Is Japan a Big Investing Opportunity in the Rubble?

By now the world is well aware of the damage caused by the massive earthquake that hit Japan (NYSE:EWJ) and the subsequent tsunami it unleashed.  Just look up some of the incredible videos on Youtube and it will really bring home the terrifying majesty of mother nature.  Following the quake, Japanese and world markets all took a hit on the expectation that worldwide economic growth and Japan’s already shaky financial situation would become even more precarious.  Given estimates of over $600 billion in damage this is hardly a phantom worry.

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In addition to the direct physical damage, there are also the ancillary issues such as production lost due to the ongoing electricity shortages.  Tourism is bound to take a sharp hit.  Irradiation concerns with regard to Japanese food exports have prompted protectionist reactions from neighbors such as China (NYSE:FXI) and South Korea (NYSE:EWY).

But when Warren Buffett followed on the heels of the disaster by saying “something out of the blue like this, an extraordinary event, really creates a buying opportunity” I wanted to do a little research myself to see if I agreed.  Some of the well known economic facts about Japan are:

(1) Very high debt-to-GDP ratio approaching 200% (well past the level many analysts believe leads to chronically slow growth)

(2) High corporate income tax rates of 39.5%

(3) Average real annual GDP growth of less than 0.7% annually since 2001

(4) GDP in dollar terms a little over one-third of the United States

High debt, a high corporate tax burden, and slow growth are hardly the investment factors one would look for in a country to invest in.  To add insult to injury, in light of the massive repairs needed, S&P (NYSE:MHP) has downgraded Japan’s debt rating outlook to negative citing an absence of alternatives other than to raise more debt to finance such repairs.

But Japan (NYSE:EWJ) also has an educated and healthy workforce, very low crime, and close proximity to the fastest growing Asian economies.  It is a technologically (NYSE:XLK) advanced nation with ready access to both air transit and shipping.  It has very firm contract law, low political risk, and despite its looming fiscal issues the Japanese Yen has remained historically strong against the dollar (NYSE:UDN).

One of the oddities of Japan’s fiscal deficits is that they are financed by the country’s massive postal savings which is similar to our Social Security system.  While Debt-to-GDP has surpassed the 200% level, $3.9 trillion of that debt is held by the Japanese Postal System.  If you adjust Japan’s Debt-to-GDP ratio for the Postal Savings you’re left with a Debt-to-GDP ratio of 135%.  This is still very high, but much less frightening than 200%.

This dynamic helps explain why the nation’s high deficits have not resulted in an inflationary spiral or substantially higher interest rates – they are being partially financed by the savings of Japan’s (NYSE:EWJ)  labor force.  On the other hand, such a large amount of assets being essentially locked up as savings being lent to the government means those assets are not being invested in business development.  Japan’s political process is no different than any other; favored interests of dubious economic worth receive funds.  Essentially, the crowd-out theory of large fiscal deficits has taken its toll in Japan, but rather than lead to very high interest rates it has instead led to moribund levels of investment and growth.  Without the necessary private demand for loans, both interest rates and inflation remain low.

Former Prime Minister Junichiro Koizumi was able to push through a moderate privatization of the Postal Savings System, but those reforms are very gradual and will have little effect in the short to intermediate term in changing the anti-growth dynamic that dominates the nation from a macroeconomic perspective.

But like any developed country, innovation and execution are still rewarded.  There are positive returns to be had!  The most immediate opportunity would seem to be any construction company that can position itself to take advantage of what is bound to be a large scale, government driven effort to rebuild Sendai and the surrounding areas.  These projects could potentially go on for years and offer the potential for multi-year earnings bumps for any company who can take advantage of them.  Some of this potential may have already been priced into such companies as Kajima, Japan’s largest construction firm which is up around 15% since the earthquake.  Other such firms include Tasei Corp and Daiwa House Industry Co., Japan’s biggest home builder.  The Japanese government is exploring how exactly to fund construction efforts and the largest firms will likely be the ones best equipped to lobby for and get government contracts.

Japanese utility companies may also provide an opportunity to the patient investor.  No, I would not recommend Tokyo Electric Power Company (TEPCO), the company that owns the Fukushima Nuclear Power Plant.  Even if the rumors that the Japanese government (NYSE:EWJ) will bail them out of the litigation they face from people who were exposed to radiation are true, the uncertainty is simply too large at this point for me to say they’re a good value pick.  But that doesn’t mean there aren’t plenty of opportunities worth picking up in the sector.  And despite the immediate vilification nuclear power will face, it is still a viable and clean source of large quantities of energy so companies that generate nuclear power should not necessarily be shunned despite the bad press.

Japanese grocery stores also represent a stable pick simply because demand for their products will only be marginally affected by the economic problems the nation faces.  People still need to eat food (NYSE:RJA), wash clothing and dishes (NYSE:RTH), and buy other household sundries (NYSE:XLP).  An earthquake won’t change that.

Personally, I have recently invested in Toyota Motor Company (NYSE:TM).  I do not expect much out of the Japanese economy nor do I expect much as far as growth in the worldwide automotive market in the near term.  But the company does make good cars and has a far stronger balance sheet than any of its competitors.  It is also well ahead of its competitors in the market for hybrid vehicles.  Its stock is down nearly 50% from its peak, but the company is still profitable and likely to be more so once the immediate aftermath of the earthquake passes and demand stabilizes in Japan (NYSE:EWJ).

The Japanese people face a myriad of challenges that make their stock market look like it isn’t the best place to be invested.  But one of Warren Buffet’s strategies has always been to go where others are leaving and see if there are areas where the consensus is wrong.  I see no reason why I should not recommend following in his footsteps.

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