FORTUNE–David Herro liked Japanese stocks way back in 2011, when some economists and fund managers were convinced that the country was heading for a financial blowup. He thought many of Japan’s companies were producing excellent returns on equity while trading at low valuations. Such stocks comprised many of the top holdings in his $13.6 billion Oakmark International Fund (OAKIX). It seems that Herro, 52, was ahead of the curve. The election of Japan’s Prime Minister Shinzo Abe in 2012 sparked a massive rally in the Japanese equities market, with the Nikkei 225 rising more than 80% from November 2012 through this spring.
Japan’s stock market recently began to falter, and some analysts said it was because investors doubted whether Abenomics, short hand for the economic policies Abe has pushed to revive Japan’s moribund economy, would really work. Herro says he’s unwilling to write off the turnaround so quickly. “We’re on track to see that a real reform story is happening in Japan,” he says. “This is a multi-year investment.” Below Herro tells Fortune what it will take for Japan to be a successful turnaround story, and what stocks he likes now.
Fortune: Why do you think Japan’s stock market has fallen more than 20% since May 23rd?
Herro: The selloff is completely understandable given that the market jumped from 700 to almost 1300 in 6 months. You’re bound to see some profit-taking when you have moves up nearly 100%. There are certain things you can do to take advantage of that situation and make sure you’re positioned right.
For example, we tend to be very buy-and-hold, but we were overweight [Japanese stocks] a year or so ago. At one point they made up about 25% of the portfolio. Now that is more like 14% because we trimmed our position when the market nearly doubled and the upside shrank. In the last week we’ve been adding back because stock prices fell, and some became attractive again. This is all short-term trading stuff. The real question is whether there is value to be had and if Abenomics will crystalize that value.
Why do you think there is still value to be had after a huge, fast gain?
The Japan [investment thesis] depends on long-term structural change, and three things need to happen for that to take hold. The first is ending deflation, which creates a consumer mindset of, Why buy today when it will be cheaper tomorrow? That’s bad for growth. When it seemed that [Prime Minister] Abe was serious about ending deflation we saw the Yen weaken and rates go up, indicators that the market was building in inflation expectations.
Step two is to implement what I call structural micro-economic reform. This means reforming things like labor policy, health care, and the agriculture sector. These sorts of reforms were not specifically addressed in Abe’s recent speeches in anything but a general sense. It was probably wise for him to wait until after the [Upper House Diet] elections in July to give specifics, but it disappointed the market.
The third reform, which is also a medium- to longer-term issue, is to see the state of Japanese corporate governance change. Many management teams and boards are not focused on building shareholder value.
Where are we in the process? We can almost tick the first box because there is an aggressive program in place to end deflation; and in the end I think it will work. Numbers two and three are easier said than done. Much like in this country, all kinds of constituents don’t want change. Abe needs to focus on the greater good, ignore minority screaming, and proceed with reforms. Corporate governance is getting a little better.
If we have one, two, and three in place we’ll see a Japanese market recovery truly take hold. In the meantime the market will be volatile. On top of the bounce and the selloff, most professional investors have long been underexposed to this market and will try to get in.
Do you think Japan could see the sort of shareholder activism that has become popular in the U.S.?
It won’t be the same as what we have here. The real sign that things have changed will be when there is a more active Japanese shareholder base. When you see big Japanese investors, particularly insurance companies and pension funds, complaining about low returns that will create meaningful change in corporate governance.
You mention that rising interest rates on Japanese governments bonds is good because it indicates an end to deflation. But Japan’s gross public debt is projected to hit 230% of GDP by 2014. Won’t rising rates make it harder for the country to make interest payments on this debt?
Japan has a lot of debt, but it also has a lot of external and internal assets. The weakening Yen should be good for the country’s net debt position. The country is one of largest holders of U.S. Treasury securities, and when the Yen weakens, the value of those holdings should go up dramatically.
Japan can also privatize a lot of state-owned assets, including power companies and highways. The country has already sold shares in Japan Tobacco, and a strong stock market should make privatization easier. This could help make the country more competitive and chip away at that debt.
But look at what happens in the U.S. when local governments attempt to privatize assets. The public balks.
Well, the U.S. doesn’t have that much to privatize compared with Japan. But yes, bureaucracies don’t like privatization. Still, it’s probably a good way to make reform happen.
What stocks do you like now?
I like Daiwa securities because it’s soundly managed and has a great balance sheet. It has a good asset management and brokerage business, making it the best way to benefit from rising Japanese share prices; and you get all of this for under next year’s book value.
I also like Canon (CAJ). Again, it’s a soundly managed company and it benefits hugely from the weaker Yen. It also has great exposure to emerging markets. [Both stocks are top holdings of Herro’s fund.]
What are your hopes for the upcoming election?
Abe’s party needs to dominate in order for him to get anything done, and it looks like that might happen. If things go his way, it would be very bullish and give him the cover he needs to do unpopular things.