TOKYO'S STOCK MARKET: STRONGER THAN YOU THINK Those harrowing P/Es look safer when you adjust for accounting and cultural differences between East and West. And the economy is booming. Still, buy with caution.
By John J. Curran REPORTER ASSOCIATES Leslie Brody and Fumiko Shioda

(FORTUNE Magazine) – WESTERN INVESTORS have been worrying about the Tokyo stock market, which many consider, to adapt a phrase, a riddle wrapped in an enigma, with a dash of inscrutability thrown in. Share prices that seemed high before Black Monday have now practically climbed back to where they were before the crash. Will Tokyo lead the way down next time, dragging the whole world with it? Not likely. The Japanese market is not as overvalued as you may think. What's the evidence, you ask? Japan's economy is booming, yet inflation remains at what Americans would consider a satisfying creep. After a two-year lull, corporate profits are surging. Domestic spending has increased sharply, making up partly for the drop in exports induced by the rising yen. Tokyo's high-priced Ginza shopping district, once a mecca for tourists, now bustles with Japan's own legion of consumers. The country's GNP charged ahead at a 7% rate in the fourth quarter of 1987, a big surprise to Western forecasters who thought the strong yen would strangle growth. Does all that mean you should buy in? Perhaps -- but with caution, not gusto. No bull market lasts forever, and Tokyo's has been chugging along for 12 years. Even the good economic news could damp the fires a bit. As growth accelerates, Japanese companies that had been pumping cash into stocks are bound to need the money for their own businesses. Furthermore, some stocks really are overpriced. But others still bear considering if you've got a lot of patience -- and know what to look for (see box). The biggest Japanese investors remain unflappably bullish. Money managers at Nippon Life saw a cool $15 billion melt out of their portfolio in the crash. But they have recouped most of it since and now believe that improved corporate profits and a surplus of buying power among Japanese investors could push the market up another 15% by the end of the year. They insist that if stocks did dive again, they would be buyers, not sellers. Says Nobuyuki Adachi, the newly appointed master of Nippon Life's $95 billion stock portfolio and a man who must invest a chunk of the $20 billion of new funds he receives each year in the stock market: ''Our assets are increasing so fast the stock market cannot absorb all of our funds.'' Japanese investors see in their market something that many Westerners have long been unable to discern: value. Japanese stocks have never fit very well into Western methods of valuation because of large differences in accounting and culture. Rather than bridge those gaps, many foreign investors simply stayed out, citing Tokyo's triple-digit P/E multiples as evidence of Oriental money madness. With proper adjustments, though, those P/Es don't look so scary. For starters, Japanese earnings often include only the parent company, typically about 70% of what a consolidated report would show. In many cases the understatement can be much larger. In the most recent fiscal year, Honda's consolidated earnings were twice as high as the parent's alone; Matsushita's were 72% higher. Even when earnings are consolidated, they are still lower than they would be under American accounting standards. That's because Japanese companies have a compelling reason to minimize reported profits: The corporate tax rate in Japan runs to 53%. Under U.S. guidelines, companies are permitted to report profits two ways: as low as possible for the Internal Revenue Service and as high as possible for shareholders. Many factors contribute to making earnings higher for shareholders than for the tax man, but the big one is accelerated depreciation. American companies typically use this method of tax accounting to take a big bite out of earnings. In reporting to shareholders, they use a slower ''straight line'' method, which reduces the yearly amount by spreading it over a greater number of years. The effect is a lower tax bill and a rosier annual report. In Japan, companies count their winnings only once. As a result, the accelerated depreciation they use to push down earnings for tax purposes also squashes profits reported to shareholders. SECURITY ANALYSTS concede that because Japanese and American accounting procedures differ at every step, a perfect translation of earnings is impossible. For that reason, they prefer to look at the cash flow of Japanese companies rather than reported earnings. Cash flow includes those revenues written off through depreciation. While the method has flaws, it does help wash out distortion in comparing U.S. and Japanese stocks. And it quickly debunks the notion that Japanese stocks are somewhere out in hyperspace. Take the case of Hitachi vs. General Electric. GE was recently selling at $43 per share, and its 1987 earnings per share were $2.43. Its P/E based on the most recent four quarters was 17.6, not far from the average P/E of 15.5 for all American stocks. Hitachi's share price is 1,360 yen. The company's reported earnings per share were 33 yen, which gives it a reported P/E of 41. Put both companies on a cash flow basis, and the picture changes radically. GE's cash flow per share is about $4.40, while Hitachi's is about 144 yen. Thus GE sells for 9.7 times cash flow, Hitachi for 9. Viewed this way, Hitachi is a rather moderately priced stock. Other Japanese industrials sell for more in relation to cash flow, but nowhere near the lunatic levels many Westerners think. The average price-to-cash-flow multiple for industrial stocks in Japan hovers around 15, twice the average multiple of 7 that prevails for American stocks. IF THAT STILL SOUNDS dangerously pricey, the adjustments aren't over. Any measure of the value of a stock doesn't mean much without comparison with other investments. Bonds are the chief alternative in all of the world's major financial markets. In the U.S., the price-to-cash-flow multiple on the Standard & Poor's 400-stock index is 7, while the return on risk-free ten-year government bonds is 8.3%. To place the stock and bond markets on an equal footing, divide the stock market's price-to-cash-flow multiple of 7 into 1. That provides a theoretical bondlike yield from stocks -- in this case, a little over 14% -- which can then be compared with the yield available from bonds. The comparison is not exact since it does not take into account future increases in the company's cash flow. Nor do investors pocket the entire cash flow from stocks as they do with a bond. But it does offer an acceptable comparison across markets. In Japan, the price-to-cash-flow multiple is 15, which translates into a cash flow yield of 6.7%. But the interest rate on ten-year Japanese government bonds is only slightly more than 4%, or about half the rate prevailing in the U.S. What the comparison shows is that while Japan's industrial stocks are not cheap, they are only slightly more expensive in relation to bonds than American stocks (a 6.7% yield and a 4% bond rate, vs. a 14% yield and an 8.3% bond rate). But simple financial ratios, even after adjusting for accounting differences, tell only part of the story. Japanese companies generally pursue long-term strategies that give only passing consideration to current earnings. ''How do you factor into the P/E that Toyota has said it will forfeit profits to maintain market share?'' asks a longtime investor in Japan. Fukuo Shigeta, an institutional investor who translated Benjamin Graham's Intelligent Investor into Japanese and has worked on Wall Street, finds Western methods of valuation wholly inappropriate to Japan. Sometimes Shigeta will shun stocks that Americans would love, and buy those that Western valuation methods would point to as overvalued. ''I won't pay 20 times earnings for a big company that has 5% profit margins. Where's the room for improvement?'' he says. ''But I may pay 30 times earnings for a smaller company that has a good market share and only a 1% profit margin.'' The lure, he says, is in potential for improvement, however far off. Shigeta, who is president of Nippon Finance Management, an investment advisory firm, boasts an enviable performance record: His Samurai Portfolio for institutional investors is ranked No. 1 for three-year performance among 36 Pacific Basin stock funds tracked by the Lipper Overseas Fund Table. Overvalued stocks do exist in Japan, but their high prices generally reflect unusual circumstances rather than widespread investor lunacy. NTT, the telephone giant, is the prime example. Its shares have been trading recently at just over $19,000 each, or a P/E of 225. Most Japanese investors would agree that it is no great buy at that price, but the stock is a rare bird for two reasons. When the government sold 12.5% of NTT to the public in 1986, it distributed shares to NTT customers. The new stockholders, many owning a single share, cherished their possession as a symbol of Japan's technological progress. Institutional investors, who saw NTT as a good long-term holding, had to offer a handsome price to pry away those shares. In addition, the government apparently has been pressuring major brokers to keep the price up because it is using cash from NTT stock sales to pay for major public works programs. Another factor driving up the prices of some stock groups is the widespread cross-ownership of shares by major corporations. The custom was Japan's reaction to U.S. attempts just after World War II to restructure Japanese industry along the lines of American publicly held corporations. The U.S. disbanded Japan's great industrial families, or zaibatsu, breaking them up into many separate companies. When the American Occupation ended, Japanese companies re-formed their corporate alliances on an unofficial basis by buying large blocks of one another's stocks and tucking them away. Yusaku Futatsugi, a professor of business at Kobe University, estimates that within the big industrial groups, an average of 25% of a company's shares are held by other companies in the group. For banks, some 90% of shares are held by major corporations. Thus, when investors got interested in the group in 1984, prices rose tenfold because so few shares were available. The Industrial Bank of Japan, for instance, still sells at 14.4 times book value and 140 times earnings. Since bank stocks make up over 20% of the Japanese market, some Western analysts have worried that a collapse in their prices could trigger a general slide. The threat seems overblown because the banks' corporate stockholders, usually big customers, are extremely loyal. If outsiders started bailing out, corporate holders would undoubtedly buy to support the stocks. More vulnerable, though, are the so-called hidden-asset stocks. Assets in Japan mean just two things: stock and real estate -- especially in downtown Tokyo, where prices are the highest in the world. The price of prime Tokyo land has been as high as $29,000 per square foot. One-bedroom apartments can cost $1 million or more. Reflecting those way-out values, the shares of big landholders like railroads and utilities have shot up. Now the government is cooling down the market. To discourage speculation, the ministry of finance slapped a 90% capital gains tax on land held less than two years. The ministry also asked banks to cut back real estate lending. Land prices in Tokyo are down as much as 20% in some areas, and many analysts think the hidden-asset stocks, already below their highs, could weaken further. One factor that calms Japanese investors' nerves is confidence that the government can keep the market under control. Can it? The web of regulations along with vigorous government intervention did help limit the damage in the crash. While prices dropped 23% in New York, they were down only 15% in Tokyo. The rules impose daily price limits to keep stocks from falling too far in a single trading session. The government pulled plenty of strings in the weeks and months following too. Shortly after the market's drop, officials at Japan's powerful ministry of finance became concerned that stock held on margin might have to be sold, so it quickly moved to loosen margin requirements. Government officials also apparently asked banks and brokers to step in and support the market when it dropped enough to trigger widespread margin calls. Says one Tokyo-based money manager: ''No one will admit that's what happened, but when the market approached certain levels, buying really picked up.'' In a further step to ease selling pressure, officials rewrote some reporting procedures that would have required big corporate investors to reveal the size of their losses to their own shareholders. Among the biggest losers in the market crash were the aggressive Tokkin funds, large mutual funds for spare corporate cash, which had amassed some $230 billion in recent years, roughly one-third of it in stocks. Officials feared that reports of huge paper losses could frighten many Tokkin investors into withdrawing their money, prompting a deluge of stock sales. In the aftermath of the crash, the net selling of Tokkin funds alone could have run into the tens of billions of dollars according to studies compiled by Swiss Bank Corp. TO HELP the Tokkin fund managers weather their losses, and to prevent further selling, the ministry of finance rapidly instituted several rule changes. It permitted fund managers to carry stocks on their books at cost, ignoring the losses suffered in October. In another instance the ministry allowed certain companies to remove stocks that were big losers from their Tokkin accounts without recognizing the loss. Nobumitsu Kagami, a managing director at Nomura Investment Management who handles Tokkin funds, believes the accounting rule changes alone spared the market considerable losses by relieving the pressure to sell. And by bolstering confidence, he thinks, they contributed as much as 1,000 points to the Nikkei stock average's recovery. It is dangerously naive to believe that such last-minute interventions can save overvalued markets from correcting, or hyped-up markets from crashing. Nor can accounting rules keep losses from being losses. But those stopgap measures did slow the whole process to the point where it became manageable, staving off a rash of selling. These events highlight the unusual relationship between business and government in Japan, a relationship so strong that it has to become part of any analyst's system of evaluation. The relationship leads investors to believe that a consensus-driven, interventionist government will somehow prevent things from unwinding. That is why the Japanese did not panic on the day of the crash and why the perception of value in Japan is ultimately so difficult for Westerners to grasp. Says Donald Krueger, a Japanese stock analyst at Wertheim Schroder & Co.: ''There is an invisible hand that creates value in the Japanese market.'' THE HANDS-ON management style of government extends far beyond the financial markets. Faced with falling exports that jeopardized economic growth during the past two years, Japan's Diet quickly moved to turn the tide by spending heavily to stimulate domestic demand. The Diet voted last year to inject $11 billion into the domestic economy through a newly created public works program. To further spur domestic consumption, government officials moved to unleash years of pent-up consumer demand by cutting taxes and stripping away the tax exemption on Japan's great savings system. Called the Maruyu, the system bottled up individual savings of more than $2 trillion. Finally, taking advantage of the disinflationary effects of a strong yen, the Bank of Japan allowed money supply growth to climb to double-digit rates. The results of these stimulants were quick and dramatic: In the fourth quarter of 1987, Japan's Economic Planning Agency estimates, domestic demand grew at a 10% annual rate, surpassing a robust 7.8% growth rate in the third quarter. Investors' faith in the healing power of governmental intervention has rarely run higher. Still, all is not necessarily rosy for stocks in the months ahead. As the economy picks up speed, capital investment will increase, leaving corporations less money to put into the market. In the fourth quarter of 1987, capital spending rose 10%. Says Nomura's Kagami: ''Clients are saying, 'Why take the risk of investing in stocks when you can make good money from operations?' '' At the Tokkin funds, among the biggest buyers of stocks in recent years, redemptions exceeded new investment in three of the last five months reported. A wave of foreign buying is currently taking up the slack, but analysts are increasingly worried about who will replace the foreigners once they start slowing down. Also inflation is coming back, at least in Japanese eyes. In 1987 the rate was an infinitesimal 0.1%. But reflecting the economy's new zip, it increased to a 0.9% rate in January. Such a minor blip hardly seems worth noting, but Japanese investors have an extremely low threshold of pain when it comes to inflation. A rate of 3% could send them toward the exits, according to a number of institutional investors FORTUNE spoke with. Not that a 3% inflation rate would ravage Japan's robust economy. But it could undermine the Japanese perception of value by reducing confidence in the economy's long-term stability. IF THE PRICE OF OIL, Japan's chief import, continues to drop, the small threat of inflation should go away. Hirohiko Okumura, chief economist at Nomura Research Institute, figures that cheaper oil will make up for any price increases elsewhere in the economy. By his reckoning, a $1 change in the price of oil raises or lowers Japan's inflation rate by about half a percentage point. As of mid-March, world oil prices have slipped by $3 per barrel, though many analysts do expect higher oil prices later this year. The biggest problem for foreign investors is that the notion of a crash- resistant Tokyo stock market may be dawning on them a bit late. In January, after years of staying out, foreigners once again became major buyers of Japanese stocks. But by then the dramatic improvements in the Japanese economy had already pushed up prices. Inscrutability lives. $ BOX: WHAT TO BUY IN THE TOKYO MARKET

Whether to invest in Japan is just the first question. What to buy after you decide to is the second head-scratcher. Japanese investors don't get nearly as excited about undervalued stocks as Americans do. In fact, the familiar Wall Street approach of buying out-of-favor stocks with low P/E multiples usually comes up short. A better bet, old hands in the market say, is to go with stocks that investors can get excited about. As Edwin Merner, a director at Schroder Investment Management of Japan, says, ''Japanese like stocks with a story.'' The best story right now for Fukuo Shigeta at Nippon Finance Management is Japan's construction boom. ''Since the Roman Empire,'' he says, ''whenever a nation becomes rich you see an explosion of construction of new buildings. Now it's about to happen in Tokyo.'' Among Shigeta's favorites is Taikisha, a Tokyo company that engineers air-conditioning systems. Outside of construction, Shigeta likes a pharmaceutical company called Tanabe, which supplies Cardizem, a heart drug, to Marion Laboratories in the U.S. Nomura's top strategists think some play is left in selected hidden-asset stocks -- companies that own land in Tokyo and other desirable places -- despite very high P/Es. Hideo Nakazawa, general manager of Nomura's equity department, recommends Mitsui Real Estate, which holds a large tract near Tokyo Bay. He also likes Kawasaki Steel, not for its steelmaking prowess but because of a big chunk of land it owns in Chiba Prefecture southeast of Tokyo. Toru Hiramatsu, a strategist at Nikko Securities, has a scheme that may well offer investors the best chance for success, but its logic is sure to leave Westerners feeling like victims of a double reverse. Hiramatsu believes that a big payoff in 1988 will come from buying low P/E stocks. Reason: Foreign investors will be the big new buyers in Japan, and those foreigners, Hiramatsu says, are notoriously big fans of low P/Es.

CHART: NOT AVAILABLE CREDIT: NO CREDIT SOURCE: MORGAN STANLEY CAPITAL INTERNATIONAL PERSPECTIVE CAPTION: THE SPEEDY RECOVERY IN JAPAN Stock price controls and government intervention kept Japan's market from sliding as far as Western exchanges -- and brought it back faster. DESCRIPTION: Stock prices in United States, Japan and United Kingdom, September 1987 to March 11, 1988.