Nikkei 225 Is A Better Value Than S&P 500

Summary

• The Nikkei 225 is trading at a lower P/E ratio than the S&P 500 despite stronger earnings growth and a lower interest rate environment.
• Although real GDP growth in Japan has lagged the U.S., corporate earnings in Japan have been stronger.
• Reversal of the recent strengthening of the U.S. dollar would be a windfall for U.S. investors in Japanese equities.

Photo by Matteo Colombo/DigitalVision via Getty Images

Adding a position in Japanese equities could provide meaningful diversification and boost your portfolio’s return. Japan has generally been out of favor with foreign investors. This sentiment stems from its extraordinarily poor performance during “The Lost Decade,” which began in 1989 and lasted much longer than 10 years and complicated the relationship between the Japanese yen and the U.S. dollar. However, the below chart shows the Nikkei 225 has essentially kept pace with the S&P 500 in the past five years. Furthermore, there are reasons to be more bullish on Japan.

• Corporate earnings in Japan appear stronger than in the U.S.
• The Nikkei 225 is trading at a lower price-to-earnings (P/E) multiple than the S&P 500 despite its stronger earnings and lower interest rate.
• A reversal of the recent rise in the exchange rate for dollars to yen would be a windfall for U.S. investors in Japanese equities who select a fund that does not hedge its currency risk.

Cumulative Total Return

Source: Yahoo Finance

Strong Corporate Earnings

The below chart shows that Japanese companies’ earnings have outpaced the earnings of their U.S. counterparts. Corporate earnings in Japan grew at an average annual rate 5% between 2014 and 2019 compared with 2% growth by U.S. corporations.

The U.S. growth rate will seem low to investors who track the S&P 500 for two reasons. First, S&P 500 earnings are generally measured in earnings per share (EPS); therefore, this metric improves when companies repurchase shares. Second, companies in the S&P 500 tend to be more successful than U.S. corporations not in the S&P 500. It is reasonable to assume that both of these statements would be true for the Nikkei 225 relative to all corporations in Japan.

The pandemic had a more significant, negative impact on corporate earnings in Japan than in the U.S. However, Japan is poised to bounce back strong. According to Thomson Reuters, analysts expect publicly traded companies to report earnings growth of 40% in 2021 compared with 26% for S&P 500.

Earnings Growth

Sources: U.S. Bureau Economic Analysis, FX Empire and S&P

More Attractive Valuation

Nikkei 225 represents a better value than the S&P 500. The Nikkei 225 consistently maintained a lower price-to-earnings (P/E) ratio than the S&P 500 before the pandemic, and it remains more conservatively valued today. This difference is clearly not a function of weaker earnings growth or higher interest rates in Japan. As explained above, Japanese companies’ earnings have grown faster in recent years, and that trend is expected to continue. The latest data from CNBC.com show 10-year bonds issued by the Japanese government only yield 0.07%, which is much lower than the 1.67% yield on 10-year U.S. Treasuries.

Trailing P/E Ratio Based on Reported Earnings

Sources: S&P and Siblis Research

COVID-19

Government restrictions to stem the spread of COVID-19 can decimate earnings. For example, operating earnings for the S&P 500 declined 49% in 2Q20 from the same period in 2019 due to limitations on dining in restaurants, traveling, and shopping in stores. COVID-19 has taken a less severe toll on Japan as demonstrated by the below chart.

Recent activity confirms Japan has much lower exposure. The U.S. reported 131 new cases per 100,000 citizens for the week ended March 29, which is significantly greater than 8 per 100,000 in Japan. Consequently, the U.S. CDC Director warned of impending doom, and President Joe Biden recommended state governments stop reopening plans while Japan is lifting its emergency order.

Total COVID-19 Cases as Percentage of Population

Source: Worldmeter

Potential for Favorable Exchange Rate Movement

Investors in Japanese stocks could benefit from a reversal of the recent surge in the U.S. dollar. Since U.S. investors value their holdings in U.S. dollars, a decrease in the exchange rate of yen per dollar would cause the dollar value of an investment in Japanese equities to increase. For example, the current exchange rate is about 110 yen per dollar. Therefore, a 10,000 investment in Japanese equities is worth ¥1,100,000 at the current exchange rate, but it would increase to $10,476 if the exchange rate were 105 yen per dollar, which is what it was in February.

The dollar is the strongest it has been in the past year. Analysts ascribe the dollar’s strength to traders’ bullishness on the U.S. economy that has led to higher yields on U.S. Treasuries. However, two things could quickly reverse this trend.

1. Traders become less confident in the U.S. economy either due to a government shutdown to stem COVID-19 or weak corporate earnings.
2. U.S. Treasury yields decline, which could occur after statements by Fed Chairman Jerome Powell or one of the governors of the Federal Reserve.

USD / Yen

Source: CNBC.com

Antithesis – Anemic Real GDP Growth

The chief counterargument to investing in Japan is the country’s historically weak real GDP growth which began with The Lost Decade. During this time period, the country struggled with deflation and intense competition from cheaper labor, especially in the production of automobiles and electronics. The Lost Decade may be finally over, but Japan’s real GDP growth still consistently lags the U.S., and Merrill Lynch expects the U.S. economy to post a stronger recovery in 2021.

Real GDP Growth

Sources: Federal Reserve Bank of St. Louis and International Monetary Fund

Conclusion and Viable Investment Strategies

Strong corporate earnings growth and relatively low P/E multiples make Japanese equities attractive. They should improve a U.S. focused portfolio’s diversification and return in the next few years. Japanese equities would also benefit if the U.S. dollar weakened to the level it was at less than two months ago. While Japan’s real GDP growth has been lackluster for decades, this concern is largely mitigated by companies’ robust profitability. The majority of the Nikkei 225 are multinational corporations that generate a substantial portion of revenue and earnings from outside of Japan. Firms like Toyota and Sony have been dealing with anemic real GDP growth for decades; therefore, it should not dissuade investors from capitalizing on Japan.

Investors who agree with the thesis that Japanese companies are generating strong earnings growth, are more attractively valued than U.S. corporations, and face less risk of COVID-19-related restrictions on activities still have to make three key decisions. Do you want an index fund or an actively managed mutual fund? Do you want to hedge currency risk? Do you want to use options to manage downside risk?

1. The iShares MSCI Japan ETF (EWJ) is the best choice for investors that want to use options to manage downside risk and are willing to accept currency risk. However, its total return has lagged its benchmark index in most years, and its expense ratio is above average. EWJ's portfolio is fairly well diversified among large-cap stocks with a balance between value and growth stocks.
2. The Franklin FTSE Japan Hedged ETF (FLJH)’s holdings are similar to those of EWJ. It has a lower cost structure and has generated a better return. It is an ideal investment for investors seeking a passive strategy in Japan without exposure to currency risk. FLJH has a short operating history, but it has generally beaten its benchmark.
3. The Hennessy Japan Fund Investor Class (HJPNX) concentrates its holdings in large-cap growth stocks, which is why its P/E ratio is significantly greater than that of EWJ and FLJH. HJPNX has a higher expense ratio than EWJ and FJJH because it is actively managed. HJPNX consistently outperformed its benchmark index until recently. The recent subpar results are due to the lackluster return on three of HJPNX’s largest holdings – Nidec Corp. (OTCPK:NJDCY), Keyence Corp. (OTCPK:KYCCF), and Daikin Industries (OTCPK:DKILF). All three companies are large-cap manufacturers that have been successful over the long term.

	EWJ	FLJH	HJPNX
Morningstar Rating	3	4	5
P/E Ratio	16.8	16.6	29.5
Options Available	Yes	No	No
Expense Ratio	0.51%	0.09%	1.43%
Value or Growth	Balance	Balance	Growth
Holdings	301	509	27
Top 10	22%	19%	55%
Turnover	4%	10%	23%

Click to enlarge

Annualized Total Return

Analyst’s Disclosure: I am/we are long HJPNX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.