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The Foreign Electronics/Entertainment Industry is comprised almost exclusively of Japanese companies. These firms, which possess some of the world's oldest and most recognizable brand names, have their roots in the electronics business. But many, during the boom times of the 1980s, acquired entertainment outfits in order to benefit from the marriage between consumer content and audio-visual hardware and software. The companies here are a diverse mix, marketing everything from copy machines, digital cameras and flat-panel televisions to power plants and blockbuster Hollywood-style movies.

Economic Factors

The fortunes of participants in this industry are closely tied to the fate of the Japanese economy, which has performed rather unevenly, to say the least, since it peaked in the late 1980s. (The 1990s, while a prosperous period for much of the globe, was essentially a lost decade for Japan, with the country suffering through one bad recession after another.) Consequently, investors would do well to carefully track conditions across the world's second-largest economy, paying especially close attention to business investment, private consumption, pricing trends, personal income and employment. The Bank of Japan's actions on the critical borrowing-cost front should also be watched rigorously. While it has maintained a near-zero interest rate policy in recent years, the central bank will probably move to gradually raise overnight lending rates to a more "normal" range of 1%-2%. This can be a dangerous balancing act, however. The bank has to hike rates fast enough to head off harmful asset bubbles (e.g., real estate, stock market, etc.), but not so fast as to discourage spending within the public and private sectors.

Another key to Japan's $5 trillion economy is exports. In fact, while exports account for less than one-sixth of gross domestic product, they are responsible for closer to half of the nation's economic growth. Thus, any material drop in external global demand would likely send the country into recession and severely hamper the collective earnings power of this group. With China, which is firmly in expansion mode, as Japan's largest trading partner (the U.S. now holds the number two spot), however, there is ample reason to believe that overseas shipments will remain healthy.

Currency Considerations

There are significant foreign-exchange risks associated with American Depositary Receipts (ADRs). A strong yen-relative to the U.S. dollar, the euro and other leading currencies-can be problematic for export-driven outfits in the sector, since it generally serves to decrease the level of a company's overseas profits and render its products pricier in international markets. A comparatively firm yen also makes imports into Japan cheaper, which forces firms to spend more time and money fending off rivals and protecting their home turf.

Given these potential headwinds, a few of the better-managed industry players have moved to insulate themselves from unfavorable currency swings by setting up production and distribution facilities in overseas markets, including parts of the U.S., where they conduct a lot of business. These efforts make sense from a cost perspective, as well. Specifically, by shifting manufacturing plants to underdeveloped countries, most notably China and India, companies can take advantage of an abundance of cheap labor and raw materials.

Product Innovation

Operating predominantly in the fast-changing technology field, industry participants, from chip and electronic parts makers to consumer goods manufacturers, must be nimble, and focus intently on product innovation, in order to survive and thrive. With this in mind, would-be investors should consider how much money (as a percentage of sales) a company devotes to research and development. Elevated levels of R&D spending can penalize profits and frustrate the impatient Wall Street crowd in the short run. But they signal a firm's commitment to staying ahead of the technology curve, and often foreshadow healthy top- and bottom-line growth spurts.

Restructuring Activities

Japanese companies are not historically known for their lean cost structures. On the contrary, they have long been criticized for overstaffing, especially within the managerial ranks, and adapting slowly to changing market conditions. Still, many firms-the ones most worthy of investment consideration, in our view-restructure in response to challenging macroeconomic periods. In fact, some companies have launched large, and initially costly, restructuring initiatives aimed at reducing headcount, cutting fixed operating expenses, and relocating production facilities offshore. Growth areas (e.g., flat-panel display materials, medical imaging equipment, and high-performance semiconductors) get much attention, when Japanese firms look to offset declines in struggling legacy businesses and find refuge during difficult economic times.

Concluding Thoughts

Members of the Foreign Electronics/Entertainment Industry are impacted by a whole host of factors, from currency swings and macroeconomic conditions to company- and sector-specific fundamentals. That said, special attention should be paid to yen/U.S. dollar fluctuations (both favorable and unfavorable), the Japanese economy, product pipelines, R&D budgets, and cost structures. Good judgment in the executive suite is also an important ingredient for long-term success. Indeed, given the turbulent nature of demand in this industry, managers frequently need to be visionaries in order to keep their firms on a sustainable growth track.