How to Invest in Japan? Small Caps & Dividends

08/31/2017 2:50 am EST


Nicholas Vardy

ETF Strategist, Oxford Club

Say Japan to a global investor, and he thinks “stagnation,” “malaise” and the “financial bubble popping”. It wasn’t always so. Thirty years ago, Japan was the “China” of its day, notes Nicholas Vardy, editor of Global Guru.

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After nearly reaching 40,000 on December 29, 1989, the Nikkei index plummeted more than 70%. The Nikkei recently closed at 19,753 yesterday -- almost 28 years later.

A country that once accounted for 30% of the global stock market capitalization all but disappeared from the radar screens of U.S. investors. Today, an entire generation of U.S.-based professional investors have never invested in Japan.

After spending almost three decades in the doghouse, here’s why I think the Japanese stock market’s recent rally is set to continue.

First, the Japanese government is doing everything in its power to revive the Japanese stock market. The Bank of Japan has doubled its annual ETF buying target to ¥6 trillion ($48 billion).

Japan’s Government Pension Investment Fund, the world’s largest, now invests 25% of its assets in Japanese stocks. And yes, even skeptical foreign investors are once again investing in Japan.

Second, Japanese small caps are both hated and ignored. Since the Japanese stock market peaked in 1989, trading volumes in Japanese small caps have all but evaporated.

Investment banks and brokerages produce next to no research on lightly traded Japanese small caps. And what little research there is rarely gets translated into English. No wonder individual Japanese investors dominate the small caps, accounting for 60% to 80% of trading on JASDAQ, Japan’s version of the NASDAQ.

Third, the valuation case for Japanese small caps is compelling. Hundreds of stocks trading at less value than the cash on their balance sheets. That means that investors can buy some Japanese small-cap companies for free.

Japan is one of the few stock markets where the father of value investing, Benjamin Graham, could still employ his “cigar butt” approach to investing. All this makes Japanese small-cap stocks the cheapest asset class in the developed world. And by some measures, Japanese small-cap stocks are cheaper than those in Russia.

As irrational as the exuberance around Japan’s prospects was in the 1980s, today’s despair is just as far off the mark. Japan today reminds me of commodities at the height of the tech boom, when Merrill Lynch shut down its commodity trading desk in 1999, just as commodity prices bottomed.

State Street Bank did something very similar when it shuttered its small-cap Japan ETF SPDR Russell Nomura Small Cap Japan (JSC) last year, almost at the exact bottom of the market. Almost like clockwork, Japanese small-cap stocks began to soar.

Luckily, you can still invest in Japanese small caps. My favorite way is through the WisdomTree Japan SmallCap Dividend (DFJ). Despite rallying 24% over the past year, DFJ remains remarkably cheap.

As of June 30, 2017, the companies in DFJ were valued at a mere 0.58 times price to sales and 1.11 times to book value. By way of comparison, S&P 500 stocks now trade at 2.14 times sales and 2.88 times book value. That means that Japanese small caps could double or even quadruple before matching U.S. valuations.

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