When fund managers from Jardine Fleming Investment Trust and Advisory visited Yasumitsu Shigeta at his office in downtown Tokyo a year ago, they noticed a display showing the top 10 Japanese companies by market capitalization. The company Shigeta is president of, Hikari Tsushin, wasn't on the list.Back then you could have bought shares in his telecoms firm for Yen10,000 ($98). Today, you would have to pay Yen160,000, and the company has now claimed its place in the Japanese top 10. But the display on Shigeta's wall no longer shows that listing. Instead, it shows the top 10 companies by market capitalization in the world. Hikari Tsushin isn't on the list--yet.
Companies such as Hikari Tsushin are revitalizing Japan's stockmarket, making it the second-best place, after the United States, to bet on Internet stocks. But more significantly, they're creating a new Japanese economy, where the old, lumbering industrial giants are being overtaken by nimble hi-tech and services companies led by innovative and young entrepreneurs. "We believe there has been a fundamental change," says Masato Kawada, a director at Invesco Asset Management (Japan) in Tokyo. "The new economy is about free markets, labour mobility and an emphasis on performance."
Because much of the bullishness about the new economy rests on the belief that Japan will follow the continuing stock-market surge in the U.S., the recent frenzy over new tech issues has fuelled fears that the boom is a bubble close to bursting. But while there are some excesses--with more undoubtedly lurking--most fund managers still believe there is upside to come, especially for the discerning investor.
"Despite the spectacular gains, we're optimistic," says Simon Jones, a senior portfolio manager for Jardine Fleming. "We're all firm believers in the new economy here."
And, with tech mania still on the rise, Jones doesn't appear to be alone. On December 22, a pair of young Internet plays instantly shot up to their daily limits after becoming the first two companies to trade on the Tokyo Stock Exchange's newest--and most oddly named--market, Mothers (which stands for Market of the High-Growth and Emerging Stocks). The market is the Tokyo Stock Exchange's attempt to tap into the Internet frenzy, and if its first two stocks are anything to go by, it looks to be in for some stunning gains. One of the two, consulting and technology provider Internet Research Institute, is profitable. The other, Liquid Audio Japan, expects to produce a loss for the year to the end of June. Never mind. Both stocks doubled in price on opening day; Internet Research Institute to almost Yen21 million and Liquid Audio to Yen7 million.
Just the week before, Itochu, one of Japan's giant trading companies, listed its hi-tech affiliate Itochu Techno-Science on the Tokyo Stock Exchange at Yen22,000 a share. In the following days, the value of the stock nearly tripled to Yen60,000, giving the computer-systems developer and integrator a market capitalization of more than Yen1.2 trillion--50% more than that of its parent. Its price-to-earnings ratio, meanwhile, stands at more than 200; double that of major U.S. Internet plays such as Cisco Systems or Sun Microsystems.
Growth Potential
What's most compelling about the hi-tech story is the sheer size of the industry's growth potential--despite the heady valuations. Information technology is the only area where Japan Inc. is spending, and there's about a decade of catch-up ahead for cash-starved industries such as banking. Technological retooling has become the new mantra--even for company presidents who still don't have personal computers and only learned how to send an e-mail after their mobile phones began offering the service. At this point, most analysts believe technology will be increasingly integrated into the mainstream; to survive, all companies must bring it in-house. With that sort of potential demand, why worry about valuations of 50 times earnings when a company is growing at 100 times earnings?
The hi-tech companies also appear to have a long lead over the old giants of Japanese business, which may not be able to reinvent themselves sufficiently to catch up. The traditional monopolies--which is most of the first section of the Tokyo Stock Exchange--are uncompetitive, high-cost industries that are confronting overcapacity and a still-deflationary environment. "Steel and shipbuilding have completely lost market share," says Invesco's Kawada. "And for automobiles and consumer electronics, that will be the case in the future. Their technological lead is disappearing and domestic demand is maturing. We stay away from manufacturers who can only hope for new products."
For instance, shares in Mitsubishi Heavy Industries, one of the core companies of the Mitsubishi Group, are now valued at about a tenth of what they were a decade ago; Jardine Fleming's report of the company's fortunes is titled "Welcome to Death Row." With the stock price at Yen300, tradition and history say the upside is far greater than the downside, but the most successful fund managers still consider it a sell. "Value analysis for a company that has consistently destroyed it is irrelevant," Jardine Fleming said in a recent presentation.
Even when one of the established companies has a valuable nugget, such as Itochu's Techno-Science unit, most fund managers believe that it makes no sense to buy the company for the golden bits because they are too small. Nippon Steel, for example, has a remarkably successful computer-software arm (Tokyo-Mitsubishi Securities is a major customer), but it's simply not strong enough to lift the fortunes of the giant steelmaker by itself. And that applies to most companies in the old economy, says Jardine Fleming's Jones.
"Divergence, not catch-up, will characterize the market next year," he says. "Forget a broadening out. Avoid old Japan where the headwinds are strongest and which lack the management to deal with those headwinds." Many Japanese firms also have black holes in the form of finance and leasing subsidiaries that are still reeling a decade after the bubble burst. In short, Jones says investors should wait to buy until the hi-tech arms are spun off. For example, Matsushita's hot new telecoms unit, Matsushita Communication Industrial would be a good buy, but not Matsushita Electric Industrial itself. "Get them clean," counsels Jones.
Buying Vision
Or ignore them altogether and look to the new economy. But what's worth watching there? At the core of it are some heavyweights such as Sony and the three companies of the NTT group (NTT itself, NTT Data and NTT Mobile Communications Network, or DoCoMo). Many fund managers also hold Fujitsu and FSAS, Fujitsu's communications and computer-maintenance division, which was spun off from its parent a year ago.
And of course, prominent in the new landscape is Softbank, which most fund managers still consider the best bet on the Internet in Japan. "He is the pipeline," says David Scott, a Tokyo-based fund manager for Jardine Fleming, referring to Masayoshi Son, the founder and president. "He is the logical train to jump on. It's more than a holding company; there is real synergy there. I'm investing in a vision."
To be sure, the meteoric rise in Softbank's share price has more to do with the U.S. than with the transformation of Japan; returns on Softbank's vision in Japan are still years away. But, in any case, Softbank is only the boldest and brashest of the new-economy plays attracting attention. The group also includes a new, fast-growing companies with even younger management. "The average age of the presidents in my portfolio has come down to 40 (Son's age) from the mid-60s," says Scott. Some, like Hikari Tsushin's Shigeta dropped out of university. And others, like Hiroshi Mikitani, founder and chief executive officer of Rakuten.co.jp, the largest business-to-consumer e-commerce site in Japan, are dropouts from corporate Japan; Mikitani left the Industrial Bank of Japan to start his company four years ago.
Rising Services
Technology is only part of the new economy. The other area for which fund managers reserve their keenest enthusiasm is the underdeveloped services sector. The Goodwill Group, which supplies personnel outsourcing and home-help services, is the sort of young company that typifies the new economy. Its president, Masahiro Origuchi, is only 34. The average age of his employees is 28 and 90% of them hold equity or have share options tying their fortunes with those of the company.
But even for sceptics who aren't convinced by the prospects of individual companies, or the new economy as a whole, there are other factors to justify investing in Japanese growth stocks now. For one, interest rates are so low in Japan that alternatives to equities aren't very attractive. "For years, the Bank of Japan has been trying to seed inflation with easy money," says Kawada of Invesco. "The stockmarket has been the first place to react." (Given how low those rates are, it's even more attractive for investors to borrow yen for their purchase of Japanese equities--especially if they have yen income.)
Last year, foreigners were the big buyers--they spent Yen9 trillion in the market. Some were pausing by the end of 1999 over Y2K concerns. Barring disasters over the millennium, another wave of foreign money may well make its way to this side of the Pacific.
In addition, bubble-era scars have finally faded and today individual investors are returning to the market. Many are flush with cash from 10-year postal savings accounts that are now maturing, and are attracted by novelties such as low-commission Internet broking.
Nomura Securities, for example, has 100,000 Internet broking clients. While most of them had accounts with the brokerage previously, they are three times as active now, according to Nomura staffers. Moreover, Nomura expects that number to double over the next three months alone, as investors opt for the low-stress alternative of trading over the Net. "Wherever the salespeople are particularly nasty, like in selling insurance or cars or shares, the Internet will be very powerful," predicts one Nomura executive.
To be sure, optimism over the new economy needs qualification. For one thing, while the Japanese stockmarket in the past has been utterly divorced from trends on the other side of the Pacific, that's not true of tech stocks. Many are priced off their peers in the U.S., while some of the highest of the high fliers, such as Softbank, reflect the value of their U.S. investments.
Indeed, Softbank's share price is based primarily on its stake in Yahoo!. And since many Japanese shares, such as Oracle Japan, are simply transplants, they hardly deserve to trade at a premium. So be warned: If the U.S. market slips, Japanese tech shares can collapse.
Moreover, the very divergence in the performance of the new vs the old worries some analysts. So far, the stock boom has been very narrowly based on a small number of stocks. For instance, by late November just 20 stocks accounted for 60% of gains among small-caps during the year, according to Dresdner Kleinwort Benson (Asia); in the wider market, just 25 firms accounted for 70% of the market's total gain. On the downside, as of late November, 700 stocks were trading below their levels at the start of the year.
"Relative out-performance by telecom stocks is nearly as high as that recorded by any other sector in the past 25 years," notes Ken Okamura, strategist for Dresdner Kleinwort Benson in Tokyo. "We believe a correction is highly likely."
Only Beginning
In addition, many of the young stars shine so brightly because there are so few and only a small percentage of their shares trade publicly. The over-the-counter market in Japan always has been seen as a market that is prone to manipulation and insider dealings. There have already been a few cases of abuse--one hi-tech company failed to disclose, for example, that its accountants had attached lots of qualifications to its financial statements. "Next year, there will be some major actions from the prosecutor's office to discourage such practices," warns Rikio Takezawa, a managing director at Universal Securities in Tokyo.
But for many fund managers, the real action is just beginning. With their bulging coffers, the new and quasi anti-establishment young executives could buy up their less switched-on peers--a prospect many foreign fund-managers relish. "We've got a hit list," says one. "These are companies we don't own today because the present management destroys value. But if we felt that hostile takeovers were about to happen here, we'd buy up a whole lot of candidates."
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