Japanese Small-Caps Hold Big Rewards For Contrarian Investors

Tony D'Altorio
updated | Author's Website

Mention Japan to any global money manager and he or she will probably react with a frustrated look and a weary sigh.

That’s because too many investors have lost fortunes trying to call Japan’s market bottom ever since the Nikkei 225 index began falling from its peak of 40,000 in 1989. So naturally, skepticism runs deep about any real improvement over there.

But this time may be different.

Really.

After all, Japan has a new government with new ideas of how to run the country. In taking office last September, the Democratic Party of Japan (DJP) officially ended more than half a century of dominance by the Liberal Democratic Party (LDP).

The last time such a large political switch happened was in 1867 when Japan’s imperial court toppled the long-ruling Tokugawa Shogunate. That action successfully catapulted the country into modernity. And this newest change could have a similarly significant affect, possibly even driving the Japanese stock market to greatness once again.

Sure, as Investment U’s Small Cap and Special Situations Expert, Louis Basenese, recently said, betting on Japan “is about as popular as a geek on prom night.” But he still concluded that investors who want low risk and high return “can’t ask for a better opportunity.”

I couldn’t agree more. Contrarian investors need look no further than Japan.

Why It’s Worth The Heckling

Anybody who puts money into Japanese small-caps should expect at least a few weird looks or snickers, and maybe even a less flattering name or two. Those stocks are too often illiquid, little researched and family-dominated. And savvy investors know that.

Yet by ignoring them altogether, they overlook some of the cheapest opportunities in the world. Japan’s small-cap market abounds with companies valued at deep discounts to their assets. More than 60% of them currently trade under their book value… exactly the kind of discounts that made Warren Buffett rich.

Just take Katsuragawa Electric, which makes wide-format printers. It has annual sales of about $200 million, $55 million net cash on its balance sheet and total net assets of about $190 million. And at its recent peak in 2007, it made a net profit of around $17.5 million.

Yet the company’s full valuation on Japan’s Jasdaq stock exchange amounts to less than $40 million. That means that every one dollar put into Katsuragawa shares yields $1.39 in net cash and $4.81 in net assets, while costing the investor only a little over twice the company’s peak earnings.

Enticing, right?

Return On Equity

Of course, there’s a reason why those small companies cost so little.

Japanese brokerage firm Nomura estimates a mere 4.7% return on equity for small caps this year, as compared to 6.6% for all Japanese companies and 13.4% for stocks in the developed world.

Fortunately, a projected earnings recovery over the next few years could push return on equity to 7%. That, in turn, could rally small-cap share prices up more than 50% just to keep up with other markets. And even if it doesn’t, low return on equity indicates a lot of room for improvement, something investors should pay attention to.

Let me explain…

Investors who put their money into highly valued stock market like the U.S. depend on real earnings growth to push their shares upward today, despite already historically high profit margins. But investors in Japanese small-caps only need companies to start using their balance sheets more efficiently to wow everybody and collect the resulting profits.

For that to happen, management needs to start viewing shareholders as vital pieces of their businesses instead of nuisances as they have in the past.

The evidence points to them catching on slowly but surely.

In 1992, only 12.1% of small Japanese companies even bothered with investor relations meetings. But Nomura reports that by 2007, that percentage rose to 63.7%. Likewise, the government is actively trying to improve minority shareholder rights and corporate governance in a number of ways, including requiring independent, non-executive directors.

Those efforts on both the political and corporate side should change Japanese business for the better and in turn, benefit the markets.

Four Ways to Invest in Japan’s New Revolution

American investors who want to buy Japanese small-caps have a few options, including purchasing specific exchange traded funds (ETFs).

  • Despite having different holdings, iShares MSCI Japan Small Cap Index (SCJ) and SPDR Russell/Nomura Small Cap Japan (JSC) have very similar sector weightings.
  • For that matter, so does WisdomTree Japan SmallCap Dividend (DFJ), an ETF that Investment U Chief Investment Strategist Alexander Green mentioned in his own article on Japan last month.
  • Or for those interested in closed-end funds, Japan Smaller Capitalization Fund (NYSE:JOF) trades at a discount to its net asset value of about 10%, giving investors a further discount on already deeply discounted stocks.

My contrarian bet is that those deeply discounted stocks will rise as Japan puts itself back together.

Good investing,

Tony Daltorio

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