As a value investor, I’ve had a fair amount of success with S&P, Russell, Canadian and European exchange traded funds (ETFs). With diversification in mind, I asked myself, why not broad-based ETFs in other developed markets?

 

It is a great example of an investment idea which appears unbeatable at the start, but after analysis…not so hot. The initial idea then needs to be executed far differently than originally thought.

 

Zeroing in on Japanese Investments

I thought Asia-Pacific would be a perfect place to look, especially since things have been economically shaky there, which started with the global financial meltdown in 2009. That financial crisis was followed closely by the exporting emerging market economies being put under pressure by depressed commodity prices and as China cut back and dealt with its own economic slowdown. The poor economic performances, of individual countries, within the region are ongoing to this date.

 

I saw that the overall economic situation in the Asia-Pacific could possibly provide investment prospects. Some asset classes may be undervalued while the region is in the middle of an economic slump. I would then be able to purchase and hold them for the long term, which is always my preference.

 

First off, I bypassed Australia. Its economy looks too similar to that of Canada’s where I already have holdings; I’ve got the basic materials sector covered. New Zealand was a pass also; economically not sufficiently diversified.

 

Hong Kong and Singapore were definite passes. With serious issues of lack of protection for minority investors, financial disclosure and corporate transparency, corporate governance, etc. etc. etc. Too much additional risk that I am not ready to take on.

 

All indicators pointed towards Japan as the single best prospect, principally as I tend to strongly favor developed markets rather than emerging or frontier ones. The reasons for favoring developed markets all involve management and mitigating of investment risk.

 

Japan looked ideal.

 

Economic Problems Brings Opportunities for Investors

To give myself a footing in any geographic area, in this case Japan, I tend to look at low cost ETFs. First, I had to check out the economic situation in Japan. It was from this starting point that I was in trouble.

 

Briefly. The Land of the Rising Sun has a population of 127 million and a nominal GDP of $4,601 billion. This makes Japan, as a single country, after the United States and China, the world’s third largest economy and holders of approximately 5.6% of global wealth.

 

Also, after the U.S. and as a single country, Japan has the world’s second largest manufacturing output, $1,650 billion. Not bad for a country that has less than 2% of the global population.

 

Now some bad stuff. Good stuff for investors looking for deals.

 

It’s well known that the Japanese economy has gone through tough times since its heydays in the 80’s. Except for somewhat brief periods in 1989, 2008 and recently in 2014, the country has essentially been in a deflationary cycle. November 2015 saw the economy enter into the latest in a series of recessions.

Japan GDP Growth. Index Tracking in Japan of the Nikkei. Not Easy for Value Investors

The unemployment rate is low and sitting at 3.2%.

Japan Unemployment rate. Index Tracking in Japan of the Nikkei. Not Easy for Value Investors

Since 1999, to stimulate inflation and consumer spending, the Bank of Japan has had a zero interest rate policy and has been buying government debt, among other assets. Presently, BoJ monetary easing is peaking at over $708 billion per year in asset purchases. The inflation rate is now at 0%, well off the 2% target. That inflation target has presently been postponed by the bank due to low oil prices.

 

On the fiscal side of the house, large public deficits followed the financial crisis in 2009. Public spending was again accelerated to deal with the effects of the magnitude 9 earthquake and tsunami of 2011, including the Fukushima nuclear power plant disaster.

 

Public debt is presently approximately 229% of GDP and expected to worsen into 2020. This ratio is the largest of any nation. Japan, however, still holds a Moody’s A1 Stable rating on its sovereign issues.

 

For a thorough economic report and forecast, check out the most recent OECD report on Japan.

 

Validating some Investing Assumptions About Japan

Even when data appears similar to that in the U.S. it sometimes mean different things in different countries. For example, Japan’s unemployment rate. To put all the data into context, I read, talk to or listen to investors and follow the business news from Japan and the rest of Asia.

 

Value investor blogs operating from Japan provided some of the context I was looking for. As I don’t speak Japanese I was limited to English speaking sites, of which there are not many. One that focuses more on small cap, published in English, by Steven Towns was insightful, another more value investor oriented site added color to the data.

 

All to say that Japan’s economic challenges are many. I was undaunted by the challenge of finding an investment, but I knew that any investment decision I make would be surrounded by clouds of uncertainty.

 

To start the initial analysis, I needed to strip away the Bank of Japan’s current non-conventional monetary policies which have an effect of de-valuing the Yen. Strip away the problematic execution of Prime Minister Abe’s fiscal stimulus plan. Population shrinkage, recent and on-going corporate governance issues also had to be stripped from the initial calculus.

 

Now, that is not to say that I waved a magic wand and forgot that the problems Japan faced are serious and posed a serious portfolio risk.

 

It’s more that, first, I would look at whether an index fund investing strategy was applicable to the main indices. Then, should everything look positive I would follow up and perform a full investment risk analysis and find ways, should they exist, to mitigate those risks.

 

Here’s Where the Index Investing Plan Goes off the Rails

The broadest index covering the Japanese equity market is the Nikkei. As a bit of background. The Nikkei (short for the Nikkei 225) is price-weighted and is the leading index for stocks in Japan. It has approximately $4.9 trillion in market cap or, put another way, 5.2% of global market capitalization.

 

Essentially, the Nikkei is the equivalent of the DOW Jones Industrial Average.

 

The index is composed of 225 of the top blue-chip companies listed on the Tokyo stock exchange. After the United States and the London Stock Exchange Group, the Tokyo Exchange is the 3rd most important exchange in the world by market value.

 

Here’s the problem. Generally, for a first indicator, if I am interested in a particular index I will look at its growth profile which has to be generally moving up and to the right over time.

 

So there must be, over time, a sustained growth profile even when various corrections are taken into consideration. Here’s what the DOW’s historical chart looks like going back to the ’20’s. (Charts from TradeEconomics)

DOW

A cursory glance at the Nikkei shows quite a different profile. It is a highly cyclical pattern with big sweeping gains and big losses.

Nikkei

What’s worse is that data (chart below) appears to be projecting a market slump in the medium term. However, I’ve data from other sources which show a market moving up in the medium term. Still, all long-term projections for the Nikkei are cautious to negative.

Nikkei-forecast

 

Difficult to Buy the Market

The holding period, to maximize returns, in the last 15 years seems to be less than 5 years. That buy/hold/rebalance period is not exactly long term investing. If by long term I meant, generational endowment type investing, then maybe an index would work, but I would like to enjoy the fruits of my investing labor during my lifetime, so my long term investment strategy does not mesh well with cycles of that magnitude.

 

The other major Japanese index, the Topix, fared no better.

 

Another significant factor that I considered. The BoJ has essentially been devaluing the Yen against the greenback for the past several years. Let’s say that I had made the same value call on the Nikkei as I had on the S&P and picked up investments somewhere between 2010 and 2012.  I would have then faced very strong currency headwinds against any unhedged equity positions.

japan-currency-1

The Yen has effectively lost approximately 50% of its value over the past 4 years. The forecasts looking forward are cautious.

japan-currency-forecast

 

Overall, what the data says is that should I make a mistake and not monitor the moving markets closely enough, I could end up financially right back where I started. Or worse. Add in the dividends and subtract out trading commissions, fees, taxes, etc., then convert yen to dollars. It’s would not be a pretty picture.

 

If I looked at the history of the index purely from a technical point of view, I could not see any compelling argument towards projecting a sustained growth pattern. In fact, all seem to point towards another attempt at an 80’s style asset bubble by BoJ.

 

My overall investment strategy is dependent on very simple expectations of the future. My expectations are that the long term valuations and dividends of solid companies will increase. I wrote about expectations in a previous article. Without dealing with the reasons why the indices behave in that way, I could not reconcile a Nikkei or Topix broad based index fund within my investment strategy.

 

…But I Still Needed to Diversify my Stock Portfolio

There were definitely pockets of opportunity, but I would have to look…and stock pick carefully. Specific sectors were doing well, such as consumer discretionary. I still needed broad based exposure simply for diversification purposes. So I still needed an investment solution beyond something exposing me to a sector.

 

Of the options, mutual funds and pooled funds seem to be the best investment solution. After seeking financial advice, I purchased a few mutual funds that were recommended to me by my investment advisor.

 

The one that is the most committed has a 3.6% exposure to Japan, with a low correlation to the Nikkei but hits the hot technology and consumer discretionary sectors.

 

The fund managers balance off the risk mainly through diversification and, obviously, Japan is not viewed as an easy target. The fund was recommended because of the caliber and the history of the portfolio managers shown by their rigour and consistent application of a winning stock picking philosophy. More on this fund in a later article.

 

Importantly, with these mutual funds, I’m inching my way into Japan.