In the broader sense, and not just looking at the aftermath of the recent events, some globally oriented investors will be looking at whether appropriate returns can still be achieved from Japanese stocks. The counter-arguments are well known. The most common being Japan’s declining economic muscle. At the end of 2010, Japan’s nominal gross domestic product was roughly at the same level as at the end of 1991. In addition, the outperformance that Japanese stocks built up relative to the world index since the start of the 1970s has now all but evaporated.

To invest or not to invest?

If you look at the figures it is difficult to discern a correlation between the economic trend and stock market performance in Japan (and indeed elsewhere). Japan’s real economic output is only around 4 per cent below the record figure posted in March 2008. The weightings of the various industries in Japanese stock market indices differ considerably from those underlying the GDP figure. Equity market volatility is also about ten times as pronounced as the fluctuations in the economic trend. As at the end of March 2011, the stock market, as represented by the MSCI Japan Index, was back at March 1986 levels in local currency terms, when adjusted for dividend income.

If we look more closely, there’s a change in the correlation with the world index over the past ten years. There are charts that show the average annual relative performance on a rolling basis for five-year periods. In the recent past, there have been no extreme peaks or troughs, and the local market is performing more in line with the global market than it previously did. In short, the assumption that no growth means no momentum means do not invest, actually makes no sense.

What should potential investors be looking at? First and foremost they should focus on the industry structure of the index universe, as well as its profitability and valuation relative to the world index. According to data from MSCI Barra, the composition of the Japanese equity market index has changed dramatically over the past 21 years.

At the beginning of the 1990s it had around 10 per cent more financial stocks, 5 per cent more industrials, around the same number of cyclical consumer goods companies, and 5 per cent fewer energy firms than the world index. As at the end of May 2011, the corresponding relative weightings were -3 per cent in financials, +9 per cent in industrials, +10 per cent in cyclical consumer goods and -10 per cent in energy. Anyone investing in the Japanese index basket is investing in a portfolio that is disproportionately dependent on the global economy, and this dependence has increased over the decades.

As for the profitability of Japanese stocks, the Japanese index portfolio has consistently shown a lower return on equity than its global counterpart over the past 40 years. Given the industry structure, we should not expect the Japanese market to completely close the gap on the world portfolio over the near term, but further convergence could be on the cards.

Ultimately, what really matters for investors is whether the lower profitability can be bought at the right price. This has not always been possible in the past; however, as at end of May 2011, the Japanese market was trading at around 6 times its operating cash flow, compared with 9 times for the world index.

What’s important for Japan

Such analysis shows that the typical assumptions against investing in Japan are not as clear cut as they first look, and that Japanese stocks can still demonstrate long-term potential. However, to achieve this investors need sufficient practical experience and empirical data.