costs after two decades of deflation."

He and other investors make the case for Japanese equities because they are historically cheap and may be great value. They offer some downside protection as it is assumed they couldn't fall much further, so have less downside risk than US or Asian equities. Japan is one of the cheapest developed markets; around 40 per cent of the companies on the Tokyo Stock Exchange are trading at price-to-book ratios of one or lower: a book value of lower than one suggests that a company's shares are trading at a discount to its assets.

Following the disaster last year, Mr Farago expects decent economic and earnings growth over the next 12 months, and as Japan had a banking crisis 20 years ago its banks are healthier than their western counterparts. Japan is also less correlated with other developed markets and, in 2008, for example, didn't perform as badly.

"Japanese equities are cheap both relative to their history and to other international markets," says Alastair Mundy, head of contrarian investments at Investec Asset Management. "We see signs that Japan is finally changing for the better from a corporate governance perspective; cross-holdings have come down significantly, companies are showing increasing willingness to cut costs and reduce bloated staff numbers, and are demonstrating an increased focus on balance sheet efficiency. Countless studies have shown that cheap Japanese stocks outperform the market, with this applying to a number of value metrics."

There has been an increase in interest from foreign investors in Japan who have been largely underweight, and this could push up share prices. There are also signs that domestic retail investors, also underweight, are showing interest in equities, and even a modest inflow of assets into domestic equities would have an effect.

The weakening of the currency, the yen, is helping exporters. Global growth investment trust Ruffer Investment Company has nearly a quarter of its assets in Japanese equities, its largest sector exposure. Its managers are hopeful that the weakening Yen will help the Japanese market and say that in February their holdings in financials rose by 15 to 20 per cent, with more cyclical stocks also posting healthy gains.

"Given that companies and investors in Japan have become so accustomed to falling prices, the effect of a small amount of inflation could be dramatic; a growing top line will quickly reveal the cheapness of companies that have been cutting costs and prices for years," they comment.

Meanwhile James Sullivan, co-manager of the CF Miton Special Situations Portfolio has the fund’s second-largest equity allocation in Japan. He points out how Japanese companies are focusing more on selling to their neighbours in Asia. "People should perhaps view Japan as a wealthy Asian economy. Growth in Asia remains and there are cheap Asian companies domiciled in Japan. It is an untruth that Japanese companies have little growth potential. Companies in the Topix have achieved earnings per share growth of 200 per cent since the peak of the technology bubble in 1999."

With full recovery to supply chains after the earthquake, tsunami and Thai floods, and with reconstruction pressing ahead, managers expect that the ability of companies to increase profitability should be easier over the coming months. "As production normalises, especially in the automobile sector, we believe the trade balance will move back into a surplus in the second half of the year," says Pinakin Patel, client portfolio manager at JPMorgan Japanese Investment Trust. "Industrial production was stronger than expected and the near-term outlook is also upbeat. Additionally, there was a further improvement in the headline manufacturing, consistent with the optimistic outlook for a continuation of the recovery in production."

Risks

Just because shares are cheap doesn’t mean they can't fall further. "We remain bullish on Japan but caution that the market has rallied substantially so far this year," says Adrian Lowcock, senior investment adviser at Bestinvest.

Japan's economy faces massive economic problems, including national debt of around 205 per cent of gross domestic product (GDP), while constant changes in government mean it can be hard to enact decisive policy.

But this does not mean individual companies will have problems, according to John MacDougall, manager of Baillie Gifford Shin Nippon investment trust. "Despite the events of 2011, some areas of the Japanese economy experienced very impressive rates of expansion, including e-commerce, smart phones and energy-efficient products," he says. "Some of these companies in dynamic sectors are run by younger, more entrepreneurial managements who should be able to generate strong earnings growth irrespective of whether the broader economy is expanding."

GDP doesn't necessarily reflect the health and growth opportunities of individual companies. "Investors are well advised to differentiate between companies that are trapped in the lethargic home market and global players that do a large portion of their business overseas," says Ernst Glanzmann, fund manager of the JB Japan Stock Fund at Swiss & Global Asset Management.

"Many global companies have learnt to innovate and flexibly adapt their business strategy to tap the higher growth potential abroad. And they don't have to go far: Japan is surrounded by growth markets. Around 50 per cent of exports go to Asia."

This also makes Japanese exporters vulnerable to a slowdown in the world economy. But Japan has among the highest developed world GDP forecast for 2012, albeit partly as a result of industry increasing following the disasters of last year.

While a weaker yen is welcome for Japanese exporters, if it continues to weaken this poses a problem for UK investors translating it back to sterling as it will dent returns.

"Like for Europe, our recommendation to investors is to enjoy the liquidity-fuelled rally in equities but stay sober, recognising the huge structural issues," advises Karen Guinand, member of the investment strategy team for private banking at Lombard Odier.

Read our assessment of Japan one year ago

Japan investment trusts

Source: Morningstar as at 2 April 2012

Open-ended Japan funds

Source: Morningstar as at 2 April 2012