SOURCE: Japan Equity Fund

September 08, 2010 11:06 ET

The Japan Equity Fund Announces Third Quarter Earnings

JERSEY CITY, NJ--(Marketwire - September 8, 2010) -  The Japan Equity Fund, Inc. (NYSE: JEQ), a closed-end management investment company, today announced its performance results for the three months ended July 31, 2010, the third quarter of its 2010 fiscal year.

For the quarter ended July 31, 2010, the Fund incurred a net investment loss of approximately U.S. $184,000 (equivalent to a loss of U.S. $0.01 per share) resulting in net investment income for the nine-month period of approximately U.S. $1,000 (equivalent to income of less than U.S. $0.01 per share). In addition, net realized and unrealized losses from investment activities and foreign currency transactions during that same three-month period were approximately U.S. $6,805,000 (equivalent to a loss of U.S. $0.47 per share). As a result, the net realized and unrealized gains were approximately U.S. $367,000 (equivalent to a gain of U.S. $0.03 per share) for the nine months ended July 31, 2010.

In comparison, during the quarter ended July 31, 2009, the Fund incurred a net investment loss of approximately U.S. $233,000 (equivalent to a loss of U.S. $0.02 per share) resulting in net investment income for the nine-month period of approximately U.S. $65,000 (equivalent to income of less than U.S. $0.01 per share). In addition, net realized and unrealized gains from investment activities and foreign currency transactions during that same three-month period were approximately U.S. $12,775,000 (equivalent to a gain of U.S. $0.88 per share). As a result, the net realized and unrealized gains were approximately U.S. $9,238,000 (equivalent to a gain of U.S. $0.64 per share) for the nine months ended July 31, 2009.

On July 31, 2010, the total net assets of the Fund were approximately U.S. $86.8 million. The net asset value ("NAV") per share on that date was U.S. $6.01, based on 14,446,336 shares outstanding. In comparison, total net assets on July 31, 2009 were approximately U.S. $86.9 million, equivalent to a NAV of U.S. $6.01 per share, based on 14,441,200 shares outstanding. 

Assuming the reinvestment of the U.S. $0.038 per share dividend paid on December 30, 2009, the Fund generated an investment return of 0.56% for the nine months ended July 31, 2010, when measured against the NAV per share of U.S. $6.02 on October 31, 2009, based on 14,441,200 shares outstanding at that time. During the same period, the Fund's benchmark, the Tokyo Stock Price Index (the "TOPIX Index"), decreased by 0.10% in U.S. dollar ("USD") terms.

As of July 31, 2010, the Fund had 98.85% of its net assets invested in Japanese common stocks. The remaining net assets were represented by a short-term USD-denominated time deposit (0.34%) and other assets less liabilities (0.81%). 

As of September 7, 2010, the Fund's NAV per share was U.S. $6.09, based on net assets of U.S. $88.0 million. On the same date, the market price of the Fund's shares on the New York Stock Exchange closed at U.S. $5.31, representing a trading discount to net asset value per share of 12.81%.

Market Review and Outlook

During the period from May to July 2010, the NAV of the Fund decreased 8.08%, while the benchmark TOPIX Index declined 6.62%. As a result, the Fund underperformed the benchmark by 1.46% in USD terms. In Japanese yen terms, the equity portion of the Fund fell 15.20%, while the TOPIX slid 13.89%, after double-digit gains in the previous quarter. Soon after the period began, the market headed south on renewed concerns over Greece's sovereign debt woes, which was a repeat of events in February. At the same time, the Japanese yen, which lately has been regarded as a safety-net, resumed its rise against the USD and euro amid deepening global financial anxieties. This resulted in the underperformance of the Tokyo market compared with those in peer developed countries. Fundamentals for Japanese companies have remained positive, and strong results in the April-June quarter reinforced this view. However, the positive showing could not outstrip concerns over a "double-dip" in the global economy, which have loomed large of late.

Summary of current Tokyo market investment themes:

A deflationary mindset
There have been many investigations into the possible causes of Japan's persistent deflation, including falling demand and oversupply, an aging society, globalization, the proliferation of IT, insufficient credit easing by the central bank and the crippling of productive 'credit creation' by banks. Government economists, including those from the Bank of Japan (BoJ), tend to emphasize the real economic aspects, such as the demand shortage/supply excess. On the other hand, private economists tend to emphasize the monetary aspects. While both perspectives are valid, no single factor from either camp can sufficiently explain Japan's mild but persistent deflation. Countries with higher unemployment rates and similar demographic patterns have had positive inflation, while globalization and the IT boom are both global phenomena. The egalitarian mindset of the Japanese society and culture may have contributed to the country's persistent deflation. The Japanese tend to accept wage cuts rather than job cuts, and share the workload. In addition, suppliers approach competition using price discounts to attract customers, despite the fact that in doing so they may be sacrificing profits. While mild deflation is quite agreeable to Japan's aged pensioners, government employees and salaried workers comfortably ensconced within large corporations, the status of the latter group may no longer be as secure as it once was, as evidenced by the recent situation at Japan Airlines. This is probably one reason why the U.S. will not be mired in the same sort of persistent deflation that is currently plaguing Japan.

Therefore, the question now becomes, "how do we reverse this deflation?" Recent political developments can provide some clues. The ruling Democratic Party of Japan (DPJ) fared quite poorly under Prime Minister Kan's leadership in the recent Upper House elections, with one major reason being Mr. Kan's suggestion of a hike in the consumption tax from 5% to 10%. By contrast, the new reformist party, 'Your Party', picked up ten additional seats, making it, even more than the opposition heavyweight Liberal Democratic Party (LDP), the clear winner in the recent elections. Your Party insists on a bill that would require the BoJ to pursue an inflationary target as part of its monetary policy, a stance echoed by some in both the DPJ and LDP. Combining a series of gradual consumption tax hikes, say 1% per year over a 10-year period to bring it up to 15%, with a BoJ inflation target of 2% would be enough to eliminate the deflationary mindset that has been deeply rooted in Japanese society. In addition, reductions in corporate and capital gains taxes would also be necessary in order to encourage investment. The DPJ's setback in the recent Upper House elections is expected to force a reorientation of the party from center-left to, at least, center, which will hopefully prompt it to heed the needs of both businesses and investors.

The yen's paradox
Following the Lehman Brothers bankruptcy, the Japanese yen acquired 'safe haven' status, marked by an inverse correlation between its movement and that of riskier assets such as commodities and equities. By contrast, the USD lost some of its safe haven status in response to the country's sluggish economic recovery, the aggressive policy actions of the Fed, and the favourable export policies of the Obama administration. This is quite unfortunate for Japan, which, as previously stated, has been hampered by mild but persistent deflation. The somewhat complacent and 'behind-the-curve' stance of the BoJ sharply contrasts with the aggressive and forward-looking policies of the U.S. Fed and, as a result, may lead to further yen appreciation against the USD. The threshold appears to be at the 85 yen per USD level and, beyond this, the passivity of monetary authorities will elicit a storm of complaints and pressure by both businesses and politicians.

Cheap equities
Japanese equities are cheap, with an average dividend yield of 2% versus the 1% yield of 10-year Japan Government Bonds (JGBs). This is perhaps attributable to the tendency of risk-averse financial institutions and pension funds to favor fixed income securities over equities. The corporate internal growth rate, a proxy for the capital appreciation potential of the Japanese equity market, has been calculated to be 6.6%, or 4.4% using estimated earnings and payouts for the fiscal year ending March 2011. Taking into account for the 2% dividend yield, we arrive at a total return expectation of 6.4%. Even after allowing for the increased risk premium inherent to equities, particularly with the increased volatility of recent years, a 6% to 7% annual return is quite attractive relative to a 1.0% JGB yield. Although this is a rather simplified calculation, it is quite challenging to reverse hidebound investment trends, especially after the spectacular performance that JGBs have had relative to Japanese stocks over the past two decades. Regardless of the methodology, an end to deflation is definitely required.

Risk factors
In the near term, risk factors include: 1) a double dip in the global economy, led by the world's advanced countries; 2) a slowdown in the Chinese economy; and 3) a double dip in the Japanese economy on the back of an overvalued yen as well as the expiration of fiscal stimulus measures, with corporate profits likely having peaked during the April-June 2010 quarter.

With regard to sector strategy, there will be no change to our strategy of modestly overweighting Industrials, Consumer Discretionaries and Materials, while we will continue our modest underweighting of defensive sectors such as Utilities and Health Care. We are neutral with regard to the remaining sectors. Our allocation strategy is largely based on valuations as well as stock selection opportunities. With regard to stock selection, we will continue to focus on the beneficiaries of the strong growth in Asian domestic demand. In addition, we will focus on value stocks with strong balance sheets and cash flows. Mergers and acquisitions (M&A) could also be a positive catalyst in the market, given the abundance of cash currently being held by Japanese corporations.

The ten largest industry classifications of the Fund's Japanese equity investments held as of July 31, 2010 were:

Industry Percentage of
Net Assets
1. Electric Appliances 13.39 %
2. Transportation Equipment 9.35  
3. Banks 9.29  
4. Machinery 5.65  
5. Chemicals 5.31  
6. Wholesale Trade 5.17  
7. Retail Trade 5.00  
8. Communication 4.50  
9. Insurance 3.92  
10. Land Transportation 3.82  

The Fund's ten largest individual common stock holdings at the same date were:

Issue Percentage of
Net Assets
1. Mitsubishi UFJ Financial Group, Inc. 4.64 %
2. Honda Motor Co., Ltd. 3.07  
3. Toyota Motor Corp. 2.67  
4. Panasonic Corp. 2.40  
5. Mitsui Fudosan Co., Ltd. 2.08  
6. Tokio Marine Holdings Inc. 2.05  
7. NTT Corp. 2.05  
8. Mitsubishi Corp. 2.03  
9. Ajinomoto Co., Inc. 1.97  
10. Sumitomo Electric Industries Ltd. 1.91  


QUARTER ENDED   Net Investment Income (Loss) Net Realized and Unrealized Gains (Losses) on Investments and Currency Transactions Net Increase (Decrease) in Net Assets Resulting From Operations
    Total (000) Per Share Total (000) Per Share Total (000) Per Share
January 31, 2010   $ (212) $ (0.01) $ 2,190 $ 0.15 $ 1,978 $ 0.14
April 30, 2010     397   0.02   4,982   0.35   5,379   0.37
July 31, 2010     (184)   (0.01)   (6,805)   (0.47)   (6,989)   (0.48)
For the Nine Months Ended July 31, 2010   $ 1 $ 0.00 $   367 $ 0.03 $ 368 $ 0.03
January 31, 2009   $ (140) $ (0.01) $  (249) $ (0.02) $   (389) $ (0.03)
April 30, 2009     438   0.03   (3,288)   (0.22)   (2,850)   (0.19)
July 31, 2009     (233)   (0.02)   12,775   0.88   12,542   0.86
October 31, 2009     266   0.02      (163)   (0.01)      103   0.01
For the Year Ended October 31, 2009   $ 331 $ 0.02 $ 9,075 $ 0.63 $ 9,406 $ 0.65
      Net Asset   Market   Share
QUARTER ENDED     Value   Price*   Volume*
      High   Low   High   Low   (000)
January 31, 2010   $ 6.54 $ 5.73 $ 5.69 $ 4.74   1,548
April 30, 2010     6.64   5.96   6.02   5.11   1,374
July 31, 2010     6.49   5.76   5.93   4.82   1,067
January 31, 2009   $ 5.98 $ 5.06 $ 5.43 $ 4.26   1,709
April 30, 2009     5.36   4.28   4.84   3.56   1,965
July 31, 2009     6.01   5.15   5.52   4.37   1,407
October 31, 2009     6.37   5.88   5.76   5.01   1,932
*As reported on the New York Stock Exchange.

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