Japan: Everybody Back in the Pool
Restructurings are giving investors new faith

Global investors are justifiably skittish about dipping into Japanese stocks. First, the market is already up some 30% so far this year. And past rallies in this decade have quickly fizzled. But many Japan watchers believe the market still has a long way to run. For the buy-and-hold investor, that means a Japan mutual fund might be a prudent way to offset the risk of a downturn in U.S. stocks. ''There is plenty of skepticism about Japan,'' says Paul Quinsee, chairman of the International Equity Strategy group at J.P. Morgan. ''But when everyone agrees that everything is wonderful, that's when it's time to move on'' and invest elsewhere.

Underlying the bullishness on Japan is the belief that the eight-year recession has bottomed out and that real economic changes are taking place. The government has injected money into the banks on the condition that they restructure and improve disclosure standards. That has helped to restore consumer confidence in the banking sector. And the willingness of leading companies such as Mitsubishi Chemical, Asahi Glass, and NEC to fire employees and close inefficient plants indicates ''there is a great restructuring going on,'' says Charles Clough, the global equity strategist at Merrill Lynch. For the first time, corporate management is committed to improving profitability and shareholder value.

Because restructured companies should help prop up the stock market, top fund managers have sought them out. Nicholas Edwards, portfolio manager of the Warburg Pincus Japan Growth fund, says he's ''looking for companies that are changing Japan or changing with Japan,'' and cites consumer electronics giant Sony Corp. as an example. Sony's $2 billion cut in inventories, its labor force reduction, and plant closings are reasons to expect strong returns. ''Sony's recent financial results were better than expected, and there is still more good news to come,'' says Edwards.

NIMBLE. Edwards also heads up the Warburg Pincus Japan Small Company fund, which has had year-to-date returns through Aug. 5 of 119% (table). One reason for the recent success of the small-capitalization stocks is that smaller companies can move quickly to make the necessary changes to survive in the new economy. On the downside, small companies have a hard time obtaining financing for expansion. As a result, these stocks--and the funds--are extremely volatile.

You can gain exposure to the sector with less risk through Japanese growth funds, which generally hold about 20% in small stocks. Small caps make up about one-third of the Liberty-Newport Japan Opportunity fund. ''I buy across all industries, all market caps, in search of the 35 best companies,'' says manager David Smith. One of his biggest holdings is Shohkoh Fund, which despite its name, is not a mutual fund but a popular small, nonbank financial company. Nonbank financials make loans to those who can't get money elsewhere. The business is extremely profitable when you consider the loans carry interest rates of 25% to 30%, and the cost of funds is only 2.5%. In the past 14 years, Shohkoh has had a compound annual growth rate of 40%. ''Not bad for a company operating in a sick economy,'' says Smith.

Another small-cap favorite is retailer Don Quijote. Part department store, part convenience store, Don Quijote has broken from Japanese tradition by tying pay to sales. It has also expanded its hours until midnight--45% of its business is done after 8 p.m. ''These entrepreneurs really carved a niche for themselves,'' says Smith.

A portfolio with a mix of large- and small- cap stocks is the T. Rowe Price Japan fund. Manager David Warren focuses on quality companies with strong balance sheets and stable growth. ''We're looking for sustainable growth at a reasonable cost,'' says Warren. About 30% of his portfolio is in technology stocks. Some 4% alone is in computer maker Fujitsu, which recently announced an Internet plan. He also likes Softbank, which invests in Internet startups, and has a significant stake in Yahoo! in the U.S.

If you go for a Japan fund, you're not likely to see the sizzling returns of earlier this year. But if the economy is finally headed on the right course, Japan funds will continue to ride up with it.


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Japan: Everybody Back in the Pool

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