Japan – I just can’t look away and I think there’s an opportunity

Written October 15th, 2010

I’ve written often about the challenges facing Japan in the next few years, from an aging population and the resulting transformation from savers to spender to the unsustainable debt that can only be financed with printing, all leading to an eventual devaluation if not complete collapse of the yen. I have been premature, but I am not wrong. Today, I actually want to point out a different opportunity in Japan – equities.

While the yen will top out (see chart below) if it hasn’t already, Japanese equities are looking relatively cheap. Trading at single digit P/E’s with an export focus that will only be helped by a declining yen, many Japanese companies will be poised for higher earnings going forward. The current yield on the Japanese market is hovering around 2%, but with potential for expansion with a declining yen.

Dylan Grice just put out a research piece highlighting how the Nikkei could rally significantly as a result of the coming devaluation of the yen. So the question is how to play it?

There are multiple ways from taking a currency position (we have been short the yen as we’ve written about endlessly) to going long the equity and hedging out the currency. This is not easily done by individual investors – or so I thought. When I started looking for different options, I came across a WisdomTree ETF that does just that – DXJ.

EWJ is the popular Japanese ETF. Most investors believe that because it is bought in domestic accounts on US exchanges with dollars, that it is dollar based; however, EWJ is NOT currency hedged. Meaning that if the index went up 1% and the yen went down 1%, USD based investors would not see any return.

DXJ on the otherhand, uses futures and forwards to hedge out the yen currency fluctuations for USD-based investors. Amongst some of the drawbacks it has: it’s small, has little daily volume, and the currency hedge can (and has) worked against it as the yen has strengthened. That being said it looks like a viable alternative for investors looking to get exposure to Japanese equity without the yen risk. For the record, this is in no way a recommendation to buy or sell any security, and at the time of this writing I do not have any position in EWJ nor DXJ, but do have a short yen position.