Not Buying Into Japan's Siren Call 

08/31/2009 10:39 am EST

Focus: GLOBAL

Gordon Pape

Editor and Publisher, The Income Investor and the Internet Wealth Builder

Beware claims that this is the year the long-floundering Nikkei finally takes off, warns Gordon Pape in the Internet Wealth Builder.

One of the big economic stories [recently] was the news that Japan has emerged from the recession and is growing once again. During the second quarter, the country's GDP moved up by 0.9% or 3.7% on an annualized basis. The last time Japan's GDP moved higher was in the first quarter of 2008, meaning the recession there lasted 15 months.

The results were a huge improvement over the previous two quarters, which saw the Japanese economy contract at an annualized rate of more than 10%. BusinessWeek quoted Credit Suisse economist Hiromichi Shirakawa as saying he expects growth to strengthen further in the current quarter.

Japan's turnaround—which, it should be noted, comes while Canada is still officially in recession—has led to renewed interest in the country's stock market, which many analysts believe is seriously undervalued. Writing in a recent issue of Newsweek, well-known hedge fund manager Barton Biggs said: "If ever there was an equity market that qualified for the legendary 'Four U's' (underowned, undervalued, unloved, and ugly), it's Tokyo".

Biggs freely admits that "No one has made any money in Japan in what seems like forever". He adds: "It is often dismissed as a 'value trap', with stocks that seem like bargains but go nowhere". But this time may be different, he suggests. To make his point, he cites Japan's high-quality, technology-oriented manufacturing base, its expanding trade with the fast-growing Chinese market, and the high net worth of Japanese families which may lead to large cash flows into stocks as confidence returns.

As for value, he says few markets offer better deals right now. The Nikkei is trading at about 1.3 times book value and at 50% of sales, he says. "Because of their stability, I find these are the two best valuation measures for stocks." You can read the full article at www.newsweek.com/id/208451/output/print.

Biggs advises his readers to look at the iShares MSCI Japan Index ETF (NYSE: EWJ). As the name suggests, it tracks the performance of the MSCI Japan Index. The management expense ratio is a low 0.52% and the fund has been around for more than a decade, having been launched in 1996. The focus is on blue-chip stocks with names like Toyota (NYSE: TM), Honda (NYSE: HMC), Mitsubishi (OTC: MSBHY), Canon (NYSE: CAJ), Panasonic (NYSE: PC), and Sony (NYSE: SNE) dominating the list of top holdings.

Recent returns have been respectable, although you would have done better by staying in Canada. For the six months to July 31, the fund gained 14.3% while the iShares CDN Composite Index Fund (TSX: XIC) was up 25.9% in the same period. Longer-term results for the Japan fund have been terrible. If you had invested US$10,000 at the time the fund was launched, you would have only US$7,288 today. That loss would have been compounded by the rise in the value of the loonie over that period.

That said, Barton Biggs is looking to the future, not the past, and he is convinced Japan is finally about to begin rewarding investors. Unlike Biggs, I am not convinced the case for Japan is compelling, at least not at this stage. There is an election coming up at the end of the month which could result in a change in government and an ensuing period of political uncertainty which would not be good for the stock market. More importantly, I think there are better opportunities in other parts of the world, including right here [in Canada].

So if you want to put some money into Japan, my advice is to use caution. Choose a diversified fund with a large position in the Japanese market rather than one that is completely focused on that country. Yes, this amounts to hedging your bets. But given the long history of losses associated with investing in Japan, I suggest that's the prudent way to go.

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