Surging Japan ETFs Ride New Tail Wind

November 08, 2017

This year has been one of the best years for the stock market in history―and it's not just U.S. stocks that have been rising. Equities around the world have been on a tear.

One of the markets that's been doing particularly well is Japan, where stocks have seen an under-the-radar rally that's recently accelerated since the landslide victory of Prime Minister Shinzo Abe.

Since Abe's victory on Oct. 22, the benchmark Nikkei 225 jumped nearly 7% and now trades at its loftiest level in 25 years.

That's caught the eye of investors, who, since the election, have added a combined $900 million to the two largest Japan ETFs, the $17.7 billion iShares MSCI Japan ETF (EWJ) and the $9.3 billion WisdomTree Japan Hedged Equity Fund (DXJ) (year-to-date, the two ETFs still have combined outflows of $650 million).

The Nikkei hasn't touched a record high since 1989, when it reached nearly 39,000 amid a ballooning asset price bubble in the country. Today the index is still well below that level, at 23,000, but some analysts say the rally in Japan's stock market has much more room to run.

If that's the case, EWJ and DXJ, which are up this year by 21.9% and 20.2%, respectively, could continue to outperform. For comparison, the SPDR S&P 500 ETF Trust (SPY), which tracks large-cap U.S. stocks, is up 17.5% so far in 2017.


YTD Returns For EWJ, DXJ, SPY


Trading At A Discount

One of the analysts who has a bullish view on Japan is Jesper Koll, CEO of WisdomTree Japan. WisdomTree is the issuer of the second-largest Japan ETF, DXJ, and the fifth-largest Japan ETF, the WisdomTree Japan SmallCap Dividend Fund (DFJ).

In Koll's view, sales for Japanese firms will easily grow faster than the consensus expectation, while the Japanese yen will be weaker than many anticipate, bolstering the bottom line for companies in the country.

"At the peak of the bubble economy in the 1980s, when the Nikkei was 40,000, you had earnings-per-share of $40. Now you have an EPS of $106, but the Nikkei is 21,000. You had this enormous multiple compression," which has resulted in Japan trading at a discount to the U.S., Koll explained in a recent podcast.

He said Japanese stocks are trading at 15.5-16x earnings, compared with U.S. stocks, which are trading at 20x.

"It's very rare to see Japan trading at a discount," he said. With the landslide victory for Prime Minister Abe, Koll noted it should become clear that "the growth momentum in Japan is going to be maintained; policy is not going to be tightened prematurely and as a result of that, multiples can expand in Japan."

11% Upside
Koll believes Japan's TOPIX index can increase from the current levels around 18,000 up to 20,000, an increase of around 11% over the next six months.

"We maintain our bullish call for Japanese equities: valuations are attractive, and positive earnings momentum is likely to keep going. Japan is not a “value trap.” In our view, profits can rise 25% in FY3/2018, which in turn suggest TOPIX at 2,000 is a reasonable fair-value target," he wrote in a recent blog post.

While Koll likes Japanese stocks in general, he favors small-caps, which he says are much more focused on the domestic Japanese economy. In contrast, large-cap multinationals in Japan are much more dependent on exports to the U.S. and China.

The WisdomTree Japan SmallCap Dividend Fund (DFJ) and the iShares MSCI Japan Small-Cap ETF (SCJ) gained about 27% apiece this year, outpacing their larger-cap counterparts.


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