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Turning Japanese

William Ehart

AS AN INVESTOR, I’d describe myself as a small-cap-value-aholic with a worldly outlook. Right now, I’m betting that one of world’s least loved overseas markets will finally return to favor after decades of disappointment. You can laugh out loud now.

Last year, my investment in U.S. small-cap value stocks was a great play from the March 2020 market bottom through about mid-May of this year. I didn’t catch the market bottom perfectly, but—luckily—I was close.

Since then, the large-cap growth stocks that I’m convinced will fall back to earth someday (they will, won’t they?) have instead resumed their inexorable outperformance. Admittedly, I thought Apple stock was too popular 10 years ago, which is why I still need to work for a living.

Lately, I’ve been looking to developed foreign markets for small-cap value opportunities. In May 2020, I added money to WisdomTree International SmallCap Dividend Fund and since then it’s up about 50%. Yet its return slightly lags the S&P 500 and trails well behind that of Vanguard Growth ETF.

Fortunately, I try to limit my style bets to about 10% to 15% of my stock portfolio. I own the FAANG stocks (Facebook, Apple, Amazon, Netflix, Google or whatever the latest lineup is) and the rest of the market through my total U.S. and total world stock index funds, as well as through my 2035 target-date fund. With 10 years until retirement, I can’t afford to bet too big on any one style factor—and risk being wrong.

Still, I figure if small-cap value is supposed to work here at home, it should work overseas as well. Foreign stocks have lagged the U.S. market return since 2007. Even more, I like the idea of investing in the most overlooked of the least-loved asset classes.

That’s why I started reading about Japan. Talk about an unloved—perhaps even hated—market. Snake-bit since 1990, investors throw money willy-nilly at China, yet ignore Japanese shares. You could say Japanese small-value stocks are unloved about three times over. It’s as if their appeal is hidden inside one of those Russian matryoshka nesting dolls.

Since May, I have invested close to 2% of my stock holdings in the WisdomTree Japan SmallCap Dividend Fund. Some of the data that convinced me to invest came from WisdomTree itself. It reports that foreign investors have been net sellers of Japanese stocks for many years. To be sure, WisdomTree has an incentive to promote an asset class it also happens to sell shares in.

More data in the WisdomTree report came from the thoughtful, value-oriented and market-skeptical investment managers at GMO (who, it should be noted, sell fund shares as well). They produced historical charts showing which stock classes are at extreme undervaluation, plus projected market-beating expected future returns should share prices revert to the mean. Japanese stocks may never revert, but the projections are promising: Japanese small-cap shares are a pocket of real value in a world where so many assets have been bid to the moon. In addition, Japanese corporate managers are finally becoming more shareholder friendly, using their mounds of cash to increase dividends and buy back stock.

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Since my purchase in May, my Japan small-cap stock fund has slightly trailed the broader WisdomTree International SmallCap Dividend Fund that I trimmed to buy it. Altogether, just over 5% of my total stock position is in these two foreign small-cap value funds. I have another 8% invested in U.S. small- and mid-cap value funds.

Japan has had a well-developed small-cap market for, well… I’m old enough to remember the 1980s. Outside of North America, the largest foreign small-cap markets were—and are—the U.K. and Japan. Back then, we thought Japan was taking over the world. The prevailing wisdom was it would buy every company and every acre of U.S. commercial real estate, and even every U.S. golf course. (Remember the 1993 movie Rising Sun, with Sean Connery and Wesley Snipes, based on the Michael Crichton novel?)

Instead of the Japanese taking over the U.S. with their capital, we witnessed Japanese shares and real estate collapse after one of the most storied investment bubbles in history. Ever since, Japan’s policies have been held up as examples of what not to do in response to a market bust, how not to run an economy and how not to treat foreign shareholders. But change is afoot.

The oldest Japan small-cap fund I can find is the DFA Japanese Small Company Portfolio, which was launched on Jan. 31, 1986. It’s up 37% since the Japanese market peaked on Dec. 29, 1989. That’s not a typo: Just 37%, versus more than 2,200% for Vanguard’s S&P 500 index fund.

I’m thinking that the cheap valuation and neglect of Japanese small-cap value shares by foreign investors, coupled with the companies’ more shareholder-friendly practices, make betting on reversion to the mean a reasonable strategy—at least with a small slice of my portfolio.

William Ehart is a journalist in the Washington, D.C., area. In his spare time, he enjoys writing for beginning and intermediate investors on why they should invest and how simple it can be, despite all the financial noise. Follow Bill on Twitter @BillEhart and check out his earlier articles.

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Sunil Sharma
Sunil Sharma
2 months ago

In comparison with the Japanese small-cap value asset class, global ex-US small-cap value provides greater geographical diversification. As a result, this global asset class has lower risk than a less geographically-diversified asset class. However, the ETFs for these asset classes have high bid-ask spreads. I would probably wait for Vanguard to introduce a low-cost international small-cap value mutual fund.

Philip Stein
Philip Stein
2 months ago

Bill, I wonder why Japanese small companies have been undervalued for so long. If smaller companies in general are more affected by local conditions, isn’t one reason for the underperformance of Japanese small companies the poor demographics in Japan, one of the most rapidly aging societies? I would be more optimistic about the future of Japanese small companies if Japan became more open to immigration to attract younger, foreign workers.

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