Long time readers will know that I’ve been unconvinced by Japanese stocks for a long time. But conditions have changed and so has my mind. Japanese stocks look like they could offer a highly profitable opportunity over the next year or two. But it’s essential that any investment is made in the right way.
It’s important to keep an open mind when investing. Way back in March 2013 I wrote about why it was best to stay away from Japanese stocks. My view didn’t change much since then, until now.
Several things have changed recently. You just have to be careful to approach Japanese stocks in the right way if you want to take advantage of the situation.
There are four main reasons to invest in Japanese stocks, which I’ll go on to explain in more detail:
- The likely returns to Japanese investors are way ahead of the alternatives
- The government is a huge buyer of stocks
- The market is a lot cheaper than before
- The government is likely to try to weaken the yen substantially after a period of strength, sending stocks higher
Put these together and investors could make impressive profits from Japanese stocks over the next year or two.
Japan is a country where savers and investors are now suffering negative yields. If you buy a two year Japanese government bond (JGB) and hold it to maturity (when the loan gets paid back) you’ll lose 0.21% a year. Even if you buy a 10 year JGB you’ll lose 0.08% a year.
It’s perhaps no surprise that there have been reports of the Japanese hoarding cash (and perhaps gold) in safety deposit boxes. At least zero yield is better than negative yield.
By comparison Japanese stocks look like high return alternatives. The dividend yield alone is about 2.4% a year. And that’s not including the potential for capital gains, from either multiple expansion (higher P/E) or earnings growth. More on that shortly.
In any case, whatever ordinary Japanese investors think or do, there’s a huge buyer out there that cares little about price: the Japanese government. It has two huge pools of money – old and new – that it’s throwing at Japanese stocks.
The first comes from the vast public pensions, in the form of the Government Pension Investment Fund (GPIF). This organisation wields US$1.4 trillion of funds to invest, and set out in the past couple of years to allocate much more of that to local stocks.
The second source comes from unlimited money printing by the Bank of Japan (BoJ), the central bank. In July it announced that it would step up annual purchases of Japanese stock ETFs (exchange traded funds which own Japanese stocks) to around $59 billion a year. This will be done by printing new money. (By the way, how long until one or more of the US Federal Reserve, European Central Bank or Bank of England copy the BoJ?)
… 8% of the stock market is now owned by government controlled entities. And the central bank alone will add 1.2% to the total each year.
According to The Nikkei, a Japanese newspaper, the GPIF and BoJ now own around US$381 billion of US stocks between them. That means about 8% of the stock market is now owned by government controlled entities. And the central bank alone will add 1.2% to the total each year.
That’s a huge and constant buyer to have in the market, bidding up prices. Others are sure to follow.
One of the main reasons I’ve been sceptical about Japanese stocks, up until now, is they’ve never been especially cheap. That’s especially true because Japanese corporations aren’t particularly profitable when compared with US and European counterparts, although there’s been some improvement in recent years.
When I wrote about Japanese stocks back in March 2013 they had a P/E of 16.7. Compare that to the median P/E of US stocks since 1871 of 14.6, or 13% lower. Clearly there wasn’t much value on offer.
The good news is that Japanese stocks have become a lot cheaper recently, as profits have improved and stock prices have fallen back. The benchmark Nikkei 225 index is down 19% since August 2015, measured in Japanese yen, after a strong bull run since late 2012. Japanese stocks now have a P/E of 13.5, which is also 19% cheaper than back in March 2013.
Five years of the Nikkei 225 (in yen)
Looking at that chart you can see the market rose massively between late 2012 and mid 2015, up over 140%. Then it fell back hard. Having stabilised it’s back on a rising trend.
The big increase was driven by a government policy to weaken the Japanese currency, the yen, and give a big boost to exporters’ profits. The weak yen policy worked surprisingly well for a while, but more recently went into reverse. More on that in a minute.
By my estimates a Japanese index of large stocks good for long term total returns of between 8% and 9% a year, measured in yen. That’s pretty attractive in a low yield world.
Japanese investors and others may or may not get enticed back into this market, now that it has a more reasonable valuation. But the government looks set to keep throwing money at it whatever happens. There’s a really good chance that prices could be driven much higher due to a renewed surge in valuation multiples.
If those multiples rise then annual returns from Japanese stocks could easily be well into double digits over the next couple of years. That’s adding business growth, dividends and the P/E increase together.
If the P/E goes up by, say, 20% over two years investors could make around 40% overall. If the P/E rises more quickly they might make 30% over 12 months, perhaps more.
In fact, if Japanese stocks traded at similar levels to the MSCI Europe index in two years time, with a P/E of 21, then the total profit would run to 70-80% (and still leave it 20% cheaper than the expensive US market).
But now we get to the crux. Since 2012 the government has been trying to weaken the yen to boost exporting companies. This cuts domestic costs, meaning they can price products more competitively on global markets. But even if manufacturing is done overseas – and much of it is – as the yen weakens foreign profits become worth more in yen terms. That drives up yen earnings and boosts the stock market.
After a period of deliberate weakening the currency reversed strongly. Between late 2012 and mid 2015 the yen lost a third of its value against the US dollar. But since mid 2015 about a half of that advantage has reversed. The following chart shows how many yen can be bought with one US dollar, meaning a rising line is a weakening yen and vice versa.
Dollar-yen exchange rate, past five years.
There’s a high chance that the government will try to get the yen back on track again – meaning driving it down against the dollar (a rising line on the chart). That will be good for Japanese stocks.
But there’s a catch for non-Japanese investors. Yen stock prices could race up once again, as happened between late 2012 and mid 2015. But if the yen falls then most of those gains could be wiped out by the currency fall.
…if you buy Japanese stocks today, you must have a currency hedge. It means you’ll get the gains of rising stock prices in yen, without suffering the losses from a falling yen itself.
This is why, if you buy Japanese stocks today, you must have a currency hedge. It means you’ll get the gains of rising stock prices in yen, without suffering the losses from a falling yen itself.
Luckily there are funds that do this for you, making it easy. They invest in the same underlying stocks, but then bet against the local currency. They’re not good long term investment vehicles, due to the ongoing hedging cost. But they’re ideal for a position that you intend to hold for no more than a couple of years.
One easy way to buy currency hedged exposure to Japanese stocks is the Wisdom Tree Japan Hedged Equity Fund (NYSE:DXJ). It’s a big fund that’s been around since June 2006, with US$6.8 billion of funds invested. Fees run to 0.48% a year.
Investors that bought DXJ in late 2012 and sold in mid 2015 made over 80%. That was when stocks were rising and the yen was falling.
One last thing though. If those same investors had held on until today then they would have given back three quarters of their profit. That was as the stock market fell and the yen strengthened.
If the yen continues to strengthen from here then DXJ could fall a lot further. Japanese stock prices would likely fall in yen, plus the currency hedge would lose money as well. You’d get hit twice.
So if you’re going to dip a toe into (currency hedged) Japanese stocks I recommend you set a stop loss. Sell if the US dollar price of DXJ price falls more than 10%. At the time of writing DXJ is trading at US$42.73.
Stay tuned OfWealthers,