Why You Shouldn’t Ignore This Beaten Down Market…

I�ve been a long-time watcher of Japan. When I started writing newsletters for the public in 2004, it took me my third issue to get to Japan. The country has long fascinated those with a taste for cheap stocks � like me. But it�s been a long time in waiting for the payoff.

Some of the long-standing bulls have thrown in the towel.

Jim Grant, for example, was a general partner in Nippon Partners from 1998-2010. The idea was to invest in undervalued Japanese securities, of which there were many. Nippon Partners closed up shop in December 2010 because it wasn�t making any money.

Why?

�Japanese corporate managers, by and large, don�t own equity,� Grant said. �They have a platonic interest in the stock price.� In Japan, there is not much of a market for corporate takeovers, activist investors and the like. Management teams are entrenched. Shareholders are unimportant.

�You get tired,� Grant writes. �The last straw was when one of our companies was selling at a huge discount to everything and announced that it would undertake a capital investment larger than its stock capitalization.�

Maybe this will be the catalyst that sparks some life in Japanese equities. After all, there is precedence for the creation of great wealth during a time of lessening government involvement. Even in Japan.

At the Agora Financial Safety and Survival Summit, I talked about the Japan. As I said earlier, the great appeal of Japanese stocks is how cheap they are…

This table below, from Symphony Financial Partners, which runs a Japan-focused fund, shows you the percentage of Japanese stocks that meet three tough valuation criteria:

However, as the Symphony guys point out, �low valuations and cash-rich balance sheets are all chants we have heard before.� The common lament of an investor in Japanese stocks is that they are cheap and stay cheap, that the management teams do nothing to unlock the value in their companies, that they just sit on the cash or blow it on dumb projects.

What�s different this time? �The real change,� they continue, �is the discernible increase in high premium M&A/MBO activity.� (MBO stands for �management buyout� and is when a management team buys out a company, taking it private.)

For the first nine months of 2011, there were more MBOs than in all of 2010. It looks like it will be a record year for MBOs in Japan. What�s interesting is the fat premiums they are paying to make those deals. On average, buyers are paying 50% above the stock market price!

In a September note, the Asian research firm CLSA gave six reasons for the increase in mergers and acquisitions in Japan:

• Japan is dirt-cheap.
• The rules have been changed, with the specified aim of spurring M&A.
• Companies have so much money it is burning holes in their pockets.
• Even if companies don�t have the money themselves, banks are falling over themselves to lend them the money.
• Corporate governance just overtook the U.S. (40% of U.S. companies have poison pills, 45% have staggered boards � which means it takes many years to fire the board � and 70% have golden parachutes. These are not problems Japanese investors have to handle.)
• Rules on what constitutes a monopoly just got wildly more liberal � from the old, parochial domestic market view to taking a worldview of market share: Nippon Steel/SMI may have had a combined 40% share in Japan, but it had less than 3% global share.

Maybe, just maybe, a fire has been lit under Japanese shares… this is a market you should not ignore.