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Canon Inc. (ADR) (CAJ): Even with a Cheap Yen, These Japanese Companies are in Trouble

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Japan’s Nikkei 225 has been one of 2013’s best performing stock indices. Year-to-date it’s up nearly 40%, almost double the performance of the S&P 500.

Nevertheless, there are some Japanese stocks investors should consider avoiding. In particular, Kubota, Komatsu and Canon Inc. (ADR) (NYSE:CAJ) are all facing significant challenges.

Canon Inc. (ADR) (NYSE:CAJ)

Japan’s market has been aided by Abenomics

Since last December, Japanese stocks have been aided by the policy goals of the country’s newly elected prime minister, Shinzo Abe.

Abe’s program for economic growth (dubbed “Abenomics”) is intended to dispel the deflationary depression that has gripped Japan for the last two decades. As part of the program, the Bank of Japan has promised to aggressively ease, causing Japan’s currency, the yen, to weaken significantly.

As most of Japan’s major corporations are exporters, a weaker yen benefits Japanese stocks. Goods sold by Japanese corporations, when priced in a weaker yen, appear cheaper (and thus more attractive) to foreign buyers.

Kubota, Komatsu, and Canon Inc. (ADR) (NYSE:CAJ) are all major exporters, and should therefore benefit from a cheaper yen. However, all of these companies are facing secular issues in their respective markets.

China has been behind the demand for commodities

Both Kubota and Komatsu are primarily makers of heavy machinery, and that could be a problem going forward.

Industrial commodities drive most of the demand for heavy machinery. For example, when the price of copper rises, companies invest in copper mining, leading to an increased demand for copper mining equipment.

As most commodities have been in bull mode for years, the demand for heavy machinery has remained strong. But that could change.

China’s rapid development over the last decade has largely been the driving force behind the commodity bull market. The country surpassed the US in 2002 to become the world’s biggest copper consumer, and just eight years later it became the world’s largest consumer of energy. In 1990 it surpassed the US in meat consumption, and now consumes more than twice as much.

Should China’s economy run into problems, the demand for commodities will plummet–and many observers believe that’s a likely scenario.

In 2011, economist Nouriel Roubini predicted that China would have a “hard landing” in the second half of 2013. Citing excessive fixed investment (about half of GDP), Roubini reasoned that China’s economy was setting up for a crash.

In recent months, China’s economic data has taken a turn for the worse. In June, trade data showed a sharp drop off, and in July, HSBC’s Chinese PMI showed a contraction in the country’s manufacturing sector.

Jim Chanos is short Caterpillar on its exposure to China

Jim Chanos has been bearish on China for years. He’s mostly been shorting the country’s property developers, but recently, he turned his attention back to the US. Last month, he said he was short Caterpillar, largely because of the company’s exposure to mining equipment.

Kubota and Komatsu have similar exposure.

All of Komatsu’s revenue comes from the sale of heavy machinery — construction, mining and utility equipment. Caterpillar is actually Komatsu’s chief rival, as the two companies produce many competing machines (bulldozers, excavators, etc).

Komatsu has already seen a slowdown in China — from 2011 to 2013, its Chinese revenue dropped by over 60%. Demand from other sectors (the Americas, Europe) has increased to offset this decline somewhat, but if China’s economy struggles, commodities will take a hit, demand for Komatsu’s machines will fall.

Kubota is similar, although admittedly, its business is not as cyclical.

About 72% of Kubota’s revenue comes from industrial machinery. However, most of that is farm equipment. Obviously, that’s less susceptible to economic downturns than construction and mining, but it is still affected.

Agricultural demand in the US fell after the financial crisis. People didn’t eat less, but they did switch to cheaper foods.

Similarly, China has had a stable population for years, but its demand for particular food items (like meat) has increased as the nation has become more wealthy. Cattle consume plants, putting increased demand on the overall agricultural sector.

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