Japanese Financials: Opportunity or Value Trap?

Recently, Japan has lost its allure among global investors, but I think this will only be temporary, and given the underlying earnings growth, I believe Japan offers an attractive opportunity, which I discussed in more detail here. It is important to remember that we are still in the early innings of "Abenomics" and that the Bank of Japan (BOJ) remains, by far, the most expansionary central bank in the world¹. The financials are the lowest-priced part of Japan’s market, as measured by the price-to earnings ratio or price-to-book ratios, and could be a higher beta exposure for those who want to make what is now a contrarian allocation to Japan. Hedge Funds See Opportunity One value investor who doesn’t shy from contrarian investments, David Einhorn, recently announced a position in a regional Japanese bank. In Einhorn’s quarterly letter, he wrote: “We established a position in Resona, the largest Japanese regional bank, at a price of ¥547, representing 0.8x book value and 8x earnings.”² Those who do not want to select individual stocks but like the concept might be interested in the following: WisdomTree Japan Hedged Financials Index Characteristics For definitions of indexes in the chart please visit our Glossary. • The broader basket of Japanese financials represented by the WisdomTree Japan Hedged Financials Index (WTJFH) has more than 30% in diversified banks with an estimated P/E ratio of 8.7x and similar price-to-book ratio of 0.75x. • Another 28% of the WTJFH is allocated to regional banks like Resona with an estimated P/E ratio of 11.8x and even lower price-to-book ratio of 0.63x. • The broad index of WTJFH had a similar P/B ratio as Resona of 0.77x but higher P/E ratio at 10.6x. Other interesting takeaways from the WisdomTree Japan Hedged Financials Index: • Investment Banking & Brokerage – After strong returns in the 2013 calendar year, the capital markets industry was one of the biggest laggards in the WTJFH Index, with a median return of approximately -29%.³ Even though both Nomura Holdings Inc. and Daiwa Securities, two of the largest firms in the industry, reported strong increases in net income for the most recent fiscal year, they saw trading and investment revenue decline from their Q1 2013 highs. If Prime Minister Shinzo Abe is successful in stimulating inflation, the hordes of cash held by households likely will enter risk assets in order to sustain purchasing power, which should ultimately benefit the industry. • Divergence Among Banks – The diversified banks industry includes two of the largest banks in Japan, Mitsubishi UFJ Financial Group and Sumitomo Mitsui Financial Group, which happen to be some of the lowest-priced banks from a price-to-earnings perspective at 6.9x and 5.8x earnings, respectively⁴. But they have also been some of the worst performers in 2014, both down more than 20%⁵. These larger banks have been helped since the start of Abenomics from the earnings generated by their brokerage or investments businesses, which has actually detracted from performance year-to-date as their trading and investment revenue fall from the highs. The regional bank industry, which includes smaller-capitalization banks, was the best-performing industry year-to-date, but its performance hasn’t been as high compared to other industries since Abenomics began. Potential Opportunity Another hedge fund investor, Mark Yusko, recently wrote about continuing to favor financials and exporters in Japan. He stated, “I am always struck that investing, oddly, is the only business I know where when things go on sale, people run out of the store, and the further the prices fall, the further they run. We are very content to stay in the Japanese equity store and continue to accumulate shares of great businesses at cheaper prices in a market that we anticipate will be the best performing developed market over the coming decade.”⁶ Japan is one of the lowest-priced regional markets on a price-to-earnings basis and the only market that actually had earnings outpace price gains over the most recent year.⁷ I believe equity markets will remain supported as Abenomics continues to gain traction and especially as Abe makes more progress on his growth strategy for Japan (the "third arrow" of Abenomics). While broad-based approaches should continue to serve many investors well, those looking to allocate to the lowest-priced sector of the Japanese market should look to financials. For current holdings of the WisdomTree Japan Hedged Financials Index click here.         ¹Sources:WisdomTree, Bloomberg, 04/30/14 ²Source: Greenlight Capital, Q1 2014 Investor Letter ³Sources: WisdomTree, Bloomberg, 12/31/13-04/30/14 ⁴Sources: Bloomberg, 04/30/14 ⁵Sources: WisdomTree, Bloomberg, 12/31/13-04/30/14 ⁶Source: Morgan Creek Capital, Q4 2013 Market Review & Outlook ⁷Sources: WisdomTree, Bloomberg, 04/30/13-04/30/14