Land of the Rising Small Caps

02/28/2011 10:55 am EST

Focus: ETFS

Nicholas Vardy

Editor, Bull Market Alert, The Alpha Investor Letter, and The Global Guru

Japan’s smaller stocks, neglected for two decades, are ready to make waves—and many of these small-cap wonders are trading at a tiny fraction of US valuations, writes Nicholas Vardy in Global Stock Investor.

Two decades ago, Japan attracted the frenzied admiration of the world. Twenty years later, the picture could hardly be more different.

You see evidence of Japan’s decline in the attitudes of most investors. Twenty years ago, not owning Japanese stocks was a career-threatening move. Today, the opposite is the case. There is now an entire generation of professional investors who have learned to avoid Japan.

And can you blame them? Despite an occasional burst of optimism, more than two decades later the Japanese bear is still with us. Having kicked off in 1989 with the bursting of economic history’s largest real-estate bubble, the great Japanese bear market has lasted twice as long as any other secular bear market on record.

Twenty years of zombie banks, weak political leadership, relentless deflation, and broad-based despair have wreaked havoc on investor confidence. While Japanese management techniques were admired and studied across the globe back then, today’s conventional wisdom is that Japanese management doesn’t care about shareholders.

Throw in Japan’s declining population and the inexorable rise of China, and it’s no wonder that Japan’s prospects look bleak.

The Best Value on Earth
But just as the exuberance around Japan’s prospects was irrational, today’s despair is equally off the mark. You see this most clearly in the case of Japanese small-cap stocks.

Since the collapse of the Nikkei in 1989, trading volumes in Japanese small caps have all but evaporated. Investment banks and brokerages produce next to no research on the sector. And what little research there is rarely gets translated into English.

After all, this is a market dominated by domestic Japanese investors. While foreign investors dominate trading on the Tokyo Stock Exchange, individual Japanese investors dominate the small caps, accounting for 60% to 80% of trading on JASDAQ, Japan’s version of Nasdaq.

Yet, by any objective measure, you’d be hard pressed to find a better deal than Japanese small caps. Three words best describe the Japanese small-cap sector today: cheap, cheap, and cheap.

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Warren Buffett’s mentor Ben Graham, who prided himself on unearthing incredible values in the US stock market during the Great Depression, would have a field day in Japan today. Japan is one of the few places in the world where there are stocks that meet Graham’s criteria for cheapness, sustained profitability, and robust balance sheets.

Today, Japan has as many as 200 listed companies trading below cash on the books. That means you can buy these businesses for free. Investors have never seen such low valuations in the history of a developed economy.

Today’s recommendation, the WisdomTree Japan SmallCap Dividend Fund (NYSEArca: DFJ), boasts some stunningly low valuations. As of Dec. 31, the companies in this exchange-traded fund were valued at a mere 0.37 times sales and 0.79 times book value.

By way of comparison, Nasdaq stocks now trade at 2.4 times sales and 3.4 times book value. That means that Japanese small caps would have to rise fourfold to equal US valuations.

Despite these remarkably low valuations, Japanese small caps largely have been ignored since their March 2009 lows. Instead, both global and Japanese investors have been chasing performance in emerging markets.

The irony is that dollar-denominated Japanese small-cap ETFs have outperformed both the NASDAQ and the S&P 500 in 2009, as well as the S&P 500 in 2010. And they are still remarkably cheap.

Three Reasons to Believe
Small-cap Japanese companies should benefit disproportionately from the coming turnaround in the Japanese stock market. Here’s why:

  • First, dividend-paying companies are, by definition, cash generators. They are not the lumbering, zombie companies that have been acting as a millstone around the neck of Japanese growth.
  • Second, unlike the static large-cap indices which include a lot of underperforming Japanese companies, the constituents of the WisdomTree fund are reviewed regularly to weed out the weak companies.
  • Finally, as with US small caps, Japanese small caps go up faster in rising markets and should provide more bang for the buck for any rally in the region.

Remember, once things turn around, they can turn around quickly. Historically, Japanese small caps have been capable of powerful rallies—the JASDAQ doubled during the IT bubble between 1998 and 2000, and the Tokyo Stock Exchange’s second-section index nearly tripled between 2003 and 2006.

I think that the turnaround in Japanese small caps this time around is more sustainable than either of these false starts. But even if I am wrong, it shows that if you get in at the right time, you can make a lot of money in Japanese small caps. And you can do it quickly.

So buy the WisdomTree Japan SmallCap Dividend Fund (NYSEArca: DFJ) at market today and place your stop at $41.50. [Shares closed at $45.63 Friday—Editor.] I am giving this a low risk rating.

[Vardy joins Michael Brush on the list of pundits who believe this will be Japan’s year. Top international fund manager David Herro would seem to agree.—Editor]

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