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The Sun Rises in the East

The Sun Rises in the East

Missed the rally in U.S. equities? Japan’s may be just beginning, thanks to a new stimulus-happy prime minister and the Bank of Japan’s massive appetite for government bonds.

After languishing for much of the past two decades, Japanese stocks suddenly began showing signs of life in the fourth quarter of last year. The gains came as investors cheered Shinzo Abe, the new prime minister. Abe pledged to boost the economy, spending heavily on stimulus projects. In addition, he began pressuring the Bank of Japan to increase its quantitative easing program, buying more government bonds.

Can the rally continue? Yes, says Neil Hennessy, chief investment officer of Hennessy Funds, which operates two Japan funds. “All the pieces are in place for a long-term bull market,” he says.

The prime minister plans to spend more than a hundred billion dollars on public works and aid to small businesses. The expenditures will come as the country continues the massive infrastructure reconstruction that began after the earthquake and tsunami that leveled whole towns in 2011.  At the same time, the Bank of Japan is pumping money into the economy by purchasing government bonds. Hennessy says that Japan could print more money than the U.S. does this year.
With the central bank sending a flood of yen into the economy, the value of the currency has plunged against the dollar. Stock investors have cheered the move. By making Japanese exports cheaper, the weak yen should boost sales by Japan’s carmakers and other powerful multinationals.

Hennessy argues that the yen is likely to remain weak for a long time as the central bank continues printing money. “Once a currency breaks, the weak trend normally continues for 5 years,” he says. 

For a broad bet on Japan, you can try a fund that specializes in the country.  A top choice is Hennessy Japan Investor (HJPNX), an actively managed fund. During the past five years, the fund returned 1.5% annually, outdoing the MSCI Japan index by 5 percentage points annually, according to Morningstar. The fund is currently focused on Japanese exporters. 

For ETF investors, an intriguing choice is WisdomTree Japan Hedged Equity ETF (DXJ). The fund claims to hedge away the impact of currency moves. That can be important because the falling yen is a mixed blessing for fund shareholders. While the currency decline boosts exporters, it also lowers the value of assets for U.S. investors.

To appreciate the impact of currency moves, consider that the Tokyo stock market climbed about 30% during the three months through February 7. But during that period, iShares MSCI Japan Index ETF (EWJ) only returned 13.3% because currency losses hurt results for U.S. investors.  Meanwhile, the WisdomTree hedged fund avoided currency losses and returned 30.6%.

Investors have taken note of the currency impact. During the three-month period, the WisdomTree fund recorded inflows of $1.9 billion, a huge outpouring for a fund with total assets of $2.8 billion. 

For a more diversified approach, consider an Asia fund that invests in Japan as well as other countries. A top choice is Columbia Pacific/Asia (USPAX), an actively managed mutual fund. Columbia Pacific has 30% of its assets in Japan. Other big stakes are in China, Korea, and Taiwan.  During the past five years, the fund returned 2.9% annually, outdoing 92% of peers.

Portfolio manager Daisuke Nomoto favors solid blue chips that sell at moderate prices. A favorite holding is Toyota, which should get a boost from the weak yen. Nomoto says that the Japanese company is increasingly successful in countries such as Indonesia and Thailand. “They are gaining market shares in the fast-growing Asian markets,” he says.

Cautious investors may prefer First Eagle Overseas (SGOVX). To limit risk, the fund sticks with solid companies that sell at big discounts. When the managers can’t find anything to buy, they hold cash. The diehard value approach has resulted in sterling results. During the past ten years, the fund has returned 12.6% annually, outdoing 96% of peers.

The fund currently has 39% of assets in Japan because the country is full of depressed stocks, says portfolio manager Kimball Brooker. Despite the recent rally, Japanese stocks still sell for about one times their book value, compared to a figure of 2.4 times for the S&P 500. Brooker says the Tokyo markets are cheap partly because investors have stereotyped Japanese companies as being stagnant businesses with managements that are not focused on serving shareholders. The truth is different, Brooker says. “You can find companies with reasonably good management teams and rising cash flows.”

Brooker holds Shimano, a producer of brakes, derailleur gears and other components for bicycles. A market leader in its field, the company derives most of its sales overseas. The company has sought to boost shareholder returns by raising dividends and buying back stock.

Brooker also likes Chofu Seisakusho, a maker of residential water heaters. The business is not glamorous, but the results have been steady. Despite growing earnings, the shares sell for less than the value of the cash on the balance sheet. “You are not paying anything for the actual business,” he says.

Another solid mutual fund is MFS International Value (MGIAX). The MFS fund focuses on quality companies with high returns on equity and little debt. The cautious approach enabled the fund to excel in the downturn of 2008. During the past ten years, the fund returned 11.8% annually outdoing 98% of peers.

The MFS fund currently has 27% of assets in Japan. The portfolio managers boosted results in recent weeks by hedging about half the yen exposure. The MFS fund holds Kao, a consumer products company that is sometimes compared to Procter & Gamble. “They have a Steady Eddie business with strong brand names and good distribution,” says MFS institutional portfolio manager Camille Humphries.

The fund also owns Canon, the giant producer of cameras and copy equipment. Sales should climb as the yen weakens, says Humphries. The company pays a rich dividend and has a sizable cash stake on the balance sheet.

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