Last year, the Nikkei outperformed all major developed market indices with returns of over 14 per cent in sterling terms.
It was the culmination of three strong years for the Japanese market, driven largely by currency weakness which has benefited Japanese exporters by making their products more competitive overseas.
This year has been a very different story, however. The yen has strengthened ferociously and Japanese stocks have dropped 13 per cent since January, revealing the frail underpinnings of the rally sparked by prime minister Shinzo Abe's invigoration programme.
CHANGE IN SENTIMENT
Foreign investors, who make up some 60 per cent of trading on the Tokyo Stock Exchange, have sold down about 43 per cent of their holdings so far this year, and in a toxic feedback loop, every time they've sold stock they've simultaneously closed out their short yen positions.
This in turn has pushed up the currency, prompting investors to offload yet more stocks, as many companies have been propped up by yen weakness.
The change in sentiment can be traced back to the Bank of Japan's (BoJ's) decision to impose negative rates on excess bank reserves in late January, which was widely seen as confirmation that its massive quantitative easing programme has reached its limits.
At the same time, concern culminated over the US Federal Reserve's rate decision, the slowdown in China and rising oil prices, followed by a series of earthquakes that damaged the supply chains of car manufacturers.
Although many investors still perceive Japan as a slow-growth economy and have ignored it, at current low levels Japanese stock now arguably represents excellent value.
'The sharp market sell-off in the first quarter has left Japanese equities at even more extraordinarily cheap levels on a number of metrics,' explains Ruth Nash, co-manager of the JOHCM Japan and JOHCM Japan Dividend Growth funds.
'Over half of the stocks in our fund yield more than 2.5 per cent, broadly two-thirds of our stocks trade at below the value of their assets as recorded in their accounts, and more than one third of our holdings trade on single-digit earnings multiples. This value is unprecedented.
'Corporate profits have been increasing sharply since the introduction of Abenomics,' she adds. 'A weaker yen has certainly helped, so the recent recovery in the currency will lead to modest earnings downgrades in the near term, but valuations more than price these in.
'Furthermore, dividends look more sustainable in Japan than in other major developed markets, given low payout ratios and increasingly shareholder-friendly behaviour by Japanese management teams. A recent uptick in share buybacks provides another reason for optimism.'
The consensus among the sector's top managers is that this new focus by companies on increasing shareholder returns will continue to drive the market.
'There is a great deal of value within Japan,' explains Ian Wright, of the eponymous specialist Japan fund manager Morant Wright. 'Our portfolio for example trades at just 80 per cent of book value, and many companies have substantial holdings of cash and in some cases undervalued land.
'We believe that this cash will be better utilised in the future, to the benefit of shareholders; and the continued trend of rising dividends and buybacks, which hit a record high last fiscal year, will benefit the portfolio over the longer term.'
LARGE COMPANY FIXATION
While the temptation has always been for western-based investors to focus on the largest cyclical names - the manufacturers, export firms and financials that dominate the market - better opportunities lie in the smaller-cap areas of the market.
Often these small stocks have barely any analyst coverage, whereas the likes of Toyota are followed by an army of analysts, making it hard to gain any competitive edge.
For example, the Lindsell Train Japanese Equity fund - which has outperformed the Topix index by 2.8 per cent annually, or a cumulative 56.9 per cent net, in yen terms over the period January 2004 to April 2016 - has a very different profile from the Japanese market indices.
It invests in consumer franchises, owners of valuable intellectual property, healthcare and quoted marketplaces: four areas that together account for a combined Topix index weighting of just 5 per cent.
While the cyclical exporters and manufacturing companies at the larger end of the Japanese market rise more quickly than other developed markets in periods of economic expansion, they also fall further when sentiment turns negative, as now.
The banking sector is also currently underperforming, as poor fundamentals have been exacerbated by the move to negative interest rates.
'It is so important to have an unconstrained strategy in Japan that is able to avoid large parts of the index which will see profit downgrades due to macro concerns,' says Nicholas Weindling, manager of the JPMorgan Japan fund, whose local research team focuses on healthcare, domestic tourism, internet shopping and businesses related to the ageing population.
Such funds are attractive in terms of their portfolio structure, because the Japanese market is relatively inefficient and the least correlated of all major markets, so they can be a useful diversifier.
For the time being, however, Tokyo remains a policy-driven market, largely supported by improved governance and shareholder focus. Real economic growth is harder to come by.
With the economy dipping back into deflation for the first time since 2013 and the yen versus the dollar hovering nervously around ¥110, Abe's three arrows - monetary, fiscal and structural - can be condemned for running out of steam.
Since April, the market has been waiting for the BoJ to announce additional easing. Governor Haruhiko Kuroda's problem is how to engineer a weaker yen without being seen by the G20 as trying to talk down the currency.
He may be waiting for a US rate rise in June, which would alleviate upward pressure on the yen; another option is to emulate the European Central Bank and introduce some kind of change in the rate paid relating to bank lending.
On a hopeful note, Abe's signal that he will postpone the sales tax increase scheduled for April 2017 is a positive sign that the government is willing to deploy any tool available.
PUBLIC WORKS SPUR
One measure already in the works is the bringing forward of 80 per cent of the government budget for public works and other projects during the first half of the current financial year, which should spur real growth in construction and infrastructure.
'Construction companies are benefiting from the building boom ahead of the 2020 Tokyo Olympics, as well as the rebuilding of the Tohoku region, which was devastated by the earthquake and subsequent tsunami in 2011,' says Nash.
'Other projects, such as the new magnetic levitation bullet train, are just getting started and will keep contractors busy into the next decade.'
One final consideration for investors in the Japanese stock market is how to deal with the currency issue. Many funds make a sterling hedged share class available for investors who wish to avoid currency risk.
For as long as the yen depreciated against other currencies, being hedged was the better move, but if the yen continues to strengthen it will be advantageous to be unhedged.
SPOTLIGHT: LEGG MASON IF JAPAN EQUITY
The Legg Mason IF Japan Equity fund has been a very strong performer, topping our table over one, three and five years, but it is sometimes very volatile.
Hideo Shiozumi, its veteran portfolio manager, runs a highly concentrated portfolio of just 48 stocks, with 85 per cent in domestically focused growth companies invested in 'New Japan' themes such as exploiting opportunities relating to Japan's elderly society, the internet and healthcare.
An example is Nihon M&A Centre, an M&A advisory company for small to medium-sized family firms whose owners are typically reaching retirement age and looking to sell up and release their capital.
Shiozumi says western-based managers of Japanese funds typically focus 'in a backward-looking manner' on conventional large-cap exporting names, and we have seen their performance impacted, particularly in light of movements in the yen.
'Despite weak overall market conditions, domestic-oriented growth stocks have continued to fare well since the beginning of this year, as these companies are significantly less impacted by currency fluctuations and the slowdown in the global economy,' Shiozumi adds.
'We expect this trend to continue in the future, as investors realise that the Japanese economy can only be revitalised by increased consumption and the creation of new businesses in fields such as medical and nursing-care services, distribution and robotics, amid the ageing society. These are areas that we also expect to benefit from the "new three arrows" of Abenomics.'
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