Geoff Gannon March 16, 2011

Investing in Japan – Questions and Answers

A reader sent me this email:

In your research have you come across any good closed end funds? So far I’ve only found JEQ and JOF.

I don’t plan to buy a closed end fund. I plan to buy stocks I select myself.

If your broker can buy in Japan, I’d suggest doing that. Last I saw, the discount/premiums on Japanese closed end funds and ETFs are tighter than normal not wider. In other words, like in Egypt, foreigners are buying into the country wide funds in the middle of the crisis. People are fleeing the specific stocks. But that doesn’t seem to be matched – and certainly not exaggerated – in the funds. Usually, slow motion market declines show the reverse trend. But people may actually be attracted by bad headlines when they happen fast in a country they normally don’t invest in.

I’m working on a list of 100+ Japanese stocks. These are individual stocks I picked myself based purely on their 10 year earnings records. I’ll probably just make my own basket out of those instead of buying into a fund.

But, depending on your broker, that could be too expensive in your case.

A reader also sent me this email:

How are you sizing your Japanese positions? Are you setting a maximum limit of how much your portfolio will be invested in Japan?

I expect to put 25% of my net worth into Japanese stocks.

If prices fell a lot from here and I found stocks I liked, I’d definitely put 50% into Japan.

I’m unlikely to put more than 50% into Japan under any circumstances. It would be possible. But the Japanese stock market would have to drop further by some crazy amount like 50% or something for me to put more than half my net worth into Japanese stocks.

I’m saying that now, but I could change my mind. If I really liked the prices, there’s ultimately no limit to what I’ll put into one country. They’ve got enough public companies in Japan that interest me. If they offer them at low enough prices, I’d be willing to go to 100%. But I already own some American stocks I like, so putting more than 50% in Japanese stocks would be hard right now.

I’m expecting my portfolio will be 25% to 50% in Japanese stocks very soon.

Beyond that – your guess is as good as mine.

But I won’t buy indiscriminately. I’m not going to buy a fund. I’m going to buy from my own list of the cheapest Japanese stocks.

A reader also sent me this email:

“How are you thinking about currency risk?”

I always think about currency risk in terms of purchasing power parity. I just assume I will exchange my foreign currency back into U.S. dollars at the lower of today’s exchange rate or purchasing power parity.

So, I punish overvalued currencies, but don’t treat undervalued currencies as being more attractive. That keeps me out of some countries, because unless their stocks are super cheap I can never buy companies in Denmark, Sweden, Norway, etc. Sad but true.

Japanese and American purchasing power parity would be at 109 Yen to the dollar. So, at 80 Yen to the dollar, the Japanese Yen is about 36% overvalued versus the U.S. dollar. In other words, assume a 27% loss when you exchange your Yen back into U.S. dollars.

Basically, knock 27% off the return you expect from the underlying stock.

For my own recordkeeping, I actually carry foreign positions at the lower of purchasing power parity or the market exchange rate, the way companies carry inventories at the lower of cost or market. I view the excess of market value exchange rates over purchasing power parity as completely speculative. You shouldn’t count on them. So, assume a 27% loss on your Japanese currency offset by however big a gain you expect on the Japanese stocks you invest in.

I’m not saying the Yen will fall 27% from here. I’m saying that’s what I assume when I buy Japanese stocks, because prices in Japan are higher than prices in the United States, and I don’t think a conservative investment should ever be based on the assumption that prices will stay higher in one country than in another country. Every foreign investment you make needs to be justified on a purchasing power parity basis.

So, Japanese stocks have to be 27% cheaper than U.S. stocks just to make up for their overvalued currency and the risk that comes from that.

The Yen looks so clearly overvalued here, that I’m going to look into hedging the currency.

I haven’t decided how I’m going to do that. But I’m definitely leaning toward some sort of hedge.

I would guess a dollar should buy 90 to 110 Yen under “normal” circumstances. And that means there’s a real risk of losing 10% to 30% on the currency part of buying Japanese stocks.

That’s why I’m leaning toward hedging.