Japan is at a 28-year low: buy now
Investment Director – The Fleet Street Letter
David Stevenson Jun 12, 2012
Have you noticed what’s been happening in Japan?
Chances are you haven’t. While most investors’ eyes have been focused on the turmoil in the eurozone, Japanese shares haven’t exactly been having a smooth ride.
In fact, they’ve dropped right back. Our favoured measure here is the Topix index (TPX), which tracks the performance of all the country’s leading domestic companies. Last week, the index hit a 28-year low.
That’s a pretty grim-sounding statistic. But it could also provide a very promising entry point for investors in Japan…
Japan’s recent performance is better than it looks
It’s no surprise that Europe’s stock markets have been tumbling recently. Yet at first glance, the returns from Japan look as bad. From the end of March to the start of June, the Topix lost 20% of its value.
However, when you drill a bit deeper, a rather different picture emerges. The latest drop in the Topix is clearly a setback. But it’s merely been a mirror image of the 20% gain the index saw in this year’s first quarter.
Put another way, Italy has declined by 15% this year when measured in sterling terms. Spain is more than 25% lower. The TPX, on the other hand, and the FTSE 100, are both down by around 5% on balance. So of late, Japanese shares haven’t done too badly in comparison to the rest of the world.
But a 28-year low is still a major milestone. As regular readers will know, we’ve been keen on the Japanese stock market for a long time now. So what should you do?
You probably already have a good idea why we like Japanese shares. So I’ll keep my summary brief. In a nutshell, Japan’s stock market looks cheap.
First, the stocks in the Topix currently trade on an average price-to-book value (p/bv) ratio of 0.86, according to Bloomberg data. So investors are able to buy ¥100 of assets for just ¥86. Compare that with a p/bv ratio of 1.55 for the FTSE 100 and more than two for the S&P 500 index.
Second, TPX stocks look good on the corporate profit front. They’re standing on a forecast p/e multiple for 2012 of just over ten (also on Bloomberg numbers). In contrast the S&P 500 is on more than 12 times current year earnings.
Yes, on a price to earnings (p/e) ratio of slightly below ten, the FTSE 100 is a touch cheaper on this score. But when you compare the indices on a price-to-sales (p/sales) basis, Japan again comes up well.
The p/sales measure is useful because it shows the scope for a company to expand its profits, as I’ll explain in a minute. For 2012, stocks in the Topix are set to sell on just 43% of their sales. Against this, the FTSE 100 is on a p/sales ratio of 0.9. And the S&P 500 is on a multiple of more than 1.25.
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The strong yen has hammered Japanese stocks
So why are stocks in the Topix standing on half the p/sales ratio of UK shares, but on a similar p/e ratio? It’s because their profit margins are lower. This holds down their earnings relative to their sales. I don’t have space here to examine all the reasons for this. But there’s one key factor at work: the strong yen.
Since the financial crisis kicked off in 2007, the yen has become just about the top ‘safety-first’ currency choice. Against such a backdrop, Japan’s exporters have had to cut their profit margins to keep selling their products.
Recent euro weakness has simply driven more people into buying the yen. And that has hurt the Topix even more. But after its latest drop, does now look a good time to buy?
The country’s stock market clearly isn’t risk-free. It’s China’s largest trading partner. So Japan’s corporate sector would be hit by a prolonged slowdown in the latter’s economic growth rate.
What’s more, the eurozone’s woes are a very long way from being resolved. OK, lots of money has moved from Europe into the dollar. But the yen looks likely to remain the world’s favourite major currency.
Sure, the Bank of Japan has taken steps to reduce the yen’s value with its own version of quantitative easing. But other central bankers’ fingers are poised over the printing presses too – and they seem to have more enthusiasm for the idea than Japan’s central bankers. So the yen could stay strong anyway.
But there comes a point when all the negatives become factored into a price. And the Topix at a 28-year low is ‘discounting’ a great deal of bad news. This really does feel like a good time to buy Japan.
The downside risk from here looks limited. And if the yen does weaken a bit, exporters should really cash in profit-wise, which should give a big boost to their share prices.
How to invest in Japan
What’s the best way of capturing the upside? Cheaper-than-average Japanese stocks are the most likely to benefit from a market rally, Toshio Sumatani at Tokia Tokyo tells Bloomberg. Such a strategy has paid off before and it “should work this time too”, says Sumatani.
This all points to a Japan value fund. My colleague James Ferguson has pointed out the Morant Wright Japan Fund, run by a value specialist who concentrates on “undervalued Japanese companies that have strong balance sheets and sound business franchises”. For more ideas, you can see James’s recent cover story on this topic: Why Japanese stocks are set to soar.
Finally, there’s one issue that always crops up in relation to investing in Japan. It’s whether you should hedge the yen against sterling. The argument is that if the yen does weaken against the pound, you’d lose some of your stock market profits.
It’s a fair point. But we reckon that if the yen drops, you’re likely to make much more money from a stock market rally than you’d lose from the yen falling against the pound. And if the yen keeps rising, it will protect you against the stock market staying in the doldrums for the moment. On balance then, we’d still avoid hedging.
• This article is taken from the free investment email Money Morning.
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