Investors with a yen for Japanese stocks had good reason to celebrate in 2004, as the Nikkei finished the year with its first back-to-back gains since 1995. Now that the sun has set on 2004, however, U.S. investors bent on investing their money in foreign stocks are anxious to find out if a third year of Japanese gains is on the horizon. That's why TheStreet.com caught up with Mark Headley, president of Matthews International Capital, to get his views on the outlook for Japanese stocks. Matthews runs seven Asia-focused mutual funds, including the $200 million ( MJFOX) Matthews Japan fund. The fund was up 22% last year, easily outpacing the Nikkei's 7.6% gain. For now, Headley likes Japanese banks, which he says are at a turning point after years of bad decision making. Another favorite group is the automakers, which he says are using their manufacturing prowess to steal market share from Detroit's Big Three. He also says the sun will rise on corporate Japan again, now that it has embraced Chinese growth. What are your expectations for Japanese stocks in 2005? We continue to like the Japanese market for a variety of reasons. As bottom-up managers, the range of companies is huge and I would argue under-researched. There is a very clear effort by Japanese management to "reinvent" themselves by being more focused and profit-oriented -- lots of work to do here, but the trend is positive. Domestic deregulation is slow but real and should lead to continued asset reflation and the end of deflation. Japanese companies are also working on their pan-Asian strategies in a way they really failed to in the last decade with a particular eye to China. How is the emergence of China affecting the way Japanese companies do business? Japanese companies first ignored China, then got paranoid about China and are now generally excited about China. It has been fascinating to watch. Today, Japanese companies are free to move manufacturing to China in a way they felt they were socially not allowed to a few years ago. This should really help competitiveness and profitability. They are also very excited about the domestic Chinese market, where Japanese brands are well-recognized and valued, but we are worried that many will have the typical difficulties that newcomers to China always have.
OK. Let's get down to it. Which stocks do you like? What sectors do you like? We continue to focus on financials, consumer retail and technology, particularly domestically focused technology like Internet companies. This is what we do in all our portfolios, and at the moment at least the strategy is working well in Japan. Banks in particular are hopefully at a real turning point after a lost decade, and they represent a broad play on things going right domestically in Japan -- our core holdings are Sumitomo Trust and Mizuho Holdings. Have Japanese banks finally cleaned themselves up after all these years? The banks are, at best, halfway there. The worst have been shut down and the rest are certainly better than they were. The real challenge is to build smart, profit-oriented operations going forward, and I believe that the ones that succeed have a very bright future in the domestic Japanese economy. Toyota (TM), Honda (HMC) and Nissan (NSANY) have been stealing a lot of market share from the Big Three. What can we expect from them? Japanese auto manufacturers are very smart and should continue to do well. It is a very tough business, but one where Japanese manufacturing skills really pay off. What is the overall state of the domestic Japanese economy? The domestic economy is showing real signs of life, with property prices in Tokyo rising for the first time in many years. The recovery in Tokyo has yet to take hold in the rest of the country. Confidence has been steadily improving for both consumers and corporations, but 2004 ended with some weaker numbers, and everyone worries in Japan that the U.S. will have a big problem at some point. Japan has no natural resources of its own to speak of. How are rising commodity prices affecting them? Japan is squeezed by higher energy and commodity prices, but unlike the U.S., they have spent the last 30 years improving their energy efficiency. Most of their manufacturing is very high-end and should not be too badly affected by higher input prices. But this is a worry for Japan and all of Asia. Japan is traditionally an export-based economy. How will a weakening American consumer affect their economy? Will Japanese consumers spend enough to pick up the slack? The real challenge for Japan, in my opinion, is whether or not the economy can continue to grow in the face of U.S. consumer weakness. With the dollar weakening and interest rates going up in the U.S., one has to expect we Americans are going to start saving some money someday. I believe that there is enough pent-up demand in Japan and enough growth opportunities in Asia for Japan to grow through a U.S. slowdown, but the hardest people to convince may well be the Japanese, who can't really remember what a healthy domestic economy is. Consumers are spending, but cautiously.
Japan is a large holder of American debt. One of the doomsday scenarios for the U.S. is if they stop buying U.S. Treasuries or sell their holdings. Is this a plausible scenario? Japanese investors are very risk-averse and so I wouldn't expect any sudden shifts. And where the Japanese government is the holder of U.S. debt, don't expect any changes, as they are very concerned about a weaker U.S. dollar. A weak U.S. dollar will cause individuals and particularly corporations to rethink their strategies over time. I am hopeful that one long-term trend will be Japanese buying their own stock market again, which would be the best catalyst to the next leg of a bull market. They are absurdly underweight domestic equities, and I believe this will gradually change. A weak dollar may speed up the process. How strong or weak can the yen get against the dollar? Where do you see the currency going by year-end? We really swear never to make currency predictions, and the Asian crisis taught us that anything can happen. Hopefully the dollar has seen its worst days, but I would hazard the guess that the risks remain that the dollar will continue to weaken over the medium term.