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Rising Stocks of the Rising Sun

Ryan is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

At a glance, Japan appears to be a mess.

With GDP contracting at a 3.5% clip last quarter – and the previous quarter’s small growth revised to a small contraction – the country is officially in recession. The current quarter is expected to see GDP fall even further.

A trade spat with China has hurt the economy. Poor economic growth around the world has hurt exports. The country’s debt-to-GDP is around 250%. And the fallout from Japan’s earthquake and nuclear disaster last year continue to be a problem.

The government estimates the earthquake will cost over 16 trillion yen ($185 billion) when all is said and done – with most experts expecting that number to be low. Worse, surprisingly rampant corruption has been diverting funds earmarked for the recovery to other, less-useful projects.

However, despite all this bad news, the Nikkei index is up 25% since June 5th, hitting a post-quake high this week. What gives? Is this an irrational blip for a country in disarray, or a sign of a turnaround in 2013?

Before we can answer that question, we must ask another – what part of the Japanese economy are we talking about?

A tale of two cities

When Western pundits talk about Japan as a whole, they miss the point. In reality, Japan has two different economies – and their fortunes aren’t well-linked.

Each economy is centered around a major city – with Osaka dominating manufacturing and production, while Tokyo serves as the hub for most everything else (including plenty of high-tech manufacturing).

These two centers of activity are so dominant within Japan’s economy, that almost everything else gets washed out. Picture the U.S. with only Detroit and New York as the major economic hubs, with every other city feeding off of them.

When you view the country this way, things start to make a lot more sense.

Weakness in high-tech

Manufacturing in Japan has been decimated – it’s hit a 44-month low, with the Purchasing Manager’s Index dropping to 45 (anything under 50 indicates contraction). The strong yen and weak domestic demand have combined to see manufacturing output fall 1.7% last month alone – with both volume and, crucially, new orders falling at their steepest rates since April 2011.

No surprise, then, that Japan’s electronic manufacturing powerhouses are suffering. Sony (NYSE: SNE) has fallen 22% in the past six months, with the PlayStation nearing the end of a cycle and Sony’s flat screen TVs getting squeezed by cheaper products from China and better products from Korea.

Panasonic (NASDAQOTH: PCRFY) is doing even worse, off 29% in 2012, with no obvious plan out of the woods. Just try to think of something Panasonic makes… HDTVs? Cameras? Is Panasonic a top choice in any of its fields? At the moment, no.

And Sharp may be doing the worst of all. In the last 6 months, Sharp’s stock is down 30%, with the company selling off factories to competitors and selling pieces of itself just to stay afloat.

If you want to see the Bad Japan, look no further than these once-mighty companies bowed low by Japan’s poor economy.

But not all of Japan is suffering the same way.

Bright spots

Japan’s car manufacturers are somewhat immune to the problems in the country, because so much of the actual production takes place abroad, dampening obstacles like a strong yen and power supply issues.

That’s why Toyota (NYSE: TM) is up nearly 40% this year, Nissan has advanced 10% in just the past month, and Honda (NYSE: HMC) is up 8% in just the past week. By moving most their production offshore, these companies have avoided the worst of Japan’s fate.

Not to mention, each of these companies is on the forefront of automobile technology, with the best hybrid and electric vehicles coming from minds in Japanese headquarters. While Sony and the other electronics manufacturers have fallen behind, Japan’s automobile industry is still leading.

And they’re not the only ones thriving. When a country has that much debt to service, savings as large as Japan’s, and coming stimulus that needs funneling, the financial sector is bound to do well. The easiest way to invest in Japan’s financial industries is through Nomura Holdings (NYSE: NMR). There are other great banks – but not many on American exchanges. Besides, who needs others? Nomura – one of the largest banks in the world – is up 92% this year. It’s pretty hard to find that kind of growth in large-cap blue chips, but it’s happening in Japan right now.

When you break Japan’s economy down into sectors, it becomes much easier to see how its economic malaise and a bull market can co-exist.

Combine that with general excitement over the LDP’s election and the large stimuli promised in the latest Japanese election, and the Nikkei’s rise starts to make sense. Indeed – the Nikkei’s advance coincides almost exactly with the LDP’s landslide win.

Some might argue that this bull market is destined to be short-lived – just a product of the election. Once the results are inevitably disappointing, Japan’s stocks will tumble back down.

I’d argue that Japan’s stocks have been criminally undervalued for years. Indeed – Japanese stocks have a price-to-book ratio under one, meaning that if all those companies shuttered their doors today and sold their parts, you’d still make money. By comparison, the S&P 500 (itself cheaper than usual) has an average price-to-book of 2.15. Other metrics like price-to-sales or price-to-cash flow are even better.

Avoid the companies centered around Japan’s ailing manufacturing center. Focus on Japan’s financial sector, and it’s leading industries like automobiles. And you’ll be glad you got in on this bull market early, instead of sitting it out.

Ryan Cole has no positions in the stocks mentioned above. The Motley Fool is short Sony (ADR) and has the following options: long JAN 2013 $22.00 calls on Sony (ADR). Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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