Morgan Stanley says these Japanese stocks have the potential to beat the market

Published Tue, Aug 31 20218:50 PM EDTUpdated Tue, Aug 31 202110:33 PM EDT

Japan's stock market performance has lagged other developed markets in the U.S. and Europe — but Morgan Stanley says investors should consider buying Japanese stocks. The Topix index has climbed around 8.6% this year as of Tuesday, while the Nikkei 225 has inched up 2.4% in the same period. Both were smaller than the year-to-date gains of 20.4% in the S & P 500 and 18% in the Europe Stoxx 600 . Morgan Stanley said in an August report that the Covid-19 outbreak was a factor affecting the performance of Japan's stock market. But the country is ramping up vaccination, which would help the economy to recover, according to the report. The bank in March drew up a list of Japanese stocks with "upside surprise" potential — and made several changes to the list in August. Shares of companies on the list could perform better than expected, said Morgan Stanley. A new addition to the list is drug manufacturer Chugai Pharmaceutical . The bank's analysts said the company's earnings per share could get a boost from the approval and sale of its Covid-19 treatments — a potential development they said markets have not fully priced in. Morgan Stanley removed pharmaceutical company Astellas Pharma and insurance firm Tokio Marine from the list. Stocks that remain on the bank's list include: Auto parts suppliers Aisin and NOK Corp Consumer electronics companies Panasonic , Canon and Ricoh Japanese bank Sumitomo Mitsui Financial Group Food and beverage firms Suntory Beverage & Food and Asahi Group Holdings Flag carrier Japan Airlines Reasons to like Japan Japanese stocks could perform well through the business cycle, said Jonathan Garner, Morgan Stanley's chief Asia equity strategist. Garner said during a webcast that many companies in Japan have made "quality" investments in becoming more productive and innovative. That has allowed firms to improve their return on equity, he explained. Return on equity or ROE measures a company's profitability in relation to stockholders' equity. "That means that even in difficult environments — such as we've had clearly during the Covid pandemic — the downward movement that we have in earnings and ROE are less severe than we have seen in the past," said Garner. "And the upward cycle when economic recovery takes place globally and locally are much more impressive and more rapid than we've seen in the past," the strategist added. But several factors could slow down Japanese firms' earnings momentum, the bank said in its report. That includes the spread of the Covid delta variant, the anticipated tapering in the Federal Reserve 's asset purchases and China's economic slowdown.

People wearing protective face masks walk past a screen displaying Nikkei share average and world stock indexes outside a brokerage, amid the coronavirus pandemic in Tokyo.

James Matsumoto | LightRocket | Getty Images

Japan's stock market performance has lagged other developed markets in the U.S. and Europe — but Morgan Stanley says investors should consider buying Japanese stocks.