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How time flies. It only seems like yesterday that Japanese stocks were soaring and Japan was the hottest stockmarket in the world. Japanese small cap stocks were the place to be as investors sought to tap into a nascent domestic recovery story.

The contrast between now and then is stark. One of our colleagues has recently returned from a three-day investment conference where not one sponsor elected to profile a Japan fund. Eighteen months of poor performance has dampened the spirits of even the most ardent bulls.

It is no wonder why. Since the start of 2006, the Topix index has risen by 7.6 per cent while the FTSE 100 index is up by 10 per cent more. Ongoing weakness in the yen has taken more shine off Japan. The Topix is down by 12 per cent in sterling terms over the period and the average fund is down by a painful 16.4 per cent.

All this adds up to a major performance headache. Unsurprisingly, many long-only international funds have cut weightings. We have also lightened up a little in Japan but we are not inclined to throw in the towel. While the price action has been very disappointing, the economy and companies in it have continued to make progress.

A Western-style approach to capitalism is increasingly apparent wherever you look in Japan. In place of the flagrant misuse and waste of shareholders’ capital that sometimes characterised Japanese corporate behaviour in the past, companies now pay higher dividends, buyback shares and restructure underperforming businesses. The usual suspects – activist shareholders and private equity – police their compliance. Activists have recently had some setbacks in the courts but we expect they will not be put off. Indeed, they may now act in a way that is more beneficial to shareholders other than themselves.

These changed patterns of behaviour will go on for years and if anything will accelerate. Foreign investors account for a growing proportion of Japan’s investor base and they will increasingly demand shareholder-friendly behaviour from management. The medium-term impact on the rate of return on capital, which traditionally lags the rest of the world, could be profound.

The economic backdrop that companies are operating against is not so bad either. Inflation refuses to return, which has led the Bank of Japan to leave interest rates close to zero. That has not helped domestic spending, which would be boosted by the return of inflation (price falls encourage consumers to defer spending) and by the income uplift that comes with higher rates (most wealth in Japan is in bank deposit accounts paying no interest).

Lower than expected short rates have encouraged investors to shun the yen, which has been of huge benefit to the export sector.

Investment spend has also continued to be fairly robust. All in all, growth continues to be very respectable. There is a lot of song and dance about the renaissance taking place in the eurozone. How many people noticed Japan grew faster than Europe in Q1 2007?

We think Japan will emerge unambiguously from its extended economic malaise. A meaningful boost to its growth rate from the pick-up in the global industrial production cycle could be a catalyst for that.

Lead indicators suggest this could happen in H2 2007. We have continued to run some exposure to Japan in our funds. We also think the yen is a good hedge against unexpected upsets elsewhere in global markets. Time will tell whether our confidence is rewarded.

Bill McQuaker and Katy Gladstone are heads of multi-manager investments at Henderson Global Investors

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