Most investors gave up trying to find anything to like in Japan. Mark Headley is forced to find good plays -- it's his job as manager of the ( MJFOX) Matthews Japan fund. Like everyone with exposure to Japan, Headley's fund has had a hard time of it, losing 2.87% a year on average since its December 1998 inception through March 31. That trounces the 8.6% average annual loss of the benchmark MSCI Japan index, but you can't eat off relative outperformance when everybody is losing money. Nonetheless, Headley -- a top pick in
this week's Five Winning Funds on Japan -- is finally starting to see real promise in the country. The 30-odd stocks in his fund range from giants to micro-caps, a balance that has helped Matthews Japan smooth out the rough patches. We talked with Headley about what he likes and doesn't like about Japan, what could turn things around for the nation's second-largest economy and if the U.S. really has Japan-like symptoms these days. What have you learned after nearly five years of running a fund in Japan? We launched this fund at the end of 1998. Straight out of the gates, we put a fair amount of money in small caps. And the Japanese market exploded higher. People kept saying, "You guys timed the market bottom when you launched the fund!" The fund rose 107.4% in 1999, slightly below the category average that year. It's been three bitter years. (Laughs.) We certainly took our lumps along with the rest of the group. Bets on technology and financial companies have been a disappointment. I came into Japan with extensive experience in Korea after that country had to make tough reform decisions. I had a profound sense that Japan must fix its financial system of all is lost. While I still feel that the country will reform itself, their efforts have been frustrating. Rather than deal with it, they will endlessly half-deal with it. The Asian financial crisis forced other Asian countries to confront the problems in their systems and take drastic measures to rectify matters. The country remains rich. Japanese citizens have trillions of dollars in savings. The nation has lower unemployment than the U.S. They haven't gone through a great depression, opting instead for a slow, grinding mini-depression. But corporate dynamism and organic economic growth have been sacrificed by slow-motion deleveraging of their bubble in the 1980s. Now the question is: Where do you go from here? Japan's wealth is in fact something of a lifejacket from an economy that has suffered horrible management. The old method worked so well after World War II and they just can't seem to let go of it. People talk about a new generation being necessary to revitalize Japan. It's slowly starting to happen. The funny thing about Japan is they've done everything wrong that they could and they are still there. If your economy falls apart, even if you are Argentina, people still go to work. You can't write off a country as large and diverse as Japan -- many companies have good management, good technology, good brand names.
The economy is still there, the wealth is still there. There still doesn't seem to be an impetus for a recovery. On the other hand, nobody expects them to do anything well ever again. At this point, any positive surprise will be a shock -- not just to global investors, but to the Japanese themselves. How is China's ascendance going to affect Japan? A lot of Japan watchers see great benefits here for the entire region. Japan has been late to the game into China. I keep reading history books about the Japanese society. What I've realized is Japan had really thought that it had become a Western country. But it hasn't. Japan hates that China is discussed endlessly as the model for other Asian countries, while Japan has become an example of what the Asian countries don't want to be. However, I see Japan reintegrating back into Asia. Its corporations are finally adjusting to the fact that competing head-on with China in low-cost technology is suicidal. You have to do 50%-60% manufacturing in China to be successful. Individual companies figured it out a long time ago. Honda ( HMC) is a very sophisticated global operator, for instance. NTT DoCoMo ( DCM) is starting to come out of the dark. Then there are the others, like a Sony ( SNE), who have been slow to restructure. Why do so few Japanese have any confidence in their markets? Whatever happened to all the talk about the flood of money that would come when Japan's $1 trillion stashed away in individual's post-office savings plans matured beginning in 2000? The great postal rollover! (Laughs.) That played a big part in the run-up in 1999 -- that this huge savings dam would be unleashed. Part of the reason individuals didn't invest in the markets is that they were getting 5% returns in their savings plans -- not bad for a country with zero-percent interest rates. They still didn't invest in the markets when they rolled over at 0.5%. The Japanese are all so afraid of putting their money into Japanese stocks. The mentality of the Japanese saver, understandable after more than a decade of market losses, is: I don't care if I ever make money again, I just don't want to lose anymore.
However, they are looking for change. If things to start to get better, you'll see them coming back. Equity ownership in Japan is about 5% of their portfolios. From that base, if things start to go right, it could be a lot of fun. You don't need 4% GDP growth; 2% could be good. If you start seeing 5% to 6% return on equity, which is still half of the U.S., it would mark an upward trend. There is an awful lot of money on the sidelines. The only people in Japan are deep value investors. Poor Jean-Marie Eveillard! I heard him talking two years ago at a conference about the values he is finding in Japan, but the market hasn't caught up with him. However, the negatives are priced in and the underlying strengths of Japan as a leading technology center and brand center remain. You have Shishedo, the makeup-products company; Nintendo in games, etc. You're no longer paying the Japan premium. Some are cheap, some remain relatively expensive. But it's not this massive valuation where you multiply everything by three. The valuations, based on depressed earnings, look pretty attractive. It's been a blue-chip bear market for three years now and we're seeing a lot of companies look cheap. You can buy Honda at 7.5 times 2003 earnings, Shimano at 18 times earnings, Nintendo at 17 times earnings. My portfolio has a price-to-earnings multiple on a forward basis of 19, with forward earnings per share at 25%. I like that scenario. At zero interest rates, getting good quality growth companies is a nice thing. Japan doesn't have another leg down in derating. This huge cash level sitting there means it's like Switzerland. It's not a high-growth economy, but it's got a lot of cash. (Laughs.) Their citizenry is sitting on a huge pile of cash. And there are individual companies you can get really excited about. It does come down to looking at individual companies. Even if the government doesn't make sense, the companies make sense.
Ultimately, the financial system in Japan is priced for bankruptcy. And it can't go bankrupt. I know -- never say never. I might be deluded, but in a worse-case scenario, they are priced so cheaply that even a 50% to 70% dilution won't kill them. I've taken a lot of pain in the financial sector. When Japan Inc. finally turns around, these banks are going to turn up and they are very leveraged to a turnaround. Your fund runs the gamut from the mega-caps to the micro-caps. What leads you to like some of the smaller fry? I have a young Canadian working with me, Jason Aiken, who's been living in Japan for seven years. He's really the expert with the small caps. And the little guys have really helped the return of the fund. I didn't have the confidence to make big bets there until he came onboard, because you really have to know your stuff to get into small-caps. We've built a combination of quality blue-chips with nice, exciting small-cap growth stories. I hate to plug competitors, but look at Fidelity Japan Smaller Companies and Small-Cap Japan and Dimensional's index fund. There's been a bull market in Japan's small-cap stocks. It's very different investing in big-caps or small-caps. But there are tremendous diversification benefits. The blue chips tend to be globally oriented -- the Hondas and the Sonys. The small-caps tend to be domestic-oriented, drawing 90% or so of their revenue from Japan. If you have a global rally, the big guys go up. And if the global market weakens, the smaller companies hold up better. We believe the domestic story is ultimately very strong. The benefits of Asia's economic evolution can often flow to the small companies sooner than the big-cap companies. With the Matthew Korea fund, we've outperformed by investing in small companies. The big companies tend to represent the old system. In Japan, they have huge numbers of employees. It takes years to shed workers. Small companies don't face that problem.
Would you give an example of a favorite big-cap and a favorite micro-cap? On the big companies side I like Nomura Securities ( NMR), Japan's one remaining global financial company. In Japan, Nomura is completely dominant -- they are the Fidelity, Merrill Lynch and Charles Schwab rolled into one. If there is a recovery, look out. The outside competitors are gone, really; Charles Schwab ( SCH) packed it in. Over the long term, Nomura is very valuable. And it doesn't have all of the dangers that the big banks do -- the horrible loan books. How does it look on a valuation level? It's not dirt cheap because it is the blue-chip play among financials. Nomura trades at a 16 P/E based on last year's earnings, and it's going to go up to a 40 P/E because of an earnings shortfall. But on a price-to-book basis, at 1.7 times, it's cheap. While nobody's forecasting great earnings growth, the earnings will normalize and the P/E will stop swinging. It is a $20 billion market-cap company, but its position is so dominant that it's justified. How about the micro-cap side? You can contrast Nomura with Monex, the online brokerage and investment advice house that has built up a substantial business.
Its Japanese-language Web site is: They compete with E*Trade ( ET). They just began offering Vanguard funds, which gave the stock a pop -- they are trying to create a business for the middle-class yuppies to invest. Over time, there is going to be an opportunity for massive growth for a Charles Schwab-like low-cost broker in Japan. And it won't be Schwab because they pulled out. You'll have Nomura owning the lion's share, but a small innovative company like Monex can deliver in a Western style can make great gains. It doesn't have ADRs. It's tiny. As of the end of May, it was $130 million market-cap company. It's a micro-cap Japanese financial play. I'm only comfortable owning because I see the CEO a few times a year. (Laughs.) The guy is an ex-Goldman Sachs official, he has good backers, only about 45 employees and plenty of cash. It's a very long-term play that in a positive environment, it can be a big hit. www.monex.co.jp .
What should investors avoid when surveying the Japanese market? I would say if you are counting on rapid economic growth, you may suffer. It has been brutal for Japanese companies that can only grow earnings with the economy. On the other hand, companies that can grow and gain market share without being dependent on the economy are doing much better. That said, we do own Fuji TV, which is dependent on advertising. But predicting when a pickup in ad spending is going to happen is tough. I look for both a turnaround in Japan and companies that control their own destinies. That's what the portfolio consists of. There are companies that are moving very slowly -- Mitsubishi Electronics is one. It's so big and so complicated, and management is so unwilling to make necessary changes, that its decline is moving faster than its restructuring. Last question: Do you give any credence to the notion that America might be in the beginning of a Japan-like downward spiral? I do worry. I live in the Bay area. It is really a bit bizarre that the Nasdaq could've fallen 80% and yet the real estate market moved up. Is that real, or did we just move the bubble over? If so, we will learn what Japan did -- that declining property values is more devastating to consumers than stock market declines. I don't think we'll have a Japan, but we did put off the pain by pumping up property with interest rates. And that can be hard on consumption. I do make sure my portfolio isn't overexposed to exports to the U.S. I don't think we're going into a 12-year minidepression, but we could have several years to work off this property binge. We all want to see rates go higher, cause it means we have some genuine growth. But it also means that the mortgage-refinancing boom is over and that all those Americans who took adjustable mortgages with low rates in the short term are in for a painful surprise when rates go up.