Return of the consumer

We believe Japan's current investment climate offers great cause for optimism. During the last 15 years and following many false starts, the economy has undergone significant, albeit painful, restructuring. We believe that a return to sustainable growth is now on the horizon.

For UK investors investment trusts represent an ideal way to gain exposure to Japan. To date we have recommended three Trusts which we believe offer significant leverage to a recovery in the country's economy and equity markets. This week we add another to the stable - Martin Currie Japan Investment Trust (MCJ).

MCJ is a listed UK investment trust which was launched in 1995 with the objective of providing long term capital growth. The Trust's investment strategy is focussed on maintaining a diversified portfolio of Japanese companies across a range of sectors. As at 18 May 2005, the fund had total gross assets of £33.1 million, and a net asset value per share of 79.7p. Investors in the Trust also benefit from a relatively low cost structure with management fees set at 0.25 percent per quarter.

After trading at an all time high of 160p in January 2000, MCJ experienced a severe decline in tandem with the Nikkei. The downturn lasted until early 2003, by which time the stock had fallen by 72 percent to an all-time low of 45p. A subsequent recovery in investor sentiment drove the stock to 88.50p in April 2004 - the highest level in close to two years.

For the past 12 months, MCJ has traded in a range between 80p and 67p. In our opinion, such a pause is common after an initial advance and allows the stock time to consolidate prior to the continuation of the dominant trend.

In the 6 months ended 30 November 2004, MCJ fractionally underperformed the TOPIX first section index by 0.3 percentage points. With gearing at 120 percent, we are encouraged that the Manager shares our bullish view of Japanese equities. We are confident that the Trust will out-perform in the years ahead as the Japanese stockmarket recovers.

We agree with the Manager's assertion that growth is set to receive a boost from increased business investment. Higher levels of corporate profits should ensure that Japanese companies begin to replace old equipment stocks, which have peaked at an average age of 12 years. As such the Manager intends to focus on machinery, service and financial stocks which are leveraged to a domestic recovery. In addition, we believe growth will be consumer driven.

We are particularly encouraged by a Government report released this week which showed that Japan grew at more than twice the rate forecast as rising wages prompted consumers to increase spending on clothing and food. Gross Domestic Product increased by around 5.3 percent in the three months to 31 March.

We are heartened to learn that after three years of falling wages, workers' pay has recently shown signs of growth. The number of full-time workers in Japan rose in January for the first time since 1997, and the unemployment rate fell to 4.5 percent in March, matching a five-year low. A recovery in salary growth will further underpin consumer demand.

We also believe that some minor inflation is on the horizon. When this does occur, Japanese investors are likely to switch out of bonds into physical assets like real estate and equities, pushing both markets higher. We believe that concerns over ongoing deflation are misplaced. Last month the Bank of Japan forecast a 0.1 percent fall in consumer prices after earlier predicting a 0.1 percent rise. More significant in our opinion was the Bank's prediction that inflation will reach 0.3 percent by March 2007.

We are encouraged by the sectors favoured by the Trust's Manager, with the largest weighting being 30 percent in financials. The biggest individual holding is a 3.7 percent stake in Mizuho Financial Group, one of the country's leading financial services companies. MCJ's second largest holding is a 3.2 percent stake in Mitsibushi Tokyo Financial Group. Many problems facing Japan over the past decade have been associated with the health of the local banking system. Fortunately the banks have faced up to their creaking balance sheets and written off substantial portions of the bad loans. We believe that as investor sentiment towards the banking sector improves, funds flowing into the country will be bolstered, which will help spur a wider economic recovery.

We believe that the growth experienced in Japanese property prices in recent times will permeate throughout the wider economy with positive effects. Rising real estate prices have been driven by the wide gap between funding costs and rental yields - investors can currently borrow long-term funds at around 2 percent, and receive rental yields of close to 5 percent. As property values rise and home owners perceive their wealth to be increasing, they will have a greater propensity to spend.

There are already some signs that consumer spending is recovering. Household spending rose a seasonally adjusted 2.2 percent in the three months to March 31, the biggest gain in eight years. Retail sales rose 0.1 percent in the first quarter from a year earlier, the first gain in four quarters. Finally, consumer spending rose 1.2 percent from the previous three months, also the first gain in a year.

To this end we are encouraged by the Trust's 16 percent holding in consumer goods. MCJ has significant holdings in both Canon and Fujifilm, two leading camera manufacturers. We expect well-branded businesses such as these will benefit significantly from increased levels of domestic consumption as Japan's recovery takes hold.

We expect that businesses which supply discretionary items will thrive as pent-up demand is released - not least of which will be car makers. Toyota, Honda, and Nissan are three of the Trust's top 10 holdings. Outside of Japan, we expect these companies (despite recent recalls by Toyota) will continue to steal market share from American competitors, especially given ever increasing demand for fuel-efficient vehicles in today's high oil price environment. Toyota is already the clear market leader in the US in the supply of hybrid petrol-electric models.

Overall we are heartened by the outlook for corporate Japan, with companies (Topix excluding financials) forecasting around a 5 percent increase in sales and a 22 percent lift in recurring profits this year. On this basis equity valuations are attractive, with the forward price-to-earnings ratio standing at around 16 times - the lowest level in 30 years. Many companies have already started to revise the book value of their assets and thus have more realistic balance sheets.

Over the past two months the Nikkei has been buffeted by the volatility in global stock markets. However unlike many equity markets - the US in particular - we believe that Japanese stocks offer compelling value after a lengthy bear market which began in 1990. With stocks generally trading on undemanding valuations, and Japanese government bond yields close to historical lows, equities remain an attractive asset class. We believe a stock market re-rating will emerge in due course.

We believe MCJ's portfolio of companies within the banking, services, and consumer goods sectors offer significant leverage to an economic recovery in Japan. At the current price, the listed units provide almost an 11 percent discount to current net asset backing, which represents an inexpensive entry into the market. Accordingly, we recommend MCJ to all Members as a buy up to 73p.