Scandals are a feature of the landscape, but small cap stocks are the real investment story in Japan.

ONE CONSTANT feature of the Heisei Malaise has been scandals-most having to do with hiding the true extent of the balance sheet damage done by plunging stock prices and land values-but also about sloping quality control practices that allowed the sale of tainted milk (Snow Brand) and the continued sale of vehicles with serious design faults (Mitsubishi Motor), or the hiding of the true extent of ownership by the controlling shareholder (Seibu Railway ).

**********

This has strengthened overseas calls for better disclosure, better corporate governance and more comprehensive corporate social responsibility-which are being heard and generally responded to by Japan's regulators, the exchange authorities, and Japan's multinationals.

[ILLUSTRATION OMITTED]

But We Find Misallocation of Capital Just as Scandalous

We however believe that an equal if not more pervasive scandal has been the misallocation of capital by entrenched managements effectively answering to no one. The whole idea of capital markets and public stock exchanges is to provide the means for the efficient reallocation of individual savings (of which Japan has an abundance) into publicly listed companies through the capital markets and the securities exchanges.

During most of the Heisei Malaise, the capital markets were dysfunctional, markets were held at artificial levels for as long as possible, bad debts lingered on company books forever, and the whole system just limped along. Because prices were not allowed to decline to natural clearing levels (i.e., prices which the potential buyer would find attractive and at which the seller was willing to accept), trading values dried up and individual investors abandoned the markets.

In Q1 2003, however, the Nikkei 225 finally reached its clearing level, after hitting a historical low of 7,600. Thereafter, things have started to get interesting for Japan, especially since it also appears that the problem of a gross misallocation of capital is also being addressed on various levels.

Japan's Economic Peak Debate

Japan's cyclical economic recovery has been underway for 34 months (to November), which is the exact average of the eight economic expansions since the 1960s. Some analysts are beginning to argue that Japan's economy already peaked in June, which would have meant a shorter than average 29-month expansion.

Thus while surveys of aggregate corporate profits indicate that Japan's listed companies will record their second consecutive fiscal year of new historical highs in corporate profits (of 21% YoY for ordinary profit), the stock market had already discounted this peak in April of this year, which would makes sense because stock prices lead economic trends by about six months.

Since the stock market has already made the assumption that the economy would be peaking in April, the stock market is now focusing on when the upcoming recession will end. Since the historical average length of Japan's recessions since the 1960s is 20 months, and again assuming that the stock market will "read" the trough some six months in advance, the Topix may not be ready for a sustainable rally until the first quarter of 2006.

This implies that the poor performance of the "reflation plays" could persist as the overall market continues to consolidate--namely, retail and economically sensitive sectors like chemicals, pulp and paper, machinery.

This notwithstanding, foreign investors fleeing a weak dollar will continue to support the downside, as will continued secular improvement in Japan's economy, most notably the ongoing recovery in balance sheet quality in the banking sector. On the other hand, the very high profile and active individual investors should continue to remain cautious, meaning that the small cap stocks in general are likely to underperform for the time being, especially as they tend to underperform larger cap stocks with the onset of recession.

However, there is plenty of money (both foreign and domestic) for mid-cap and smaller deep value stocks, i.e., there is more domestic institutional money supporting the new "relationship" and "restructuring" funds than is generally believed, and there is likely to be a lot more in the foreseeable future.

Revitalization Funds

Domestic revitalization funds such as Phoenix Capital continue taking proactive positions in deep value, mid-cap companies. Phoenix has so far gathered up [yen]174 billion in funds to invest in fifty companies, and they plan to start a new fund in March 2005 due to the large increase in the number of target companies.

Another fund, Venture Revitalize Investment, that will invest in failed firms to revitalize them will be listed on the Osaka Securities Exchange in early 2004. Venture Revitalize Investment aims to use individual investors' funds collected through the stock market to rehabilitate companies. Investments will be managed by an asset management company affiliated with Softbank Corp. The fund invests in failed businesses to put them back on their feet, and will aim at profit by re-listing or selling the firms. It will also invest in promising unlisted start-ups.

Major Banking Groups Join In

Having just gotten their arms around their own non-performing loans to troubled borrowers, Japan's major banks are beginning to take a more aggressive approach in their efforts to prevent sound loans from turning sour. Mizuho Holdings Inc., Mitsubishi Tokyo Financial Group Inc. and two other major banking groups have selected some 4,700 corporate borrowers to help rebuild their ailing operations.

In a typical example, Sumitomo Mitsui Financial Group set up SMBC Asset Restructuring to restructure the bank's NPLs. In FY2003, the group achieved a [yen]2.5 trillion reduction in NPLs, 80% of which was done through its asset restructuring unit. The group also established two corporate rehabilitation funds, Daystar Fund and Japan Endeavor Fund, and set up SMFG Corporate Recovery Servicer with Daiwa SMBC Principal Investments, Development Bank of Japan and Goldman Sachs to help in revitalization of smaller companies held by the Japan Endeavor fund.

The UFJ Group along with Orix Corp., Marubeni Corp. and others plan by April to set up a [yen]20-30 billion corporate rehabilitation fund. Debt-equity swaps have also become popular, as has M & A, either by strategic buyers or financial buyers. Restructuring advisory firms have been established by banks to help troubled companies, while turnaround managers are being used as interim managers of distressed companies.

Pension Funds Go For Alternative Investments

A survey by the Pension Fund Association (PFA) of individual pension funds revealed that 231 were already invested in "alternative" investments, including hedge funds, REITs and private equity, while 315 said they are studying investing in alternative investments. This is of 1,316 funds surveyed. Of the funds investing in alternative investments, the weight of alternative investments to total investment had reached 9.7% in FY2003, up a substantial 3.3% points from the previous year. Pension consultants believe the allocation to alternative investments can rise to 15%. These funds of course look for absolute return, and moreover are not locked in to "closet indexing" investment styles.

For example, Daido Life plans to raise their exposure to alternative investments to 5% total assets, or [yen]300 billion, and they will probably have lots of company among the major financial institutions. Thus pension money managers are joining the fray in a big way.

This is good news for domestic and overseas hedge funds, and new hedge funds targeting the Japanese market are proliferating--of the 753 hedge funds that invested in Japanese equities and other instruments as of the end of December, 158 specialized in Japan, up over 100% from two years earlier, according to Daiwa Securities America Inc. Most of these funds use the long/short investment approach. Despite the explosive growth in the number of such funds, no glut has developed so far. In fact, some funds attract so much money that they have to turn away investors eager for a piece of the action. Overseas hedge funds such as Dalton Investments are seeking capital gains on management buyouts of Japanese companies.

While Japanese companies still tend to consider hedge funds as "Black Ships," referring to Commodore Perry's ships that forced open Japan to trade in the mid-19th century, up to 25% of such hedge funds' money comes from wealthy Japanese individuals. Historically, Japanese institutions and individuals did not want to appear that they were too hungry to make a buck, but are not adverse to hiding behind offshore hedge funds. These hedge funds are now being aided by Japan's online brokers such as Monex, which now markets hedge funds to its online clients.

Deep Value, Smaller Capital Stocks are the Real Japan Investment Story

Thus we believe the real investment story in Japan is deep value smaller capital stocks. While individual investor fervor for stock trading has waned, institutional investors are becoming increasingly interested in the legions of undercovered and ignored mid-cap and small-cap stocks in Japan, as the pool of "restructuring," "buyout" and "revitalization" investment funds continues to grow, while the Japanese government continues to lower barriers to more active M & A activity.

Companies with poor growth prospects, poor disclosure and investor relations programs, and little potential for change (i.e., new management) were simply uninteresting. They were therefore structurally undervalued and hardly covered by street analysts, if at all, because there was no potential for change.

We however believe that this is already changing, with adoption of more pro-active proxy voting requirements by public pension funds such as the PFA and the GPIF and the adoption of internal proxy voting guidelines by domestic institutional investors.

In the early stages of the current rally, many companies that had been priced for bankruptcy (i.e., trading at JPY100/share or lower) rebounded sharply, mainly because of the implications of the nationalization of Resona Bank. However, the FY2005 deadline to reduce NPLs that had been imposed by the FSA did put noticeable pressure on banks like UFJ to force a solution to their largest troubled borrower, Daiei.

Strong Consensus for Revitalization

Basically, a strong consensus in the government and private sector has formed to support revitalization on numerous levels. The government is actively promoting revitalization, with the earlier passage of a Civil Rehabilitation Law, the Industrial Revitalization Corporation of Japan (IRCJ) with a budget of JPY10 trillion for revitalization companies, METI's revitalization program, and the Development Bank of Japan's investing in private sector buyout funds. Seeing the writing on the wall, the private sector banks have begun their own borrower revitalization programs, and moreover are beginning to provide funding for buyout funds. Some 64% of buyout funds surveyed say they have received funding from a Japanese bank. Moreover, the major brokers are actively expanding their principal investments, to over JPY400 billion.

At the same time, the pool of foreign capital and domestic "revitalization" or "restructuring" funds continues to grow, and now is 400% above last year's levels at JPY1 trillion. In addition, other pure investment funds are focusing on causing change among management of sleepy companies with undervalued assets, including "corporate governance" funds and so-called "vulture" funds.

Accelerating M & A Activity

In terms of the legal environment, the government is expected to allow foreign firms to buy Japanese companies through "triangular" mergers, whereby the local subsidiary of the foreign firm makes the purchases and pays with parent company stock. Foreign observers however point out that technically, stock swap TOBs with foreign firms were possible already, while other issues such as the treatment of minority shareholders and the Japanese government's tax treatment for such swaps were seen as impediments. However, the Japanese government is now indicating they are willing to review their tax policies in this area. This most likely reflects PM Koizumi's announcement of a goal to double Japan's FDI (foreign direct investment) over the next five years, as well as lobbying by foreign capital interests.

Waning Business Cycle: No Impact on Takeover Value

During the bubble years, cross holdings and strategic holdings were at their highest, financial reporting was based on historical not current values, and there was effectively no corporate governance. Consequently, takeovers--especially contested takeovers--were non-existent, and therefore played no role in stock price formation. There was thus no market pressure on poorly performing companies. Consequently, undervalued companies remained chronically undervalued.

"Enterprise value" is a measurement of the total value of market capitalization plus interest bearing debt, minus financial assets which can be used to reduce interest-bearing debt. Debt must also be considered in a company takeover, because the acquiring company assumes this debt.

Conversely, companies with abundant financial assets and little debt can and often do have enterprise value that is below their stated market capitalization. This means that effective control of such companies is possible at a cost of less than the stated market capitalization. The Nikkei recently ranked all listed companies by takeover value. Some of the larger capitalized companies with noticeable gaps between market capitalization and enterprise value include Nintendo, Kyosera, Takeda, and Matsushita.

In other words, some very high profile companies in Japan look attractive from a takeover perspective. In addition, some one-third of the TSE 1 listed companies are still trading under 1.0X their book value.

Japanese stocks that 1) have no research "coverage" by the Street because their market capitalization is too small, 2) trade at PBRs well under 1.0X, 3) have good technology or business models, and 4) trade at net cash ratios that are less than their market capitalization are thus the probable targets of these new "absolute return" funds and thus should be identified and closely watched.

Darrel Whitten has been analyzing and writing about Japan's financial markets for over 25 years. A former head of equity research at the Japanese operations of three global investment banks, he is owner and Managing Director of Investor Networks, Inc., a Tokyo-based investor relations consultancy, and is also the editor and publisher of The Japan Investor.com website, a subscription site for serious investors in Japan.