Landslide Election Victory in Japan Will Lead to an Avalanche of Future Profits For Global Investors

When it comes to Japan, political change should translate into long-term profits for global investors.

After 54 years of near-single-party rule - not to mention two decades of economic malaise - it's not surprising that voters eager for change delivered a landslide election victory to the opposition in that key Asian nation.

Last weekend's Japanese election represents a major milestone for Japan, and may well change the world's second-largest economy in unexpected ways. Many of things we think we know about Japan may simply have been policies of a Liberal Democratic Party (LDP), which has been in power for all but about 11 months over the past 54 years.

The "new Japan" may in certain respects be very different.

For example, we think of Japan as a country dedicated to exports. The big exporters are aided by cheap loans. Upon retirement, senior government bureaucrats get jobs with those exporters, a practice known as amakudari - descent from heaven. Not surprisingly, Japan runs a more or less permanent trade surplus.

Under the new Democratic Party of Japan government of Yukio Hatoyama, that may change. Hatoyama has pledged to end "amakudari" - even as he reorients the economy towards domestic spending. If he succeeds, the exporters may do less well, but the economy may be more balanced. As a result, Japan's economy may finally begin the economic recovery that Japanese consumers have been awaiting for 20 years.

Japan is also famous for its infrastructure spending - at its peak in 2001, state-funded infrastructure spending was equal to 6.5% of that country's gross domestic product (GDP) - a level that's twice that of Japan, the next-biggest spender.

While anyone who has dealt with Northern Virginia traffic knows that infrastructure spending can be a good thing, much of Japan's spending was wasted on remote rural areas, which happened to be homes to politically connected LDP barons.

Hatoyama has promised to redirect about 3% of GDP from infrastructure spending to payments to individuals. He will pay each family with children $3,000 per child per year. This should help Japan's demographic problem - its population is declining and is heavily weighted towards retirees. It will also boost consumer spending, especially among middle-income families.

Hatoyama's program offers no supply-side remedies for Japan's economic ailments. Those were the policy of Junichiro Koizumi (Japan's prime minister from 2001-2006), who seemed to be bringing Japan back from recession. Koizumi's faction lost out in the LDP power struggle, but may make a comeback. Big-spending Prime Minister Taro Aso has resigned from the party leadership, and his most likely successor, former Japanese Health Minister Yoichi Masuzoe, is a supporter of Koizumi's approach.

Nevertheless' Hatoyama's policies will reorient Japan's economy towards domestic spending. The danger is Japan's budget deficit (8.9% of GDP in 2009, according to estimates by The Economist) and its debt. With GDP down this year and spending up, the International Monetary Fund (IMF) has estimated Japan's debt at 217% of GDP by the end of 2009. Only one country has recovered from debt that high - Britain, whose debt hit about 250% of GDP in 1815, only to reach that level again in 1945, at the end of two huge wars.

Hatoyama must hope that Japan's recovery from this recession is a swift one. A sharp bounce in GDP, maybe 5%-6% growth in the first year, would make the debt level much less daunting, and allow good progress towards balancing the budget. After almost 20 years of near-recession, that's perhaps not too much to ask.

For investors, Japan looks attractive. The stock market is still trading at less than 30% of its 1990 high. However, the Japanese companies you have heard of are not the ones to buy. They are too large and too oriented towards exports. The construction companies should also be avoided - they have benefited from the fixation on infrastructure.

However, buying smaller Japanese companies is a problem, because they do not have actively traded American Depositary Receipts (ADRs) so you really have to buy them on the Tokyo Stock Exchange. The good news is that some brokers, notably E*TRADE Financial Corp. (Nasdaq: EFTC), will allow you to trade Japanese shares.

If you intend to trade on the Tokyo exchange, you might want to look at some of the Japanese retailers and consumer-goods companies. Even with these more-upbeat prospects, though, you should be careful not to overpay - a Price/Earnings (P/E) ratio of 20 should be your upper limit.

For those without access to the Tokyo market, there are two alternatives. One is the exchange-traded fund (ETF) covering the entire Japanese market, the iShares MSCI Japan Index (NYSE: EWJ). That has market capitalization of $5.26 billion, meaning it has adequate liquidity.

However, too much of it will also be invested in shares of the big exporters and construction companies.

The other alternative therefore is a mutual fund, the Fidelity Japan Smaller Companies Fund (Nasdaq: FJSCX). That has expenses of 1.1% and a total size of $394 million. It represents the most readily available way of investing in domestic Japan.

With the new government, Japan will look very different in a few years. Profit opportunities will arise.

As investors, we should look to capitalize on these changes - as well as the opportunities they create.

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