The One Risk That Could Undermine Your Investment in Japan

| About: iShares MSCI (EWJ)

I’ll admit that in the wake of the earthquake, I wasn’t the first analyst to slap a “Buy” rating on Japanese stocks. Nor will I be the last.

Heck, even Warren Buffett jumped into the mix this week. On his recent trip to South Korea, he said:

Frequently, something out of the blue like this, an extraordinary event, really creates a buying opportunity. I’ve seen that happen in the United States, I’ve seen that happen around the world. I don’t think Japan will be an exception.

Here’s the problem, though ...

The People Have Spoken … But Are They Making Sense?

The latest issue of Barron’s sends an emphatic message to investors. Its cover headline simply reads, “Buy Japan Now.”

The publication isn’t alone. Many others have featured similarly urgent, pro-Japan stories. And, true to the “herd mentality,” investors are lapping up the advice and blindly acting on it.

In fact, folks are so eager to buy Japanese stocks that they’re actually overpaying. Take the most popular Japanese ETF, for example – the iShares MSCI Japan Index Fund (NYSEARCA:EWJ), stuffed with $6.2 billion worth of assets. Lately investors have been happy to pay a 4% to 5% premium over the Net Asset Value (NAV) to own the ETF.

Yet not a single pundit has addressed the crucial risk that could undermine any investment in Japanese stocks. It’s time somebody told the truth.

Buy Japan (With One Caveat)

Almost every “Buy Japan” article I’ve read goes through the same statistics to prove that Japanese stocks are cheap:

  • Based on price-to-book ratios, the average Japanese stock trades at a 56% discount to the average U.S. stock.
  • On a price-to-sales basis, the average Japanese stock trades at a 71% discount.
  • Or, as Barron’s simply sums up, “Japanese stocks haven’t been this cheap since the financial crisis.”

No arguments here. Japanese stocks are indeed dirt-cheap. But the same cannot be said about the Japanese yen.

Japan’s currency is the antithesis of its stock market. It’s one of the world’s strongest, most expensive currencies. In fact, it’s risen by about 50% versus the U.S. dollar over the last five years. Take a look:

[Click to enlarge]

The conclusion here? If you’re currently buying Japanese stocks, you’d better pray that the yen remains strong. Because if it reverses course and starts depreciating versus the dollar, look out! Such a move promises to erode, or even erase, all the gains realized from rising stock prices.

How can this be? It’s simple, really …

How a Declining Yen Could Hit Your Holdings

Most Japan funds – or Japanese stocks trading on U.S. exchanges – are denominated in dollars. When you buy the fund, the manager exchanges your dollars into yen to purchase stocks in Japan. And when you decide to sell the fund, the manager sells those stocks and exchanges the proceeds from yen back into dollars.

The catch? If the value of the yen falls during that period, the fund – and in turn, you – gets back fewer U.S. dollars. So even if Japanese stock prices increase, you could still end up losing money.

Of course, currencies can work in our favor as investors. But that’s not likely in Japan. And tomorrow, I’ll dig into the reasons why the yen is destined to stumble. For now, though, understand that the currency risk is real -- and it shouldn’t be overlooked.

The Truth Is Out There if You Know Where to Look

If you’re wondering why Wall Street remains so reluctant to temper its buy ratings on Japan by revealing the currency risk, join the club. After all, this is a basic risk consideration when investing in foreign markets. So much so, that iShares discloses it in the MSCI Japan Fund prospectus on page 2.

Currency Risk

Because the Fund’s NAV is determined on the basis of the U.S. dollar, investors may lose money if the Japanese currency depreciates against the U.S. dollar, even if the local currency value of the Fund’s holdings in that market increases.

The only explanation I can come up with is this: Wall Street is willfully ignoring the risk to make the investment case to “Buy Japan” seem more compelling.

Don’t fall for it. Truth is, the case to invest in Japan is more like one of those drug commercials. In the first 30 seconds, some tiny pill that promises to cure depression seems like a godsend if you’re down in the dumps. That is, until the images of happy smiling people fade and a man fit to be an auctioneer rattles off the ugly side-effects: “Intestinal bleeding, incontinence, difficulty breathing, and in rare cases, increased thoughts of suicide.”

Not so perfect after all.

Consider me as that guy at the end of the commercial. At first glance, Japanese stocks seem like the perfect investment – cheap and ready to rally. But if you don’t consider the side-effect of a declining yen, you could be nursing losses instead of booking profits.

Bottom line: If you’re going to buy Japanese stocks, hedge your currency risk. Especially since the yen’s decline is imminent and could be severe. If you tune into tomorrow’s article, you’ll find out why.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.