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Is It Time to Try Investing in Japan Again?

If you're ready, you need to employ a cautious strategy.

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Thirty years ago, Japan’s economy was roaring. Flush with cash, the Japanese bought such U.S. icons as Columbia Pictures, the Empire State Building, Firestone Tire & Rubber, Pebble Beach golf course and Rockefeller Center. In Japan, meanwhile, real estate values soared. “At the market’s peak in 1991,” reported the New York Times, “all the land in Japan, a country the size of California, was worth about $18 trillion, or almost four times the value of all property in the United States at the time.” The grounds of the Imperial Palace were reported to be worth more than France. Stocks went through the roof. The Nikkei 225 index tripled in just four years, from 13,000 at the start of 1986 to nearly 39,000 at the end of 1989.

See Also: Japan's Stock Market Rebounds Under Abenomics

A true managerial miracle was behind at least part of the boom. With a fiercely dedicated workforce, the Japanese pioneered such strategies as just-in-time manufacturing, which supplied parts only when they were needed, cutting expensive inventories. But much of the boom depended on low interest rates and a mania for borrowing, encouraged by banks and the government. And then it all came apart.

The Nikkei fell to 16,000 by mid 1992, followed by economic stagnation. Japan’s economy has exceeded 2% annual growth in only five of the 26 years since the bubble burst. Attempts to snap the nation out of its torpor by dropping interest rates to zero and running massive deficits failed.

Lately, Japan has been making a comeback—of sorts. The economy has grown for seven consecutive quarters, the longest streak in nearly two decades. Private investment has risen briskly, and unemployment, at 2.8%, is lower than in any other major economy. But Japan’s turnaround under Prime Minister Shinzo Abe has been modest, even if government enthusiasm is robust. Experts at The Economist magazine project the country’s gross domestic product will rise 1.3% in 2018, compared with 2% for Europe, 2.4% for the U.S. and 6.4% for China.

A Yen for Exports

Regulatory reforms in a nation with a hidebound bureaucracy have helped, but so has the decline in the value of the yen. In December 2012, the month Abe began his current tenure as prime minister, it took 91 yen to buy a dollar; now it takes 113.4. A cheaper yen makes Japanese goods more attractive abroad, and the most recent government report shows that exports grew 14% in October compared with a year earlier as demand for vehicles and electronics remained robust.

Investors have taken note of Japan’s mini recovery. The Nikkei 225 has more than doubled in the past five years, outperforming Standard & Poor’s 500-stock index, the equivalent U.S. benchmark. But the Nikkei is still about 40% below its 1989 high—even though the Japanese economy, for all its misery, is more than 60% larger. (Returns are through December 8.)

A popular exchange-traded fund that measures the performance of 322 large- and mid-cap Japanese stocks, iShares MSCI Japan (symbol EWJ, $60), scored average annual returns of 11.3% over the past five years—roughly coinciding with the tenure of Prime Minister Abe. By comparison, SPDR S&P 500 (SPY), a U.S. ETF linked to the S&P 500, returned 15.6%, and iShares MSCI World (URTH), a global index ETF, returned 11.7%, slightly more than the Japan fund. In short, the market is strong but not exceptionally so. If Japan can make a sustainable comeback, it might be an excellent time to buy shares.

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Note that might. Skepticism about Japan is warranted for two reasons. First, Japan has been through several other mini recoveries that fizzled. Second, Japan has one big problem that Abe is unlikely to fix: Its fertility rate is low, so its population has declined for eight consecutive years and is expected to keep falling. As a result, the ratio of its working-age population to its dependent population (mainly retirees) is now 1.0, compared with about 1.5 globally. That means a Japanese worker must support both himself or herself and one other nonworking person. The population, now 125 million, is projected to drop below 100 million by about 2055, when about two-fifths of the people will be older than 65. The market seems to have accepted these facts and built them into stock prices, even as Japanese companies are earning more. Matthew Klein, of FT Alphaville, a market-commentary website, figures that Japanese stocks, excluding financials, are about 40% cheaper than U.S. stocks and 20% cheaper than European shares.

How to Invest

Unfortunately, buying individual Japanese stocks is not easy. The American depositary receipts (versions of foreign shares that are traded here) of just 12 Japanese companies trade on the New York Stock Exchange, and just two trade on Nasdaq.

Among them, however, are some of the world’s great businesses, including Toyota Motor (TM, $124), with revenues that exceed those of General Motors by about 50%. Toyota’s shares haven’t budged much since mid 2013, but the dividend yield is a handsome 3.2%. Only about one-fourth of its vehicle sales are in Japan, so Toyota depends less on a robust Japanese economy. If you think that, despite demography, Japan’s own economy will turn around, consider NTT DoCoMo (DCM, $25), the country’s largest telecom company, which yields 3.5%.

Many of Japan’s best companies are available only over-the-counter in the U.S. That is, they don’t trade on an exchange, and they lack the kind of regulation and disclosure that the Securities and Exchange Commission requires for exchange-listed stocks. Also, OTC traders often mark up stock prices, and trading is generally thin, leading to more volatility.

My advice, therefore, is to let fund managers do the buying. Among ETFs, the iShares offering is the largest by assets and carries an expense ratio of 0.48%. Another good choice, with the same expense ratio, is WisdomTree Japan Hedged Equity (DXJ, $59), which is designed to neutralize the fluctuations of the Japanese yen against the dollar. The fund has significantly outperformed conventional Japan index ETFs that don’t practice currency hedging. If, however, the yen starts rising against the dollar, the fund will suffer. A big star lately has been WisdomTree Japan SmallCap Dividend (DFJ, $79), an ETF that does not hedge currency swings but has returned an annual average of 14.9% over the past five years with a gigantic, highly diversified portfolio (currently 732 stocks). Top holdings include Sankyo, a maker of popular Pachinko gambling machines, and DIC, a manufacturer of printing inks. The fund’s expense ratio is 0.58%.

Don’t neglect actively managed funds. Unfortunately, Matthews Japan (MJFOX), run by my favorite firm for picking Asian stocks, has closed to new investors, but it might be available through an adviser with other clients in the fund, if you happen to work with one. Another fund I admire, Fidelity Japan (FJPNX), launched a quarter-century ago. Among its top holdings is Mitsubishi UFJ Financial (MTU, $7), whose ADRs are listed on the NYSE. T. Rowe Price Japan (PRJPX) is also venerable, with a five-year annual average return of 15.6%. These funds have higher expenses than the ETFs, but the costs are not out of line for foreign portfolios.

In the end, I would take a cautious approach to Japan. Add a fund or two to your portfolio, but don’t go nuts. Abe seems to be on the right track, but unless Japan solves its demographic problem (probably through wise immigration policies), it could take a long time to get the Nikkei back to where it was in 1989.

See Also: 5 Emerging-Markets Funds That Are Crushing U.S. Stocks