Beast of the East Lives!
The hedge funds are buying Japan again. Should you?
By Andy Serwer

(FORTUNE Magazine) – PROVOCATIVE INVESTING ADVICE OFTEN COMES from surprising sources. Like Dan Quayle. When the former Veep was recently asked which Asian market he was most sanguine about, Quayle, now a chairman of hedge fund Cerberus, pointed to potential pitfalls of China and India (such as a fragile banking system in the former and a lack of highly developed infrastructure in the latter) and remarked, "I say keep your eye on Japan." Dan Quayle isn't alone. In case you haven't noticed, the Japanese stock market has been on a tear. The Nikkei 225 is up over 20% year to date and just cracked 14,000 for the first time since 2001. The index has nearly doubled since bottoming out in early 2003.

I know, I know. People with a speck of gray in their hair are rolling their eyes right now. They've heard that song before: "The Japanese economy is beginning to turn around. Better get in on the action before it's too late." Yes, probably no market has produced as many head fakes, false bottoms, and badly burned investors as Japan over the past decade or so. Ever since its real estate/ banking bubble burst 15 years ago (with the Nikkei topping out at an incredible 38,916 in late 1989), Japan has been on a protracted slide. The decline was in fits and starts, though, with market seers incessantly predicting recovery just around every corner--prognostications that turned out to be false time after time.

Could this be the turn that really was? "I've put money there," says the head of one of the nation's biggest and most successful hedge funds, whom I'll call Mr. Big. "There are plenty of reasons to be optimistic. So many of the old guys who ran the country into the ground are no longer on the scene. I still think it's early in the game." In fact, much of the run-up in the Nikkei is because of players like Mr. Big. "There's been a little buying by institutional investors in Japan," says longtime Japan watcher Richard Katz, editor of the monthly newsletter Oriental Economist Report, "but most of the action has come from foreign investors." There may not be many believers at home, but both Katz and Craig Phares, a managing director at Nomura, acknowledge there is a spate of heretofore unseen positive signs. Such as:

• Government reform. Prime Minister Junichiro Koizumi was elected on a reformist ticket and has made some strides, particularly in his efforts to privatize Japan Post, which runs 25,000 post offices and has some $3 trillion in assets.

• Better banking. Craig Phares says nonperforming loans "have really been cleaned up over the past two years." He sees real loan growth for the first time in seven years.

• Robust real estate. Prices are rising after 15 lackluster years, particularly in Tokyo, where Katz says there's a noticeable increase in the number of construction cranes on the outskirts of the city.

• Economic growth. The economy is expected to grow 2% to 2.5% this year, Katz says, heady stuff for Japan. Between 1997 and 2002 there was close to zero real GDP growth.

• Rational ratios. Because profits have been gradually rising at companies like Canon and Toyota and the market went nowhere for years, Japanese price/earnings ratios are finally approaching levels comparable to those of other world markets.

The outlook for Japan is not all cherry blossoms and sake, though. "We don't have a boom in consumption yet," says Katz. "The rise in corporate profits has come out of workers' hides. Also, this is an economy that still needs to make big productivity gains." But for now, at least, the Nikkei is red-hot, outperforming the S&P 500 by ten percentage points over the past two years. So is this the beginning of a true Japanese revival or just another good-sized blip? Well, they said gold and oil would never rise again, and both did with a vengeance. Sometimes you have to expect the unexpected. How about Quayle for President in 2008? Nah, that's one bet I can't see panning out.

âñ  ANDY SERWER, editor at large of FORTUNE, can be reached at aserwer@fortunemail.com. Read him online in Street Life on fortune.com and watch him on CNN's American Morning and In the Money.