Cash in on the economic revival with these three funds and three stocks. By Andrew Tanzer, Senior Associate Editor June 30, 2006 Like a bear gingerly emerging from winter hibernation, the Japanese economy is shaking off 15 years of torpor. Deflation is giving way to rising consumer prices. Banks are lending again. The job market is firm, and wages are increasing. Real estate and stock prices, which plunged 80% after the twin bubbles burst in late 1989 and early 1990, are recovering.You can sense the return of consumer confidence in Tokyo's classy Ginza district. On one recent weekday, working women -- invariably clad in fine leather boots, cashmere sweaters and Burberry scarves -- crowd the Tiffany, Louis Vuitton and Chanel boutiques at lunch hour. Business nightlife again pulsates in Akasaka's entertainment district, where immaculately dressed and coiffed women of the night scurry to appointments with businessmen. After a few false starts in the 1990s, this recovery is likely to endure. Some of the credit can be attributed to what many view as a divine wind from China. Starting around 2002, the burgeoning Chinese economy created brisk demand for exports of steel, chemicals, machinery and other low-tech industrial products made in Japan. Corporate profits surged. The Japanese government bailed out ailing banks, using taxpayer money to purge bad loans from their balance sheets. "For ten years, Japan's financial system didn't function," says Mark Headley, manager of Matthews Japan fund. Rising interest rates, firming asset prices and demand for credit mean that banks can make money again. After nearly a decade of falling prices, the return of modest inflation helps borrowers to service their debt and encourages consumers to open their wallets to pay for durable goods and housing. Advertisement Japanese companies have changed their stripes. They now focus far more on profitability than on sales and gaining market share. At the behest of foreign investors, who own 25% of the listed shares, more Japanese companies have boosted dividends and launched share-buyback campaigns. "Corporate managements in Japan are a lot more shareholder-friendly than before," says William Kennedy, who runs Fidelity International Discovery fund. Japan's largest long-term problem is demography -- a rapidly aging society coupled with a low birthrate, little immigration and a shrinking labor pool. Moreover, the government runs a huge budget deficit. But for now, the recovery is broadening, and Japan watchers are confident that the economy will end up growing at least 3% this year. Predicts Headley: "For the next five years, the Japanese economy will be driven by massive restructuring." The Tokyo Stock Exchange index has doubled in three years, but we still see value. On the basis of price-to-book-value and price-to-cash-flow ratios, stocks are cheaper in Japan than in the U.S. and Europe. Price-earnings ratios are slightly higher, but that's mainly because earnings have been depressed. They are now rebounding smartly. Advertisement Investing in Japan provides diversification for U.S. investors. Movements in Japanese and U.S. stocks have a relatively low correlation. Plus, investors may also get a currency bonus by holding yen. The world's largest creditor nation, Japan continues to run large trade surpluses. That suggests that over the long run, the yen should appreciate against the dollar, which means that investments in yen will translate into more greenbacks. Japan makes up about a fourth of the key international stock indexes, so you should have at least a fourth of your foreign-stock assets in Japan. Many diversified foreign funds already go a long way toward meeting that target. If you own one that's light on Japanese stocks or if you want to make an even bigger bet, consider one of the funds described below. The numbers have perked up at T. Rowe Price Japan since Campbell Gunn, a 50-year-old Japanese-speaking Scot, took the reins in January 2003. From the time of his arrival to May 1, the no-load fund (symbol PRJPX; 800-638-5660) returned an annualized 31%, compared with 27% for the MSCI Japan index. The fund's annual expense ratio is 1.18%, well below the 1.61% average for all Japanese funds. Gunn buys companies of all sizes, focusing on those with above-average growth potential and return on equity (a measure of profitability). The Oxford graduate favors beneficiaries of Japan's strengthening economy. One large holding is Rakuten, Japan's largest online shopping mall. It charges rent and takes a cut from online stores' turnover. Gunn also likes health stocks, such as Terumo, a medical-device maker. And by holding shares of the three biggest Japanese banks, he's placed a large bet on the recovery of the financial sector. As prices pick up, Gunn figures, so will interest rates. That should lead to wider spreads between the banks' cost of funds and the interest rates they charge, which will goose profits. Shuhei Abe learned the fund-management ropes on Wall Street in the 1980s, including a stint with hedge-fund legend George Soros. He founded Sparx Asset Management in 1989 and today runs $14 billion, which makes him the largest independent fund manager in Japan. In the fall of 2003, the guitar-playing Abe launched U.S.-registered Sparx Japan (SPXJX; 800-632-1320). From its inception to May 1, the fund gained a sizzling 36% annualized, compared with 21% for the MSCI Japan index. Annual expenses are 1.50%. Advertisement Abe's picks are eclectic. His large holdings include Sumitomo Metal Mining, Japan's largest miner of gold, and Arrk, which supplies manufacturing prototypes to the auto and consumer-electronics industries. As Japan's economic recovery takes hold, Abe's strategy is shifting from identifying successful cost-cutters, such as Nissan Motor, to finding firms that will benefit from price and revenue increases. Want a low-cost, well-diversified way to dip your toe into the Japanese market? If so, you should find iShares MSCI Japan index (EWJ) appealing. One of the largest exchange-traded funds that invests overseas, this ETF holds 281 stocks that represent 85% of the Tokyo market's capitalization. So besides the big Japanese exporters, such as Toyota, you get a portion of domestic stocks, such as Tokyo Electric Power. The fund's annual expense ratio of 0.59% is a fraction of what you'd pay for a managed fund. Three stocks on the rise Purchasing shares in Japanese companies is a cinch. Nearly 160 trade in the U.S. as American depositary receipts. We like two companies that most Americans are familiar with and the world's largest bank. Wonder why U.S. automakers are struggling? One reason is Toyota Motor (symbol TM). Firing on all cylinders, Toyota is destined to surpass General Motors in the near future and be crowned king of the global car industry. It's tough to find chinks in Toyota's armor. It sells great products, possesses a powerful brand, produces at low cost, benefits from cutting-edge technology, boasts superb management and sits on mountains of cash. Thomas Mengel, manager of some of Ivy's overseas funds, notes that Toyota is launching a blizzard of new car models, including two Lexus luxury vehicles, in the U.S. market this year. At $112, Toyota fetches 15 times estimated earnings of $7.48 per ADR for the fiscal year ending March 2007. Advertisement In consumer electronics, a reasonable facsimile of Toyota is Canon (CAJ). A leader in digital cameras, copiers and printers, Canon constantly innovates, cuts costs, churns out high-quality products and gushes free cash flow. Campbell Gunn, manager of T. Rowe Price Japan, says that Canon's profit margins tower above those of its Japanese consumer-electronics rivals. "It's not sexy, but Canon is a brilliant company," says Peggy McKay, co-manager of JohnsonFamily International Value. Analysts see Canon earning $4.06 per ADR this year. With the stock at $77, the price-earnings ratio is 19. Because Japan's long-dormant economy is gathering steam, we prefer domestic-oriented Japanese stocks to exporters. However, few domestic companies trade in the U.S. One that does is Mitsubishi UFJ (MTU), the world's largest bank by assets. "Financials are a great way to participate in the domestic reflation story," says Mark Headley, manager of Matthews Japan fund. Interest rates are rising, which should result in increased profits from lending, so banks in Japan will enjoy a windfall. In addition, businesses, consumers and home buyers are borrowing more. The $16 stock trades at 16 times estimated profits of $0.99 per ADR for the year that ended in March 2006.