Japanese Stocks: Why Small-Caps Will Lead Japan’s Economy Out Of The Wilderness

Thursday, February 11, 2010: Issue #1195

It’s a move that is about as popular as a geek on prom night.

But on Monday, my good friend and colleague, Alexander Green, took the plunge and slapped a “Buy” rating on investing in Japan.

I’m right there with him, too. And it’s not just because I don’t want my friend to be lonely.

Why? Well, given that I’m a contrarian investor by nature, I started the thought process with one simple question: What investments do people universally love or hate?

I couldn’t come up with a better answer than Japan.

Forget hated. Japan is completely ignored. Or as legendary hedge fund manager Barton Biggs said last year, “If ever there was an equity market that qualified for the legendary ‘Four U’s’ (Underowned, Undervalued, Unloved and Ugly), it’s Tokyo.”

Most international fund managers completely shun investing in the country, or at least heavily underweight their portfolios to Japanese equities.

Heck, even the Japanese can’t stomach Japanese stocks. Less than 7% of their wealth is invested in domestic equities, according to the latest data.

Fundamentally Speaking, Japan Offers Potential

Before I go any further, let me reiterate a key part of contrarian investing: It’s not simply a case of seeing what everyone else is doing and then doing the opposite. That’s just idiotic.

Being a contrarian requires verifying that the fundamentals actually support betting against the crowd. And in this case, they certainly do.

• The Economy: Japan boasts the second-largest economy in the world. But you wouldn’t know it, given the country’s prolonged comatose state. However, GDP has increased for two consecutive quarters. Yeah, I know… it’s got a long way to go before we can declare it has emerged from a decades-long slump. But the latest data is a step in the right direction.
• Political Reforms: Aiding Japan’s recovery are the economic reforms put forward by the country’s new government – the Democratic Party. They come after 54 years of control by the Liberal Democratic Party.
• Trade: Japan has an economic ally close by – one that just happens to be one of the fastest-growing economies in the world: China. Expanding trade with the Chinese certainly doesn’t hurt Japan’s prospects.

But here’s the real kicker…

Japan is the Wal-Mart of the Investment World

Japanese stocks are universally cheap.

In fact, the average stock trades for about 1.4 times its book value – roughly a 40% discount to the average U.S. or emerging market stock. And that’s got a double benefit…

• Even minor improvements in the underlying fundamentals could result in drastic price jumps.
• The downside is extremely limited. It’s unlikely Japanese stocks will get dramatically cheaper.

If you’re looking for low risk, high return, you can’t ask for a better opportunity than that.

In Monday’s issue, Alex recommended two solid options aimed at capitalizing on a Japanese rebound. Both are compelling, but I don’t want to simply say, “Buy what he recommended.”

Especially, since a third, equally compelling option exists…

Three Reasons to Buy This Japanese Small-Cap Fund

I recommend playing Japan’s revival via small-cap stocks – specifically with The Japan Smaller Capitalization Fund (JOF: 7.53 0.00 0.00%). And here are three reasons why…

• Small-Caps Are Cheapest: Based on price-to-sales and price-to-cash flow ratios, Japanese small caps are about 16% and 40% cheaper than large-caps.
• An “Extra” Discount: Since JOF operates as a closed-end fund and currently sells at a 10% discount to its net-asset value (NAV), it allows us to scoop up 150 compelling Japanese small-cap stocks at even lower prices.
• Small-Caps Are Fast Growers: Just like in the United States, small-caps tend to lead the way off market bottoms. In a big way, too! Consider that in 2003 – the start of the last rally in Japan – the broad Nikkei stock exchange climbed 17% for the year. But small-caps, represented by JOF, soared 78%.

I know it seems like forever since anyone made any money in Japanese stocks. But considering the cheap valuations, nascent signs of a recovery and the universal disdain for Japanese stocks, the time is ripe for a stealth rally. So don’t miss out.

Good investing,

Louis Basenese

Editor’s Note: Some investors are hesitant to invest in small-cap stocks because of their increased volatility. But history has shown time and again that the most powerful stock market returns come from investing in these small, often under-the-radar companies that Wall Street either doesn’t know about, or ignores altogether.

Small-cap expert Louis Basenese has taken the small-cap area a step further… into “White Cap” territory. That is, identifying the companies with unique, in-demand products that have a major edge on their competition (and sometimes entire markets to themselves). To find out more about Louis’ strategy for finding small companies that pack a big punch, take a look at this report.