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Investors Turn Bullish on Japanese Stocks as Recovery Quickens

While the U.S. and European markets are being battered by the sovereign debt crisis, Japan's benchmark index Nikkei 225 has been rallying over the past month, rising almost 7 percent, and some investors are turning more bullish, betting on a recovery for the world's third-largest economy.

Tokyo stock screens
Grant Faint | Photographer's Choice | Getty Images
Tokyo stock screens

Around $23 billion has been invested in the country's equity market over the last 3 months, according to data from Citigroup.

"There is surprise on the upside in terms of the macro story [in Japan] and we agree with more positive outlook. Japan has become a key investment theme for us in the next 3 to 6 months," says John Woods, managing director & chief investment officer at Citi Private Bank.

One reason Japan's getting more attention is that investors are looking to pull capital out of the euro zone and invest it elsewhere, says Ben Collett head of Japanese equities at Louis Capital Markets, and Japan is one market that is seen as undervalued.

"The Japanese market is extremely cheap by many measures," says Ryoji Musha, president of Musha Research based in Tokyo. For one, the Topix is trading just above book value, compared with 2.2 times book value for the S&P 500 .

And, says Musha, the 6 percent earnings yield (the inverse of price to earnings ratio) on Japanese stocks is the highest in the developed world.

According to Kenneth Herceg, Director of Japanese Equity Sales Trading at Citi, some global funds that have been shorting Japan have also come back to the market because they feel it offers value.

Investor sentiment has also been boosted by recent data showing Japan's recovery is well under way. Industrial output, for example, expanded 5.7 percent in May, the most in 50 years. "Demand is recovering because of strong pipeline orders emerging in construction and housing starts," says Naomi Fink, head of Japan Strategy at Jefferies.

Consumer sentiment also picked up in June and the unemployment ticked down to 4.5 percent in May from 4.7 percent in April.

Strong Yen Fails to Hurt Sentiment

What's been different from previous rallies though is the market's resilience even with the yen trading around 79 to the dollar. A stronger Japanese yen tends to be a dampner for any stock market rally because it hurts Japan's major manufacturers.

"The stock market is holding up relatively well despite a strong yen," says Yoshito Sakakibara, executive director of investment research at JP Morgan Asset Management. "As long as the yen is stable, it won't be such a bad environment for Japanese companies."

Sectors to Watch

Analysts are bullish on construction and raw materials sectors, which are seen as safe bets on Japan's recovery, but Fink of Jefferies is also bullish on sectors such as food and retail.

"Pricing power has really returned to the supermarkets. And the rise in food prices has been something they can capitalize on further along the line,"
she says.

Fink believes Japan is importing China's inflation with a 5-month lag, a scenario that could be good for Japan's deflation-bound economy. The latest data shows Japan's consumer price index (CPI) was up 0.3 percent and core inflation up 0.6 percent in June compared with a year ago.

Citi's Woods also favors consumer staples, retail, food and fisheries. "If you believe the world is in a mid-cycle slowdown, then in the second half of the year Japan's exports should pick up and we should get another impetus to the momentum story," he adds.

Ryoji Musha of Musha Research however warns investors to steer clear of financials given their exposure to EU and U.S. "Financial stocks are risky not just in Japan but all over the world," says Musha, "they are cheap, but exposure to sovereign debt in the West and domestic utility companies has made them a risky bet."