Last year I recommended an investment in cheap Japanese stocks, but with a currency hedge to protect against falls in yen versus the US dollar. Almost thirteen months later that recommendation has made 30%, measured in US dollars. Japanese stocks are still cheap today. But, due to new circumstances, I’ve decided it’s time to take profits and sell.
In “How to make 80% from Japanese stocks” I recommended the WisdomTree Japan Hedged Equity Fund (NYSE:DXJ). It’s an exchange traded fund (ETF) that profits when Japanese stocks rise, but insulates (hedges) investors against movements in the exchange rate between the US dollar and the Japanese yen.
Before then, I had long been sceptical about Japanese stocks. But the situation changed, and so I changed my opinion. Japanese stocks were cheaper than ever. And I reckoned the yen would resume its weakening against the US dollar, after a short period of relative strength. Not least because it was Japanese government policy to weaken their currency.
Japanese stocks of large companies tend to rise most, measured in yen, when the yen is weak. This is because both their exports from Japan and overseas profits (e.g. from factories in the US or Europe) become worth more in yen terms. However, in such a scenario, an unhedged investment in Japanese stocks would take a hit from the weaker yen itself.
This means hedged Japanese stock investments like DXJ are best in an environment where the yen weakens. They’re also terrible in an environment where the yen rises and Japanese stock prices fall in yen terms. Here the investors get all the yen stock price fall but none of the currency gain.
That’s why, in the case of DXJ, I recommended using a stop loss. My recommendation was to automatically sell the investment if the price fell by more than 10%. I rarely recommend stop losses, since they make no sense for the kind of value investments I usually look for (after all, if something gets cheaper you should usually buy more).
But, given the hedged structure meant more potential upside but also more downside risk if the yen went the wrong way, I recommended putting a stop loss in place. As it turns out it wasn’t triggered.
DXJ has performed extremely well
This is how DXJ has performed since the recommendation:
That’s over 30%, including dividends but net of fees (and before any taxes due). A great result in a relatively short time.
Also, here’s a chart which compares the performance of DXJ (in blue) over the period with an unhedged Japanese stock ETF, in this case the iShares MSCI Japan ETF (NYSE:EWJ) – shown in red.
As you can see, the hedged strategy has returned more than double the unhedged one. This is because Japanese stocks rose as the yen weakened, boosting dollar profits for investors that had hedged against that yen weakness (and holding back those that hadn’t).
The US dollar (USD) to Japanese yen (JPY) exchange rate has gone from 104 in August 2016 to 112 today. That means one dollar buys more yen than before, which means the yen is weaker.
That said, the yen was weaker back in December, when the rate went above 118, and has strengthened since. See this chart, where a rising line shows a strengthening dollar and weakening yen, and vice versa.
It’s a great result to make more than 30% in just over a year. But, in my original recommendation, I said there was potential for 70-80% profit over two years. That was assuming valuation multiples on Japanese stocks rose to levels similar to those found in Europe.
Also, Japanese stocks are still pretty cheap. The index that DXJ tracks has a low P/E of just 12.9 and healthy distribution yield of 3.5% (including dividends plus net stock buybacks).
If Japanese stocks are still cheap, why take profits so soon?
So why sell now?
There are a couple of significant risks. Both could result in a stronger yen and falling Japanese stock market, which would most likely cause a huge hit to the DXJ price.
- The vast US stock market is now firmly in bubble territory (see here). If it does crash (and I admit it may not) then it will drag everything down with it, including Japanese stocks. Worse than that, the yen is still (for some reason that I’ve never fully understood) seen as a safe haven in times of trouble. For example, it gained 60% against the US dollar between June 2007 and October 2011, during the global financial crisis (USD/JPY went from 123 to 77).
- The stand-off between the USA and North Korea has deteriorated to the point of personal (and childish) mudslinging between the countries’ two presidents (henceforth known as “dotard” and “rocket man”). Also, North Korea has already launched a couple of missile tests through the skies above Japan, a US ally. While the threat of an attack on Japan may be much less than that in South Korea, there’s still a relevant market risk. (Note: given the increasing risks, I recommended that OfWealth Briefing readers should sell South Korean stocks on 11th July – also for a substantial profit.) If there’s a war on the Korean peninsula, the yen’s safe haven status could see it strengthen, causing Japanese stocks to fall in yen terms. All of any stock price falls and none of the yen currency gains would be passed through to the dollar price of DXJ.
Hedged Japanese stocks, in the form of the DXJ ETF, have given investors a very healthy 30% return since my recommendation in August 2016. But the situation in Japan has changed (again), and it’s time to take a profit.
Action to take: sell the WisdomTree Japan Hedged Equity Fund (NYSE:DXJ).
Stay tuned OfWealthers,