How to play the 'other Japan Inc.'

When investors think of corporate Japan, they tend to think of companies with globally recognizable names like Sony and Toyota. Not only is Toyota Motor one of the biggest brands in Japan, it is also Japan's largest company with a market capitalization of US$120 billion. That's bigger than Ford, Volkswagen and BMW combined—even after shedding some $30 billion in recent losses from Toyota's recall troubles. Established in 1937, Toyota is one of Japan's oldest companies and currently makes up about 3.5% of the country's total stock market, which is dominated by long-established firms. Sony Corp. was founded in 1946 and makes up about 1% of stock market. It's no wonder then that people worldwide typically think of Japan's market as one dominated by old manufacturers whose businesses may have peaked some time ago. The casual observer can be forgiven for getting the impression that nothing new has happened in Japan over the past decade, and that the investment environment remains stagnant. As investors, we still see many of the same names we saw a decade (or longer) ago. The 30 largest companies on the Tokyo Stock Price Index today made their initial public offerings before 1999. The newest of these large listed companies, went public in 1998. What investors tend to overlook is the vast majority of “non-TOPIX 30” companies in Japan. There are 3,448 publicly traded companies in Japan, of which 1,144 (or 33%), listed after January 1999, according to Bloomberg. This is surprising considering that 1,244 U.S. companies—or 24% of all listed U.S. companies—went public (and have survived) during this same period. Essentially, Japan's stock market has attracted as much “new blood” as the U.S. in the past 10 years. Granted, most of these newer Japanese companies are small, with market capitalizations under US$3 billion. However, unlike the old dinosaurs, these are new ventures that tend to be more service-oriented rather than in traditional manufacturing. The largest segment is the Internet software and services sector, which makes up 6% of the companies that went public after January 1999. This weighting almost equals the dominant “auto” sector for the entire Japanese stock market. Additionally, these new, smaller companies are more profitable—28% have 5-year average annual returns on equity of more than 10%. One reason why these new companies tend to have higher returns than traditional Japanese companies is that they are lower in capital intensity—a measure of capital in relation to other production factors—compared to manufacturing sectors. Internet and advertising industries, for example, are usually low in capital investments. These new companies, which also include restaurant chains and convenience stores, may also be more profitable because they are succeeding at finding new markets throughout Asia. Demand for Japanese goods and services are shifting from the West to the East. For the six months ended September 30, 2009, for the first time ever, Japan's nonfinancial listed firms earned more of their sales from Asian markets than from the U.S., according to The Nikkei. After all, Asia is Japan's backyard, and Asian countries are more aligned in taste and culture compared to the West—though Asia is not homogeneous. The region's rising middle class also presents new opportunities, and a firm does not need to be large to penetrate the market. Japan has had some difficulty in the past in marketing to Western tastes, but within Asia this has proven easier. For example, Japanese convenience stores have easily expanded into Asian markets with similar product lines that were unlikely to be popular with Western consumers. MOS Burger, a Japanese hamburger chain (which uses rice buns), plans to expand to China this year. While the company has a store in Hawaii, it is doubtful it would find a receptive clientele in most U.S. towns without making significant changes. In another example, Japanese home builders are finding success building residences in China—something that would have previously seemed unthinkable given the local nature of this sector. There are many other success stories outside of Japan's traditional export sector where investors can find opportunities. Japan may be an established country and many of its large global firms are facing difficulty adjusting to the new economic world order. However, by sifting carefully under the surface, investors can uncover a variety of profitable new companies. Today, the Japanese market is comprised of more than just “old school” companies like Toyota and Sony. Investors should not throw the baby (smaller Japanese firms) out with the bath water (the overall Japanese stock market). Taizo Ishida is a portfolio manager at Matthews International Capital Management.