From the May 2007 issue of Wealth Manager Web • Subscribe!

May 1, 2007

Pacific Overtures

Japanese stocks have long trailed other Asian markets. During the five years ending in February 2007, the average Japan fund returned 12.9 percent annually, while Asian funds outside Japan returned 21 percent. But the Japanese could be picking up steam. In recent months, the Japanese gross domestic product has been growing at an annualized rate of more than 5 percent--double the figure for the U.S. Many companies are reporting double-digit earnings gains.

That is a big change from the recent past. Beginning in 1989, Japan suffered a 15-year period of stagnation and recessions. Banks struggled with heavy debt burdens. Committed to providing lifetime employment, corporations refused to lay off workers who no longer produced profits. Then gradually, the economy recovered. After writing off bad debts, banks became healthy. Corporations restructured and started moving aggressively into developing Asian markets. Now Asia accounts for half of Japan's exports. Sales to China and other emerging markets are climbing 15 percent annually.

While the Japanese economy is growing, interest rates on 10-year government bonds remain around 1.5 percent. That has made borrowing costs tiny and encouraged Japanese companies to increase their spending on capital goods. The low interest rates are also providing an incentive for Japanese consumers to buy stocks. Most Japanese now have their savings in bank accounts that yield 0.2 percent. Unsatisfied with such a tiny return, some people are beginning to buy mutual funds and stocks. The retail investors could start pushing up the stock market.

The impact of the new retail investors began to become clear in 2003. During that year, Japan funds returned 38.1 percent. For the next two years, the funds produced double-digit returns. In 2006, the funds suffered losses, as business scandals undermined confidence in stocks. But that blip now appears to be in the past. In the three months ending in February, the average Japan fund returned 5.1 percent.

Whether or not Japanese stocks skyrocket, they can still provide excellent diversification. As the history of the last three decades has shown, Japanese markets do not move in lockstep with Wall Street. Part of the reason for the divergence is that Japanese real estate and banking markets are not necessarily correlated with counterparts in the U.S. In addition, Japan's stock markets are composed mainly of industrial and cyclical companies, such as Honda and Nikon. In contrast, the U.S. markets are dominated by service businesses, such as American Express and Wal-Mart Stores. While business is becoming increasingly global, industrial and service businesses do not necessarily rise and fall at the same times.

Which Japan fund makes the best choice? To find a winner, we turned again to the eight-part screens developed by Donald Trone, chief executive officer of FI360, a consulting firm in Sewickley, Pa. Trone's due-diligence process seeks to find funds that are at least three years old and have a minimum of $75 million in assets. At least 80 percent of holdings must be consistent with the category. One- and three-year total returns must exceed category medians, as must five-year results if the fund is that old. Alpha and Sharpe ratios must also top category medians. The expense ratio must fall below the top quartile.

The screens narrowed the field from 43 contenders down to 11. Top finishers included JP Morgan Japan and T. Rowe Price Japan. But we awarded the title to Fidelity Japan, which had the top five-year returns.

Fidelity achieved its winning record by following a disciplined approach, buying companies with strong market niches and sustainable earnings. While the fund falls in Morningstar's growth box, veteran portfolio manager Yoko Ishibashi is careful to avoid pricey picks. "She has consistently stuck to buying growth at a reasonable price," says Dan Lefkovitz, a senior Morningstar analyst.

The average holding in the portfolio has been reporting annual earnings growth of more than 11 percent. Though it owns stocks of all sizes, the fund falls in the large-cap box, and many holdings are big blue chips. Ishibashi particularly likes companies that are reporting earnings surprises. One of the fund's biggest gainers recently has been game maker Nintendo. The shares have more than doubled in the past year, as sales gains surprised Wall Street. Nintendo had long been the number-three player in the field behind Sony and Microsoft. But lately the laggard has jumped into the lead, helped by its breakthrough Wii console, which enables participants to play realistic versions of tennis and golf. "The Wii gaming system is beating everyone," says Morningstar's Lefkovitz.

Another exporter in the portfolio is Toyota Motor. The auto giant sells for a modest price-earnings ratio of 15, even though the earnings are growing at an annual rate of 13 percent. The company seems likely to continue increasing earnings. Toyota is gaining market share in the U.S. and around the globe. Sales gains are particularly strong in the emerging markets. Toyota dominates Japan, with a 40 percent market share. Even in the home market, the company is gaining sales.

Fidelity is also buying stocks that should benefit from the growing Japanese market for mutual funds and investments. One of its holding is Sumitomo Trust & Banking, which is a leading asset manager. The bank oversees private accounts for wealthy clients and also offers products for middle-income consumers.

A big advantage for Fidelity Japan is its low expense ratio of 1.05 percent. In contrast the average Japan fund charges 1.70 percent. By keeping costs down and picking solid stocks, the fund should continue delivering winning results.

Stan Luxenberg (sluxenberg1@nyc.rr.com), the magazine's Best of Breed columnist, is a New York-based freelance business writer and has long been a regular contributor to Wealth Manager.

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