iShares EWJ ETF: Undervalued Japanese Yen Supplies Alternative

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Japanese equities are looking increasingly attractive relative to their developed market peers due to lower valuations, ongoing improvements in return on equity and, perhaps most importantly, a staggering undervaluation of currencies. Despite its relatively high expense ratio compared to the current dividend yield, the iShares MSCI Japan ETF (NYSEARCA:EWJ) seems very likely to outperform its competitors.

The EWJ ETF

The EWJ tracks the performance of the MSCI Japan Index, excluding the bottom 15% of Japanese companies by market capitalisation, making it slightly larger than the benchmark. With a whopping $11.3 billion in assets under management and an average daily volume of $446 million, the ETF is extremely liquid. The ETF is also among the most diversified major stock markets, with the largest stock, Toyota, making up just 5.5% of the index and the top 10 stocks accounting for just 24%. The biggest downside is its expense ratio of 0.51%, which compares particularly well to the dividend yield of just over 2%.

Underrated Relative The international average

The MSCI Japan Index underlying the EWJ is trading at a deep discount to the US as well as a discount to its international peers. The chart below shows the MSCI Japan valuation ratio versus the MSCI World and MSCI World ex-US Index based on an average of Forward PE, EV/Ebitda, Price/Sales, Price/Book and Price/Dividend.

Japan's valuations compared to its peers

Japan ratings vs. DM peers

Bloomberg

While Japanese stocks have long traded at a discount to their peers on a price-to-book basis, they are now trading at a discount on every metric, including dividend yield. The chart below shows the dividend yield of the MSCI Japan compared to the MSCI World and MSCI World Ex-US

In just 9 years, the MSCI Japan dividend yield has doubled compared to the MSCI World and is now 25% higher. This is evidence of the systematic improvement in corporate governance that has been observed in Japan during this period and is expected to continue over the long term.

MSCI Japan Dividend Yield vs. MSCI World and MSCI World Ex-US

MSCI Japan Dividend Yield vs. MSCI World and MSCI World Ex-US

Bloomberg

Continue improving corporate governance

The surge in Japanese dividend payments reflected in the chart above comes from a combination of factors that have prompted companies to increase returns on equity and returns to shareholders. In particular, since 2012, with the re-election of Prime Minister Shinzo Abe, Japanese companies have benefited from a range of regulatory and policy initiatives aimed at increasing capital efficiency and fostering collaboration between management and investors. Codes of corporate governance and stewardship, the Tokyo Stock Exchange’s efforts to promote independent board members, and changing investor behavior have resulted in Japan’s corporate governance environment resembling more closely what we see in the US

A recent article by investment firm GMO does a great job of explaining the encouraging trends in Japan’s corporate sector. The article notes that while shareholder activism was previously unknown in Japan, the country is now home to the second largest number of companies targeted by activist investors. The article also argues that cyclical drivers explain about 40% of changes in Japan’s long-term profitability, with the remaining 60% of the change attributable to long-term factors. GMO also notes that while dividend payouts have improved significantly, they haven’t kept pace with growth in earnings and free cash flow, resulting in bloated balance sheets. As corporate management and outside shareholders focus more on managing the balance sheets, they see significant opportunities to increase shareholder returns.

The yen is severely undervalued

As a dollar-based ETF, the yen’s performance can have a significant impact on the EWY’s performance, and the good news here is that even after last week’s strong rally, the currency is effectively undervalued by almost 50%. As the chart below shows, the yen is currently trading 49% below its fair value against the US dollar in purchasing power parity terms. This is a level not seen since the 1980s.

Undervaluation of the JPY in purchasing power parities

JPY % undervalued in PPP calculations

Bloomberg

It is very likely that the Yen will outperform the Dollar from such an incredible starting point in the coming years and this should help the EWJ outperform its peers. Additionally, the yen’s tendency to outperform during periods of global risk aversion should provide some support for the EWJ during periods of global equity weakness. For example, during the 2008 crash, the rise in the yen enabled the EWJ to outperform the MSCI World by around 25% that year.

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