‘Limited Attractions’

Since crashing in 1990, Japan’s stock market has struggled through seven years of flat or lower stock prices. Is a sustained rebound on the horizon? Andrew Callender thinks not.

He’s the new, straight-talking portfolio manager of the $125-million GT Global Japan Growth Fund, which has made the most of a tough situation, having risen 43% over the five years ended June 30, versus 32% for the average Japan fund (and 123% for the average U.S. stock fund).

In fact, the GT portfolio ranks among the top half of Japanese stock funds for all measurement periods in excess of one year. Former manager Michael Lindsell’s name was associated with that impressive track record, but Callender says the fund has been run as a team effort and that he has been intimately involved. He took over at the helm of GT Global Japan Growth in January.

Callender has spent the last decade in Asia, including stints in Tokyo, Singapore and Hong Kong. He has risen from a stock analyst to head of investments in Japan. The 33-year-old father of two is an Oxford University graduate who majored in modern languages. Russ Wiles, a mutual fund columnist for The Times, spoke to him by telephone at his Tokyo office.

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Times: Your fund has lagged the average Japanese fund this year. Are you doing anything significantly different from what your predecessor, Michael Lindsell, did?

Callender: No. A number of things have impacted short-term returns. During the first half of the year, the yen strengthened, rising from about 125 to the dollar to 113. We continued to hedge a portion of the assets out of the yen and into the dollar [which hurt the fund’s performance].

Also, the market over the short term has been stronger than we had expected. But the style of the fund hasn’t changed. Japan is a volatile stock market. There always will be periods when short-term volatility shows us in a less than favorable light compared with the indexes.

Times: What’s happening with GT Global in general? Christian Wignall, GT Global’s former chief investment officer, is no longer with the company. Is the firm undergoing any major turnover or transition problems?

Callender: There have been a number of departures at our San Francisco office, and there have been various reasons for them. In this part of the world, we’ve had no significant turnover aside from Michael Lindsell returning to London and myself returning to Japan from Singapore.

Times: Were those moves promotions?

Callender: Yes. There’s nothing dark or sinister about them.

Times: What is your basic investment approach?

Callender: We are growth investors. We look for companies that are seeing an acceleration of earnings growth. We can own bonds but don’t currently. We also can maintain sizable holdings in cash, as we have done over the past few years. And the fund can hedge Japanese yen back into dollars, as we are doing for a portion of the assets.

We’re certainly not market timers. We have a strong top-down approach, combining that with a lot of bottoms-up company visits that we do as a team. The fund mostly buys large stocks but does have the ability to move into smaller companies.

Times: Where does Japan stand in terms of investment appeal or the lack thereof?

Callender: We have about a 20% cash position, which is not much changed from last year. We also have some short futures positions. So I think that tells you that we remain cautious for the market and economy as a whole.

We’re certainly more cautious about the prospects for recovery than a lot of foreign brokerages, several of which are fairly upbeat about the prospects for Japan. But we’re looking for a deceleration in economic growth over the next quarter or so. We have seen the rise of a consumption tax, which front-loaded demand into the last half of the fiscal year that ended in March 1997. We also had strong automobile production, both for domestic consumption and export. That has fallen away fairly rapidly.

Others are too optimistic about the propensity for Japanese consumers to run down their savings rates. In real terms, compensation here is flat. And we still think problems in the financial system are acute.

Times: You’re referring to bad loans?

Callender: Yes. During the first quarter of the calendar year, we had two big construction-related bankruptcies, for no particularly good reason. Neither of the companies that went bankrupt had been included in the bad-debt figures. So this means the bad-debt problem is still much bigger than people think.

That’s not to suggest the whole place is going to collapse like a pack of cards--we’re not saying that at all. But with a decelerating economy, coupled with a lack of restructuring within the financial industry and a number of other industries, the stock market offers fairly limited attractions. On balance, the risk is that the Nikkei index still has more downside than upside potential.

Times: Does that make Japan an opportunity for contrarians?

Callender: Some commentators have been suggesting that you should invest in Japan if you missed the rally in the U.S. after the market there bottomed in 1992. They say Japan is in a similar situation. But I think the similarities are fewer than many people think. First, American companies had become very cheap, selling below book value. That’s not the case here. Second, you had wholesale restructuring in the U.S. That’s not occurring very quickly here.

Another point is that Japan is changing like the U.S. did in the 1970s, from a manufacturing to a service economy. That’s causing deflationary forces not very similar to what the U.S. was experiencing in 1992. The implication is that key, constituent parts of the economy and stock market are outdated.

If you want to invest in Japan, do so selectively, as we are doing. You may have a situation where 60% to 80% of the companies in the stock market continue to [fall].

Times: But aren’t there enough companies in Japan that, even if the majority have trouble, you still can find winners?

Callender: Yes. There are a number of areas that look very attractive. New companies and those that are able to change will do tremendously well. But as I mentioned, they don’t make up a big percentage of the stock market, the indexes themselves. We don’t believe buying the major Japanese indexes is the way to go.

Times: What are some industries or companies that you favor?

Callender: Obvious ones are some of the blue-chip exporters. There’s a tremendous technology cycle going on right now in the U.S., and a number of Japanese companies like Canon and Sony are part of that. They are much cheaper than the rest of the market and have much higher growth rates, especially if you factor a weaker yen into the picture.

Sony, our sixth-largest holding, recently reported its first-quarter [June 30] results. Growth was very strong, and it was made stronger by a weaker yen [compared with a year earlier]. So not only do these companies make good products, but they benefit from the yen-dollar translation.

Times: Do you mainly like multinational exporters of electronics?

Callender: Mainly. We’re not particularly positive on the likes of Toyota and Honda. The car companies are not at a particularly propitious stage of their business cycle. They’re highly priced with decelerating earnings growth. . . . The auto makers are still doing quite well in the U.S., but we don’t think it will be enough to offset weakening domestic demand.

Times: Besides electronics, what types of Japanese companies do you like?

Callender: Certain consumer finance/lending companies that cater to small and medium-sized businesses.

A host of nonbank financial companies have come into play because the main Japanese banks have not adapted quickly to new business opportunities. They have been slow to grant working-capital loans, and they’re very risk-averse. This niche has been filled by companies such as Nichiei, our largest holding. It lends working-capital requirements on a short-term basis to small and medium-sized businesses. That might sound risky, but they have very good risk controls. Bad debts have not been a problem. The company trades at about 20 times earnings and has been growing at 20% annually for the last few years.

Times: How do you think Japan might be affected by currency devaluations in places like Thailand?

Callender: The impact won’t be that important. The Japanese banks do have exposure to some real estate ventures around the region, and it’s not inconsequential. But it’s not very large compared to the problems they still have at home.

Times: Won’t Japanese exports be affected?

Callender: Yes. The devaluations we’ve seen in Asia, along with the weakness of the European currencies, will have an impact on exports over time. That part of the trade surplus is going to be under pressure.

Times: Maybe that’s not such a bad thing, considering how wide Japan’s overall trade surplus is.

Callender: It’s probably not. Japan needs a much weaker yen to bring a bit of inflation into the system. It’s still a deflating economy. You need that to help the domestic industries, which are really bleeding at the moment.

Times: So if you’re hedging part of your portfolio, you must be expecting the yen to soften.

Callender: Yes, because we see the economy weakening. The dollar has been strong against other currencies but not against the yen. I think people are going to recognize that the fundamentals for the yen are not as strong as they had thought, and that the bilateral trade surplus with the U.S. is not the only determinant of the yen’s value.

Times: Obviously, you’re cautious about Japan right now. But isn’t this a good time for contrarian U.S. investors to be sniffing at Japanese stocks? Or to rephrase the question, isn’t Japan such a large market that Americans should have a permanent exposure, regardless of the short-term outlook?

Callender: I don’t know about that. It undoubtedly is a very large market. But I’ve already mentioned that we see only limited possibilities, so market size per se isn’t a great reason to maintain a presence here. As for the companies we own, certainly we are happy with those. They offer good values, and we can see fairly decent growth for the medium and long term. But the basis for a sustainable bull market in Japan is not in place at the moment, so it’s difficult for me to beat the drum.

Times: What ingredients would be needed for Japan’s market to take off?

Callender: Greater restructurings. One of the key problems here is that the profitability of many industries is very low. Take banking, where net interest margins are at 1%. That’s the result of overcapacity. There are just too many banks. It’s very difficult to raise profitability if you’ve got too many firms competing. The steel industry is facing the same problem, along with many basic-materials industries. And in retailing, you’re seeing considerable increases in floor space, with profitability levels falling.

So what I mean by restructurings are more bankruptcies. It’s important for excess capacity to be taken out of the system, not just for mergers to occur.

Times: Anything else?

Callender: The other side of restructuring is deregulation. Japan is still a regulated economy. Deregulation has been accelerating, and that’s positive, but it’s coming off a low base. The government needs to keep up the pressure of deregulating the economy. Deregulation goes hand in hand with restructuring. One thing leads to the other.

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GT Global Japan Growth Fund

Strategy: The fund invests in Japanese stocks, primarily those of larger companies, with an eye both on growth prospects and valuations.

VITAL STATISTICS

Year-to-date total return: +9.0%

YTD total return, avg. Japan fund: +11.3%

5-year total return, through June 30: +42.9%

5-year total return, avg. Japan fund: +32.0%

10-year total return, through June 30: +92.9%

10-year total return, avg. Japan fund: +53.3%

Five biggest holdings as of July 31: 1. Nichiei 2. Takeda Chemical Industries 3. Canon 4. Ito-Yokado 5. Amway Japan

Max. sales charge: 4.75%

Assets: $125 million

Min. investment: $500

Phone: (800) 824-1580

Morningstar risk-adjusted performance rating, 1-5: ** (highest in category)

Sources: Lipper Analytical Services, Morningstar