Seeking Alpha in Small Cap Japanese Stocks

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 |  Includes: DFJ, JOF
by: Steven Towns

The mention of small cap Japanese stocks will elicit varied reactions among investors. For one, small caps have been hammered relentlessly since soaring to new highs earlier this year. This is a high-risk, high-reward segment only for the savvy investor/trader with enough investment capital to reduce the impact of transaction costs.

Today's Wall Street Journal HEARD IN ASIA discusses the need for "plenty of caution" when "shopping for Japan small caps." The article provides some price-to-earnings data and 52-week trading levels for Japan's various indices. Below is an expanded list of the data:

  • Tokyo Stock Exchange MOTHERS Index -- forward PE 125.3, trading at 52-wk low, down 60% from all-time high set in January
  • JASDAQ Index -- forward PE n/a, at 52-wk low, down 42% from all-time high set in Jan.
  • Nikkei-JASDAQ -- forward PE 37.3, at 52-wk low, down 27% from 52-wk high set in Jan.
  • TSE Topix 2nd Section -- forward PE 23.7, down 27% from 52-wk high set in Jan., 2% above 52-wk low set in Jul.
  • TSE Topix 1st Section -- forward PE 20.8, down 9% from multi-yr high set in Apr., 18% above 52-wk low set last Oct.
  • Nikkei 225 Stock Avg -- forward PE 20, down 7% from multi-yr high set in Apr., 25% above 52-wk low set last Oct.
  • * PE data from WSJ article as of 09/30/06 for forward period ending Mar. 2007, except N225, which is from Nikkei Shimbun as of 10/11/06 close; 52-wk high/low data from WSJ article and Bloomberg as of 10/11/06 close

In the same article a Nomura analyst points out that "nearly 60% of small-cap companies are trading at P/E ratios of 20 or less for the next fiscal year, ending March 2008."

In mid-August the WSJ reported that hedge funds were struggling in Japan due to among other things, volatility in small-caps:

Eurakahedge, a hedge fund performance tracking company ... says ... that 45% of the 104 hedge funds investing exclusively in Japan have posted negative returns year-to-date. Funds report voluntarily to Eurakhedge -- 40% of funds have not offered updates and the remaining 15% are positive YTD.

I commented at that time:

Managers of Japan hedge funds got trapped in micro cap stocks (not small caps; emphasis in original) that have few shares outstanding. They got greedy (or maybe missed the boat and got in too late) and subsequently got burned.

The Nomura analyst mentioned above says that in fact, '(m)any small-cap stocks now look undervalued, particularly if those in the TSE Mothers Index are excluded.'

Some points then to keep in mind when researching and trying to trade/invest in smaller-cap Japanese stocks, especially micro-caps include:

    (1) Limited number of shares outstanding
    (2) Share prices in the equiv. of $100s or $1,000s per share not uncommon given (1) above
    (3) Liquidity concerns stemming from (1) & (2)
    (4) Difficulty (read near-impossibility) of short-selling
    (5) Transaction costs if you don't have a Japanese brokerage account or aren't trading in large amounts
    (6) Trading units of some stocks in 100 or 1,000 share blocks that can make purchases costly in sum; also see (1)
    (7) Lack of English-language research reports and press coverage

Thoughts/questions on investing based on PE ratios:

    (1) How accurate is the calculation of PE ratios of indices based on the various calculation methods?
    (2) How far into the future should earnings be discounted? Consider FY07 PE vs. FY08...
    (3) Are Japanese PE ratios higher across the board if only because the rate on savings deposits remains near zero? (See Dorsch on Korea)
    (4) Use of PE ratios in conjunction with analysis of cash flows and balance sheet
    (5) Isn't it true that having a + PE ratio means there is at least positive net income being recorded?

Given the language barrier, finding and researching non-blue chip stock investments in Japan can be a challenging task. One reliable source of investment ideas focused on value and take-over potential is Pascal Jeannenot's Japan Investments newsletters. In yesterday's newsletter (10/10/2006) Mr. Jeannenot discusses the (lack of) investment vehicles for European investors interested in Japan (the same can be said for American investors) and he mentions recent IPOs of M&A advisory firms in relation to the overall M&A market. Furthermore, he lists the top-20 firms based on M&A ratio in Japan's apparel/fashion industry.

A possible method of investing in Japanese small cap stocks aside from buying shares of individual companies is the closed-end fund: Japan Smaller Capitalization Fund (NYSE:JOF). My only concern with this is not knowing what the fund is investing in since recent information is hard to find. Trading volume is decent but nowhere near the volume of iShares MSCI Japan Index (NYSEARCA:EWJ). JOF's current dividend yield of 7% is attractive but be sure to confirm the management/expense fees.

A more economical choice but with very light trading volume is WisdomTree's recently launched Japan SmallCap Dividend ETF (NYSEARCA:DFJ). It also has over 450 stock holdings and thus would be more of a buy-and-hold type play rather than trying to capture a short-term move in an undervalued sector or M&A among stocks with a high percentage of fund portfolio assets.

There are only a few mutual funds that specialize in smaller cap Japanese stocks. Among them Fidelity's Japan Smaller Companies (MUTF:FJSCX) has been the most popular but was closed to new investors earlier this year. The Advisors Inner Circle Japan Smaller Companies (MUTF:JSCFX) has only $15.61 million in assets as of 09/31/06 per Yahoo! Finance. And the DFA Japanese Small Company (MUTF:DFJSX) fund targets institutional or wealthy investors with a $2 million initial investment required.

If any readers invest in small cap Japanese stocks and want to share their ideas or if there is interest in me screening some small cap stocks for posting, please leave a comment or email steven.towns[at]gmail.com.

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Disclosure: I do not own any shares of companies/ETFs/other funds mentioned in this article.