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Japan has pretty much been in the doghouse since the market began its selloff more than 20 years ago. Local and foreign investors have lost confidence in the country, its political management and, worse, its future as an investment hub.
- Ed Merner, Japan-based money manager

I’d say that’s a pretty accurate assessment. Nevertheless, against such a discouraging backdrop, I wrote in December 2011 that it might finally be time to go ‘all in’ on Japanese stocks. Crazy call? It didn’t look like it for the first three months of 2012. During that period, both of Japan’s benchmark indexes – the Nikkei 225 and Topix – rallied about 20%. Since then however, well, I don’t look that smart. Japanese stocks have given back almost all of their gains, thanks in large part to a stubbornly strong yen.

But that’s not about to change my conviction: Japan remains a screaming “buy.”

Here’s why we need to have an ounce of patience when it comes to Japan, though, as well as the type of stocks we should be buying to capitalize on the opportunity for maximum gains.

A No-Brainer Value Trade

As I revealed in February, Japanese stocks are obscenely cheap compared to U.S. stocks.

Back then, they were essentially selling for $0.63 on the dollar, based on price-to-book ratios. And that’s still the case. Take a look:

So betting on Japan is undeniably a bet on undervalued securities. It’s a value investment. And a smart one at that. Study after study proves that value investments outperform so-called growth investments by a wide margin.

Consider the latest decile analysis out of the Brandes Institute: From 1968 to 2010, the most undervalued U.S. stocks returned an average of 15.6% per year, versus a 6.5% gain for the most hyped growth stocks. What’s more, unlike previous studies, Brandes went on to prove that “the overall pattern of substantial value stock outperformance persisted” across valuation metrics, across time, across regions and across market capitalizations. In other words, the outperformance of value stocks isn’t just a U.S. phenomenon. It’s a global phenomenon.

Of particular interest to our discussion, it also happens to be a phenomenon that’s particularly strong in Japan. From 1980 to 2010, the most undervalued Japanese stocks returned an average of 11.4%, versus 1.7% for the most hyped Japanese growth stocks. That’s a performance difference of 571%, which compares favorably to a performance difference of 140% between U.S. growth and value stocks. There’s a catch to all this upside, though: Time. Five years’ worth to be exact. And therein lies the problem.

Most investors aren’t that patient. They typically only hold stocks for about six months. So, considering it’s been about six months since I first made my contrarian call to buy Japan – if you acted on that advice – you’re probably getting an itchy trigger finger. But don’t bail yet. More than 40 years’ worth of investment returns suggests that’s precisely the wrong move.

Bet Small, Not Large

If anything, we should treat the recent sell-off in Japan as a buying opportunity. Don’t just buy any old Japanese stock, though. Stick with small caps. Here are three reasons why:

  • Limited Currency Exposure: Since small-cap stocks primarily serve the domestic market, a strong yen doesn’t significantly hamper their profitability. They don’t rely heavily on exports.
  • Better Bargains: As Merner told Barron’s recently, large-cap Japanese stocks are currently trading at a slight premium to book value, whereas Japanese small caps are trading at about a 30% discount.
  • Strongest Performers: Based on Brandes’ research, small-cap value stocks in Japan perform better than large-cap value stocks, returning almost one percentage point more per year. That might not seem like a lot, but 1% per year adds up.

If you need some extra encouragement to buy Japan, remember what I shared in February: Institutional money managers – the so-called “smart” money – are changing their minds on Japan. They’re stepping up to buy after years of completely avoiding the country.

Either they’re just as crazy as I am. Or they realize, like Merner says, “It’s a great time for bargain hunters.” Indeed!

Bottom line: Every investor loves to buy assets on the cheap, yet very few investors realize profiting from cheap assets requires time. So step up, be contrarian and buy Japanese small-cap stocks. And be patient.

Source: The Number 1 Reason That I'm Still Bullish On Japan