Japan is Looking Interesting...

Some (rare) macro investment thinking I've been doing lately has lead me to Japan. From my post early this week I highlighted how Japan is certainly below average when looking at the world markets from a profitability perspective. I will be the first to concede that low profitability may be a non-intuitive place to unearth investment ideas, but in the case of Japan, there may be something interesting lurking underneath the ugly numbers.

Japan has a couple of issues which I believe have really compressed corporate profitability:

1) Historically high valuations - Japan in some ways is still recovering from the massive excesses of the late 80's when the market took complete leave of its senses and bid anything Japanese up to stratospheric levels that would make a .com speculator in 1999 blush. After more than 15 years of property market declines and a >75% routing of the Nikkei, I believe expectations in Japan are about as close to zero as you can get.

2) Broken Regulation - The financial sector in Japan has been operating under a rather buerocratic leadership for some time. With the initial proposal recently by the Japanese Financial Services Agency to derugulate the stock exchanges and to loosen some rules on investment funds, there may be a change in the wind for the economy. Add to that the fact that the Japanese Post is also going to be privatised via a staged IPO process over the next few years and you have a few quiet rumblings that may be the beginning of a trend.

Some interesting statistics about the Japanese market (from S&P):
Net Margin - 4.26% (lowest of any country/market)
Price / Sales - 0.79x (second lowest of any country/market)
Price / Book - 1.68x (third lowest of any country/market)
Return on Equity - 8.69% (third lowest of any country/market)

Based on the above, the argument can be made that the tough, low interest rate enviroment in Japan right now is (rightly) causing the pain. The contrarian in me thinks that the outcome of Japanese economic purgatory continueing for 10 more years is already baked in here. It is reinforced for me when I looked at the Emerging Market statistics and they basically look like the above stats for Japan; just multiplied by 2 or 3x. It wasn't so long ago that Emerging Markets were in purgatory themselves... it is amazing how fast things can change when margins improve quickly (like they have for EM over the last 7 years).

All said, I think that Japan at this time offers several compelling investment traits:

1) Rock bottom expectations
2) Very attractive revenue/book valuations
3) Earnings well below any reasonable trend or mean for a country
4) Positive and changing regulatory environoment
5) Large pent up demand for Japanese citizens savings (both from the Japan Post deregulation as well as the low interest rates in Japan)

Any combination of the above could be a strong catalyst for Japanese shares.

Ok, so let's assume we've made the leap to invest in Japan, the immediate question becomes "what vehicle to use?" Well, given the proliferation of CEF/ETFs these days, we have quite a few options:

1) iShares MSCI Japan Index (EWJ)
2) iShares S&P/TOPIX 150 (ITF)
Both of these two are essentially cap-weighed straight Japanese index funds. The ITF is only the top 150 shares in terms of size, while the EWJ ETF holds nearly 400 stocks.

3) Japan Equity Fund, Inc. (JEQ)
This is a CEF that trades at a slight discount (7%) and has a reasonable expense ratio. However, historical performance has been poor. Perhaps more research would unearth some things here, but at first blush, I'm not interested.

4) Japan Smaller Capitalization Fund, Inc. (JOF)
This is another CEF but with no real discount and fairly high expenses. The portfolio seems actively chosen (not a closet indexer) and historical performance has been good. The high expenses here are a turnoff.

5) SPDR Russell/Nomura Prime Japan (JPP)
This is essentially the same as EWJ.

6) SPDR Russell/Nomura SmallCap Japan (JSC)
This is the small cap Japan ETF. It is market cap weighted and holds roughtly 400 companies.

7) PowerShares FTSE RAFI Japan (PJO)
This is a Japan based fundamentally weighted index based on the RAFI fundamental weighting. There has been a lot of hub-bub recently about fundamental weightings for indices (even though it's been around for 25 years...) and this fund may be a good play for those who view that fundamental weighted indices are the way to go.

8) WisdomTree JP High-Yielding Equity (DNL)
9) WisdomTree JP SmallCap Dividend (DFJ)
10) WisdomTree JP Total Dividend (DXJ)
On the topic of fundamental weights, the WisdomTree funds are similar to RAFI, but their only criteria is raw dividend amount. DNL focuses only on the highest yielding stocks in Japan and is very top heavy (50+% of assets in the top 10 holdings). DFJ is the small cap focused fund and DXJ is the pure overall Japan Dividend weighted fund (all capitalizations, all dividend payers).

My first instinct is to look to the smaller cap funds for Japan exposure as I think any economic improvement will be magnified in that segment of the market (due to the fact that small caps in Japan have lower overall margins than the big caps). Second, I want to own a fund that has lower valuation measure than the overall market by quite a bit.

For JSC I'm seeing that the Price / Book is roughtly 1.3x, and for DFJ I'm seeing it at ~1.15x. The DFJ index has a profit margin of roughly 2.5% shares trade at a price / sales of 0.40x. Both of these ETF shares are rather illiquid, but not to the point of being useless for most investors. The premium/discount on these ETFs is usually well within +/- 1.50%.

At these valuation levels, you have to assume that some component of it is due to the fact that perhaps the DFJ dividend weighting is selecting some non-optimal companies that are perhaps destorying value. Due to the governance issues in Japan, this is a real reason for concern. However, the thing I like about DFJ is that it only owns companies that pay dividends, which *should* eliminate a bit of the most unsavory corporate misdeads. Also, the wide diversification both by issue and by sector should also dampen any potential problem companies.

At this time I don't have a direct position any Japan ETF but I'm leaning toward possibly taking a small position in DFJ on any further weakness.

Cheers,

Ben Hacker