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Corporate restructuring and an improving domestic economy provide a solid backdrop for Japanese equities

Japanese equities posted strong gains during 2005 despite periods of sharp volatility. Increasing confidence in the health of the domestic economy, prime minister Koizumi’s dramatic election victory and better than expected corporate results spurred the Topix index to a five-year high.

Overseas investors were the dominant buyers of Japanese shares. Resource-related industries performed well, with stocks rising in line with global commodity prices. Those tied closely to the domestic economy, particularly banks and real estate, also enjoyed significant gains due to rising expectations of a sustainable recovery in domestic demand.

I feel that a sense of renewed optimism is prevailing in Japan. The economy appears poised to exit its deflationary phase amid a broadening rebound in private consumption and investment. The banking system has shed the bulk of its non-performing loan portfolios. The unwinding of cross-holdings has led to an increasingly investor-oriented shareholder base, which has added impetus to corporate restructuring.

Corporate profitability has improved and equity valuations are more attractive than at any point in the past decade, despite strong market rises.

Expanding links with China are improving profitability and opening up new growth opportunities in emerging Asia. Most important, we believe that these trends are well entrenched and contribute to cementing the foundation for a sustainable long-term recovery in the Japanese stockmarket.

Although the most recent economic growth figures for July to September slowed to an annualised 1.7 per cent from 3.3 per cent in April to June, the mechanisms driving Japan’s economic recovery have not broken down. The spectre of deflation appears to be receding with improvements in the job market and corporate earnings, along with increased private consumption. The effect of sustained deflation was to produce over a decade of misallocation of resources and consequent low growth in productivity. Reverting to a low level of inflation is likely to produce marked positive effects for a number of years, resulting in persistently impressive growth. The process has begun but is still in its very early stages.

After struggling with high debt levels in a deflationary environment throughout the 1990s, corporations have repaired their balance sheets by reducing their excess debts significantly. Cost-cutting and restructuring efforts have helped profit margins and return on equity to hit 16-year highs. Free cashflow generation is at record high levels, supporting increases in business investment, mergers and acquisitions, as well as higher dividend payouts. With balance sheets strengthened, corporations should be able to shift their attention to pursuing new profit opportunities as the recovery gains traction.

Improvements in the outlook for companies are finally providing a solid backdrop for employment. This will help sustain the improvement in the domestic economy.

This provides a solid backdrop for the Japanese equity market but we do remain cautious about the near-term outlook for small-cap stocks. Share price valuations of smaller to medium-sized companies have already exceeded those of bigger companies. Although smaller companies’ earnings’ growth for the next year is expected to be stronger than that of big companies, the question remains whether it is strong enough to justify their premium valuations compared with bigger companies.

In this environment, we at Fidelity believe that valuation analysis is critical for successful investment. By utilising an in-depth bottom-up stockpicking approach, we will continue to seek reasonably valued shares of companies that are strengthening their competitive advantages or developing new growth businesses in order to sustain their earnings potential over the longer term.

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