Everybody says the Japanese stock market is cheap. After all, it is trading at a mere one times book value. But that doesn't necessarily mean that investors will buy into it.
Why not? Well, the Japanese market is facing a unique combination of headwinds that are impeding its recovery.
A steady flow of bad news
Japan's economy shrank by a greater-than-expected 2.3% in the final quarter of 2011. And there has been a steady flow of bad news from Japanese companies as well.
Electronics stalwart Panasonic recently estimated a £6.5 billion loss for 2011-12, the largest in the firm's 95-year history. Another Japanese industrial champion, Sony, has predicted a £1.8 billion loss for the same period. And car maker Honda has slashed its forecast for its full-year profits. Even Toyota is forecasting a halving of profits. Just what is going on?
Well, one major temporary factor was last year's floods in Thailand, where several Japanese factories are based. The floods disrupted production and messed up supply chains. What's more, the disaster took place just as Japan was recovering from March's earthquake and tsunami.
Then, in addition, Japan's economy is very dependent on exports, and as the European debt crisis has rumbled on, Europe's economies have been tipping into recession and so export demand has fallen.
The third and, in my view, most important factor is that the yen has been far too strong. Money has flooded into the Japanese currency, which has been seen as something of a safe haven in these troubled times. The increase in the value of the yen has had a devastating effect on the country's exporters. Japanese manufacturers are either being priced out of the market, or their profit margins are now wafer thin.
If Japanese industry is exporting less, can the slack be taken up by domestic demand? Not likely. Japan's consumer economy is stuck in a malaise, and poor demographics mean that Japanese population, and thus consumption, is in long-term decline.
Samsung is the new Sony
I would add one more factor. Twenty years ago, Japan was seen as the undisputed world leader in electronics. No other nation could touch them.
But these days, the Koreans and the Taiwanese have caught up. Indeed, with their weaker currencies, these nations are able to match the Japanese on specifications and beat them on price.
Sony has already given up the battle in LCD televisions, by selling its stake in its joint venture with Samsung to the Korean company. Samsung is now by far the largest TV maker in the world.
Panasonic is continuing to fight on, but the losses it has incurred reflect the difficulties it has had trying to combine its operations with the recently acquired Sanyo Electronics.
Over the next few years, Japan faces a hollowing out of its industrial base. For example, car maker Nissan is moving much of its manufacturing operations to lower-cost countries such as Thailand, Brazil and Mexico. Many other companies will follow.
The Japanese conundrum
The five factors I have given above explain why the Japanese stock market is unique in the world today. By one metric (book value), the market looks very cheap. By another metric (price-to-earnings ratio), it looks comparatively expensive -- the number is 15.8 for Japan, as opposed to 10.5 for the UK.
That's why, to me, Japan remains a conundrum; it's also why I am still reluctant to invest there.
Thinking long term, the Thailand issue will eventually be resolved, damage from the earthquake will be repaired and one can expect companies to reduce their costs and increase their profits by moving the bulk of their manufacturing sites abroad.
The hope is that profitability will rebound, and that share prices will finally recover. But, if you are serious about investing in Japan, you will have to be patient.