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Japan: The market that may be the outperformer of the season

The Nikkei index is up more than 7% from the start of the year, outperforming the S&P 500.

Investors interested in diversifying a portion of their portfolios internationally may want to look beyond China and the emerging markets to opportunities in Japan. The world's third-largest economy is known for such global brands as Honda and Toyota — mammoth companies reporting earnings this week.

Overall, it has been a good year for the country's stocks. The Nikkei 225 jumped nearly 1.3 percent last week after Panasonic, Sony and Japan Airlines all posted positive earnings. On Oct. 30 the Bank of Japan also announced it was not adding more stimulus to the economy, which investors also seemed to have liked.

A pedestrian browses the day's share prices displayed on the Nikkei 225 at the Tokyo Stock Exchange.
Kazuhiro Hogi | AFP | Getty Images
A pedestrian browses the day's share prices displayed on the Nikkei 225 at the Tokyo Stock Exchange.

The Nikkei is now up more than 7 percent year-to-date, and it's outperforming many other developed nations, including America's S&P 500, which is up only 1.7 percent since January. Those gains are in spite of a rocky economic landscape — the International Monetary Fund expects Japan's GDP to grow by just 0.8 percent this year and 1.2 percent next year.

Will those gains continue into 2016? Roger Aliaga-Diaz, a senior economist at The Vanguard Group, thinks they will.

Since the beginning of 2013, Japan's market has climbed by 80 percent, which is much better than the S&P 500's 50 percent gain. Part of that has been due to optimism over Prime Minister Shinzo Abe's reforms, which have included a quantitative easing program and a push to make Japanese companies more shareholder- friendly.

If everything stays the same and the country meets its IMF projections, then the Nikkei should see annualized gains of between 6 percent and 10 percent over the next five years, he said.

Getting into the market

There are several ways for investors to get into this market, from buying ETFs and mutual funds to individual stocks on the Tokyo stock exchange or through ADRs on American exchanges.

For investors who want to make a bet on the entire market or certain parts of the Japanese market, an ETF, such as WisdomTree Japan Hedged SmallCap Equity Fund or the more vanilla iShares MSCI Japan ETF, could be good bets. The former is up 15.92 percent year-to-date, while the latter is up 10.14 percent.

There are only 11 America-based Japan-focused mutual funds, according to Lipper, but all have outperformed the index this year. The Nuveen Tradewinds Japan Fund tops the list with a 17.86 percent return.

Why buy a fund? One reason is for diversification, but the other, said Mayur Nallamala, senior portfolio manager and head of Asian equities for RBC Global Asset Management in Hong Kong, is that it's an easier way to play the economy's cyclical upswing than buying stocks.

However, there is plenty for stock pickers to choose from. Investors can buy companies through ADRs on American stock exchanges, or they can purchase equities directly from Japan's exchange. There's many more options going direct than in the ADR market, said Nallamala.

There are also currency issues to consider in the short term. You'll be paying in U.S. dollars when buying an ADR, which could be good or bad, depending on where you think the yen is headed. The currency issues should balance itself out, though, over the long term, said Nallamala.

Soaring global stocks

One of the main reasons to look at Japan is that it's rife with well-managed globally competitive businesses that would do well in a diversified portfolio of international stocks, said Rajesh Gandhi, lead manager of American Century's International Growth Fund.

One example is Fuji Heavy Industries (TYO: 7270), an automotive manufacturer that owns Subaru.

About 80 percent of its earnings are generated outside the country, with between 65 percent and 75 percent of that coming from the U.S. It generated a profit margin of close to 14 percent in the last quarter, which is higher than its U.S. peers, said Gandhi. Its stock is up 30 percent over the last 12 months, while, by comparison, General Motors' share price has climbed by only 13 percent.

He also likes Murata Manufacturing (TYO: 6981), which creates semiconductor-like parts that go into smartphones, TVs and other electronics. It's a global business that benefits from changes in the smartphone market — the more complex phones become, the more it benefits, he said. Its stock is up 48 percent over the last 12 months, and he thinks it still has a lot of room to grow.

These are just two examples of growing international operations, he said, but there are many others. Tomonori Kaneko, a portfolio manager with RBC Global Asset Management, likes companies that are in globally competitive export markets, like high tech. He also likes medical equipment companies and some of the telecoms that are expanding outside the domestic market.

There are opportunities in the domestic market, too, added Gandhi. As much as the economy has been struggling, wages have expanded from low single-digit growth to mid-single-digit growth. Unemployment is coming down, too.

With that in mind, some consumer staples and discretionary stocks, like Ryohin Keikaku (TYO: 7453), which owns Muji, a popular apparel and household item retailer, could be good buys.

Looking out for the stakeholder

One of the big differences between the Japanese and American markets is that companies in the Asian nation are stakeholder-friendly, while U.S. businesses are shareholder-friendly.

U.S. companies pay dividends, engage in share buybacks and allocate capital effectively — all things equity owners like. In Japan, companies are more focused on those that have a stake in the business, like employees, who are often given jobs for life. They also tend to hoard cash.

"Japan's society is about benefiting everyone," he said. "So companies manage their business to the good of society."

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It's a noble idea, but it doesn't jive with what international investors tend to want from the companies they own: fast growth. However, the corporate culture is slowly changing.

Prime Minister Abe wants businesses to become more shareholder-friendly, in part by encouraging them to return money to shareholders through dividends and buybacks. While it's been a slow process, it does seem to be working, as evidenced by rising returns on equity (ROE), said Gandhi. In December 2011 the average ROE in Japan was around 3 percent. It's now at 8.8 percent. That's still below the S&P 500's 12.9 percent ROE, but it's clear that improvements are being made.

Japan's international operations are still a part of its stakeholder-oriented culture, but they are cost competitive, can invest money in R&D and have economies of scale when it comes to manufacturing. So while some may not offer the dividends that U.S. companies pay, they can still compete against their global peers.

This stakeholder-friendly approach is generally seen as a negative, so look for companies that are reforming their corporate culture or are at least more shareholder-focused than their peers.

Something else to watch out for: the country's economic growth. If GDP numbers come in weaker than expected, then the markets could suffer, but if the country stays the course and ultimately improves, then returns will rise.

Own a world weighting

Even with some uncertainty, though, this large market shouldn't be ignored.

"It has a large consumer base — 127 million people live in the country — with a high level of income," said Vanguard's Aliaga-Diaz, adding that it's also tied more into Chinese growth than the U.S., which could benefit the country if China starts expanding again.

He suggests holding the global market weight of Japan, about 8.2 percent, according to the FTSE Global All Cap index. It's not time to overweight the market, but he wouldn't underweight it, either.

In any case, whether you decide to add a little bit of this country to your portfolio or a lot, it's still a good idea to own at least some of it.

"You'll get similar returns as you'll get from other developed markets," he said, "but if you want diversification and large companies (you can't get elsewhere), then you should hold it."

By Bryan Borzykowski, special to CNBC.com