Yes, you can make money in Japan

Where do you start when you list the problems Japan faces? The country is a demographic nightmare; the government changes with the tides; and its economic “lost decade” is now over 20 years old. The planet itself seems to have it out for the island nation, regularly hitting it with earthquakes and tsunamis.

Still, there is value in Japan, even if the index statistics suggest otherwise. But it’s hard to find, says Mark Grammer, one of the three managers of Mackenzie’s Focus Japan fund. So far this year, it has eked out a profit—2.4%, with double-digit returns on the US dollar version, thanks to yen appreciation—and it’s one of the few remaining Japan-focused funds to post positive results.

One problem with Japan is that the story never changes; it’s an unending diet of deflation. Grammer began investing in Japanese equities almost two decades ago. “After the bubble burst, which is when I first started following Japan… there’s really been no discernible change that has inspired corporations or investors with respect to the Japanese economy and stock market.”

As a consequence, investing in the broad market doesn’t really work. You have to pick your spots, and pick them very well. Japan isn’t really a bustling economy, Grammer notes. “I would say that macro, there’s very little growth.”

But some companies do manage to increase earnings. “On the micro, there are isolated companies that are really good quality companies that have growth. I do manage a portion of a Japan fund, but my primary focus is global and when I’m doing that I’m scouring Japan for ideas. I do come across the occasional good company that is an anomaly to the overall Japanese market, which has no growth and not a lot of return for shareholders.”

That’s despite a market that, Grammer says, would have the godfather of value investing, Benjamin Graham, salivating.

“Valuations are reasonable in Japan. That’s not the issue. The valuations are probably at 20-year lows for the market, but the growth rate is also extremely low so the metrics that I look at, which are more the growth rate, the price/earnings growth rate in particular, are fairly unattractive, even though the P/E on an absolute basis is fairly attractive.”

That suggests a concentrated strategy—not the whole Nikkei 225, but a few selections. The Focus Japan Fund holds a small number of stocks, around 30, chosen by each of the three managers (it is going down to two managers shortly).

Still, investing in Japan seems fraught with risk: economic, political and, as demonstrated this spring, natural.

Grammer mitigates economic risk by it by owning good companies.

“The risk part of it is all in the due diligence,” he says. “Our focus is on companies with above-average balance sheets; that isn’t such an issue in Japan, because the one thing that Japanese companies do have, is very strong balance sheets. They’re probably too strong. That’s how we mitigate risk, by having a diversified portfolio of good-quality names with strong balance sheets.”

Still, there are the natural risks. For power companies with leaky reactors, March’s tsunami may prove to be an enduring disaster. But the damage is not limited to the utility sector; for other companies, the disruptions in the supply chain were potentially huge. Nevertheless, the Japanese proved resilient, Grammer says.

“Despite all the headlines we read about the nuclear leak, the Japanese really they managed it very well and a few towns unfortunately were wiped out and many lives were lost,” he says. “But if that was somewhere else in the world, it would have been a much, much worse scenario than what we actually witnessed.”

And his own holdings proved resilient too. Canon, for example, was at risk “because they had some facilities that were directly impacted, but they managed to get back on-line much quicker than anybody expected.”

Unfortunately the resilience of the Japanese people does not extend to their government. With a succession of prime ministers in recent years, laid low more by internal party bickering than the electoral voice of the people, companies dependent on state spending are highly risky Grammer explains.

“I don’t want to own companies that are going to be impacted by or are going to be reliant on government contracts, government expenditures, on anything to do with government,” he says. “I want to own companies that are dealing with industry or consumers, so we tend to avoid anything that would be touched by some sort of regulation or is in need of government revenue.”

Export-oriented companies whose revenues are growing despite stagnant conditions in Japan are key; a common theme among managers working in the Euroland and the U.S. equity spaces as well. Still, those companies may only be indirectly export-oriented.

“We own a company called Keyence Corporation. They make electronic components that are used in factory automation, so they tend to have a lot of Japanese customers. But those customers of theirs tend to be more export-oriented, so while Keyence’s export profile doesn’t look that high, their end product, or the customers’ end product tends to be exported,” he explains.

“If you look at the types of names that we own, Canon has an export ratio of about 70% and Hitachi Metals is another company that has a very high export ratio, again, both direct and indirect. Some of their products, which are used as automotive parts, may be shipped to a Japanese customer, but in the end are exported.”

Japan, in the end, is a deep value situation. “There’s a lot of companies that trade below book,” Grammer argues. “If Ben Graham were around, he would salivate at some of the opportunities in Japan But my colleagues over at Cundill, who were long-time bulls on Japan, I don’t think if you spoke to them today they would be as bullish, having gone through investing there and looking at some of these names that are value and stay value for an a long time.

“To me, there has to be a catalyst that would ignite the stock so that the value is realized and in many instances in Japan, it’s hard to see what the catalyst would be.”

In the interim, “anomalous” export-oriented companies seem to keep the Japan portfolio afloat.