How you can make money in an environment of slow growth?

Maybe one of the least surprising aspects of the recent global economic slowdown and subsequent market correction, is the re-emergence of Japan’s Lost Decade as a lesson to be learned.

The period, which kicked off when the Japanese asset-price bubble collapsed in the late 1980s, holds up as one of the worst economic catastrophes ever caused by a financial crisis. Today, more than 20 years later, the country’s stock market has still not fully recovered.

Now, as markets head into the third quarter and U.S. growth wanes in the absence of more government stimulus, many investors are beginning to wonder if a similar fate to Japan awaits them south of the border. And if it does, they are asking how is it possible to make money in such a sideways, slow-growth environment?

“Whenever you have a recession, brought on by a financial crisis, you have a very prolonged period where economies don’t grow, but commonly just muddle through,” says Stephen Way, a portfolio manager at AGF Investments Inc. “That’s what is happening in the U.S. and investors recognize it.”

Mark Grammer, a portfolio manager with Mackenzie Financial who co-manages the investment firm’s Japan-focused mutual fund, believes one of the major lessons to be learned from Japan’s lost decade is the negative impact of deflation, which to him has almost become institutionalized in the country.

He began his career at the height of Japan’s bubble in 1989, and says Japanese policymakers were too slow to react to the crisis precipitated by cheap credit, which fuelled a wave of speculation on financial markets. And when they did react, he said the response was littered with missteps.

“With deflation, you can’t have growth. Japan never took the long-term steps that were needed to cure it,” he says. “That’s what the U.S. has to avoid, and so far they have done that.”

By allowing for a spiral of deflation to unfold, Mr. Grammer says Japan created a very difficult environment for equity investors to make money.

And in order to do so, he says investors have needed to focus on Japanese exporters that were globally competitive as opposed to domestically focused companies such as banks, construction firms and real estate developers.

“Anytime and every time you are investing, you should be looking for quality investments, but when you are in a market like Japan’s, it becomes even more critical,” he says.

“In particular, when I’m looking at owning Japanese stocks, I’m not looking to own the Japanese market, I’m looking at owning a concentration of really good companies that can compete on a global scale and are not dependent on Japanese growth for future prospects.”

While Mr. Grammer believes the U.S. economy will ultimately avoid deflation, there’s also little question in his mind that growth in the country will remain slow for some time.

As such, he thinks a similar strategy to that being advocated for Japanese stocks may also apply when investing south of the border. As an example, he points to the relative success of U.S. multinationals against U.S. banks over the first half of this year.

“Those that invested in the banks, have had their heads handed to them,” he says.

Alternatively, Mr. Grammer likes companies such as Apple Inc. that have strong intellectual property that allows them to grow despite limited growth in the economy.

“Companies that can grow with or without economic growth. That is one of the focuses we have right now,” he said.

Of course, picking companies that are best able to grow their bottom lines in a slowing economic environment is only half the challenge. Indeed, investors must also consider just how much they are willing to pay for that extra dollar of earnings and, once again, a look at the Japanese experience offers some valuable insight.

“Without a doubt, whenever you are talking about investing, you have to start with good valuations,” says Mr. Way, who manages the AGF Japan Class Fund. “One of Japan’s problems over the past 20 years is the fact that it was a relatively expensive market.”

Having traded close to 80 times earnings when it peaked at the end of 1989, the Japanese market has struggled to sustain rallies over the years, Mr. Way says, because it got expensive so quickly as the macro environment deteriorated.

By comparison, the U.S. market, having suffered a major valuation correction during the tech bubble, was not as outrageously priced when it collapsed. That fact, combined with the ability of U.S. corporations to cut costs swiftly and deeply in the aftermath of the financial crisis and improve profitability has allowed the U.S. market to rally hard over the past few years.

Although Mr. Way isn’t terribly impressed with either market these days, he thinks U.S. stocks offer investors a much better opportunity than Japanese stocks do.

“While current valuations in Japan are just as attractive and corporate balance sheets are arguably just as strong as those in the U.S. I have more confidence that U.S. companies are going to spend their excess cash to the benefit of shareholders than will Japanese companies.”

George Magnus, a senior economic advisor at UBS AG, hopes the Japanese experience teaches investors to expect sequential cycles of ups and downs, based around a very weak rate of growth as deleveraging from the financial crises continues, not only in the U.S. but elsewhere around the globe.

Certainly, the global economy can overcome some temporary growth drags like the Japanese tsunami and higher oil prices, he says, but the process of private sector balance sheet repair has barely begun, and the decline in debt-income or debt-GDP ratios has a long way to go.

“While we all struggle with if and how to generate an employment-generative, sustainable expansion, the de-leveraging continues and by looking at balance sheets and monetary and credit growth metrics, we can see that we’re in it for the long haul.”