(FORTUNE Magazine) – JAPAN: UP IS THE ONLY WAY TO GO

Now's the time to jump into the Tokyo market--but only if you've got an iron stomach. After four years of no growth, a devastating real estate collapse that hammered banks, and a yen so mighty it crippled exports, equities in the world's second-largest economy are selling for just 1.97 times book value, according to Morgan Stanley. That's a 38% discount to their historical ratio of 3.18. It's also well below the U.S. price-to-book ratio of 3.08 and only slightly above the comparable level in most other Asian markets, even though Japanese companies are historically much more profitable than their regional competitors and enjoy bigger market shares.

Still, when it comes to stocks, a bargain's only a bargain if its price is about to rise. Happily, a number of experts think that's just what's about to happen here. Says Shuhei Abe, president of Sparx, a Tokyo investment research firm: "Japan is at the bottom five years behind the U.S. markets, which bottomed in 1990.'' Agrees Mark Mobius of Templeton Investment Management in Hong Kong: "Long term, the only way we can go in Japan is up."

But when will the climb begin? The Nikkei stock index, which has dropped by 53% since the turn of the decade, was recently hovering at 18,384. Barton Biggs, chief global strategist at Morgan Stanley, believes "the Nikkei could get to 20,000 or 21,000 in the first quarter of 1996." (For more on Biggs, see "Hot Tips From Three Investing Superstars.")

Japan's bargain stock prices reflect longstanding investor fears that the massive problems of the banking sector, which itself represents a hefty 23% of the Tokyo market's value, aren't about to go away. There's certainly widespread suspicion that Japan's latest rescue package will be no more effective than various forerunners.

This time around, though, the rescue is likely to work. For one thing, the Finance Ministry and the Bank of Japan are pumping cash into the banks by holding the discount rate at 0.5% even as long-term government bonds pay 2.6%--a spread that yields lifesaving earnings. Giving the rescue extra credibility is a promise by the U.S. to provide billions of dollars in liquidity in the event of a major banking crisis.

So far, it's been mainly foreign investors that have shown faith in this recovery. When the locals jump in, which Abe thinks will happen next year after they conclude the banks aren't about to melt down, stocks should really take off. (For more on Japan, see "Hot Tips From Three Investing Superstars."

ADRs of well-run manufacturers like Canon and NEC are one way to play the Tokyo rebound. For a broader bet, consider the GAM Japan Capital fund, Merrill Lynch Pacific fund, G.T. Global Japan Growth, and Warburg Pincus Advisor Japan OTC fund, all among Morningstar's best performers for the year.

--Richard D. Hylton

UTILITIES: PLUG INTO CALIFORNIA'S DISCOUNT

When California's utility regulators threatened to push through a crash deregulation of electricity prices in their state in 1994, they blew a fuse on utility stocks from coast to coast. "Alarm bells were going off all over the place," says Ernest Liu, a security analyst for Goldman Sachs. Many utility investors bolted, share prices dropped about 20%, and utilities settled in for the longest sustained performance brownout since the 1970s.

Now it looks like deregulation will be more gradual. Panic has been replaced by caution, and prices have risen 18% this year, meaning that opportunity for huge gains is largely over. Even so, says Liu, "there are still some nice companies that aren't getting their due."

His favorite is Dominion Resources of Richmond. Internal squabbles and a state investigation into alleged improper business practices knocked Dominion shares from a peak of $49, in 1993, to $35. No wrongdoing surfaced, but even so, the stock only just made it back to $39. Investors don't yet realize that peace has broken out, says Liu, who thinks the stock is worth around $45. Dominion is a low-cost producer, which Liu says should provide a vital edge when full deregulation finally hits, as it will within a decade.

What else? Dan Rudakas, an analyst with Everen Securities, recommends Central & South West of Dallas and TECO Energy of Tampa. Like many utilities these days, Central & South West is on the acquisition trail. But Rudakas picks it from the bunch because its management keeps a cool head, backing out of one deal when the price went too high. Now it appears South West will merge with Seeboard, a utility in Britain. Rudakas estimates that dividends will rise by 3% to 3.5% annually in the years ahead, compared with 2% for most in the industry. Recent share price: $27. TECO is located in a growing market of the growing Sunbelt and has diversified profitably into oil and gas, shipping, and coal mining. Rudakas thinks the company can deliver a 9.5% total annual return for a long time. Shares peaked at $26 in 1993, fell to $18, and recently were around $24. TECO is selling for 15.3 times earnings, and Central is selling at 12.3.

When it comes to bargains, Kathleen Lally of Salomon Brothers goes straight to the source: California. She likes SCEcorp in the L.A. area and PG&E of San Francisco. Both are enjoying strong cash flow, paying down debt, and buying back stock. And yet their share prices, $17 and $29, respectively, have not moved up with the group. Both sell for about ten times earnings, just under the industry average of 13. Call it the California discount. Now profit from it.

--Peter Nulty

INSURANCE: RIDE THE MERGER WAVE

The property-casualty insurance business is the dog that's becoming an investor's best friend. After underperforming Standard & Poor's 500 index for most of the year, the S&P index of these stocks has been picking up speed. But with insurers panting after still more mergers and takeovers, this hound just may keep hunting. Says Weston Hicks, an insurance analyst at Sanford C. Bernstein: "The winning strategy is to gain cost advantages by acquiring competitors."

Travelers has agreed to buy Aetna's property-casualty business for $4 billion. Other suitors included Kohlberg Kravis Roberts, the buyout firm, which reportedly had made a similar bid for the unit, and CNA Financial. And there's speculation that Cigna may also be considering a sale of its P&C business.

Despite the insurance group's still-low P/Es--11.3 times earnings, on average, vs. 17.2 for the S&P--don't assume that you can blindly follow the pack. Some areas, like personal auto insurance, are delivering record-breaking returns. Others, such as general commercial liability, have declining margins and little near-term growth potential. Says Gary Ransom, an analyst with the insurance research firm Conning & Co.: "Look for companies that find better underwriting risks by segmenting the market more carefully."

American International Group, one of the world's most efficiently run and profitable insurance and financial services companies, may be your best bet, says Ransom. After pushing down AIG's stock because of higher interest rates and record industry losses from catastrophes like 1994's Los Angeles earthquake, investors are once again pushing up this blue-chip insurer. Michael Frinquelli of Merrill Lynch estimates that AIG's earnings will grow by as much as 15% annually over the next five years, vs. an industry average of 8% to 9%. Ransom and other analysts also recommend Chubb Corp., which has seen improving underwriting trends. Other strong bets: Allstate, American Re, Executive Risk, and the Allied Group.

--Richard D. Hylton

MUNI BONDS: WHERE THE REAL JUICE IS

Talk about unloved! Investors have avoided municipal bonds--at least those with intermediate and long maturities--like the plague this year, thus creating one of the biggest opportunities. Says trader Jay Chitnis, a V.P. at Gruntal & Co.: "They're being given away. If you're in the top tax brackets, do not pass 'Go.' Buy munis!"

As the chart shows, the difference between 30-year muni and Treasury yields has narrowed about one percentage point this year. That means munis now yield 88% of what Treasuries offer--very juicy given that there's no federal tax on the income. For an investor in the 31% federal tax bracket, the 5.5% yield on a 30-year muni is the equivalent of 8% on a 30-year Treasury--which right now pays only 6.2%. That's value.

The 800-pound gorilla scaring investors away is that looming bugaboo, the flat tax. Under some tax reform plans Congress is considering, all interest income would be tax exempt. This means that munis, perceived as less safe than debt backed by Uncle Sam, would need to yield more than Treasuries. Fear of this scenario has already sent prices down. Only after that tax talk dies officially--which many think will happen after the 1996 election--will muni prices rally.

Unless you have at least $50,000 to invest, it's probably best to use muni mutual funds rather than individual bonds. Susan Belden of the No-Load Fund Analyst in Orinda, California, likes Vanguard's Municipal Intermediate-Term fund. It has low expenses of just 0.21% of assets, vs. 0.96% for the average national muni fund. Vanguard's Long-Term has the same low expenses. It yields 5.32%; the intermediate-term fund, 4.63%. Robert Klosterman, a financial planner in Minneapolis, recommends Strong Municipal Bond fund, which yields 5.5%.

Hungry for more income? Marcia Christian Tarter of Merrill Lynch says a number of closed-end municipal bond funds are undervalued and sport attractive yields. Those with long average maturities include the Dreyfus Strategic Municipal Bond fund, which pays 7.4%.

--Antony J. Michels