Time to go hunting for undervalued gems in Japan

Japan is at a new turning point it's time to buy in.

The subject of Japan and equities brings out the very worst in my cussed, contrarian nature. For years, everyone MoneyWeek included has been saying that the Land of the Rising Sun is the great contrarian bet.

Friends and colleagues I trust and respect have waxed lyrically and persuasively about the opportunities on offer. And this narrative has been helped along by the actions of the vigorous new government under Prime Minister Shinzo Abe who is about to launch the third arrow' of his Abenomics' strategy to revive Japan.

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This is all very well. But I have to admit that the pessimist in me keeps focusing on the bigger, longer-term structural problems: the declining population, the truly terrifying government deficit, and the appalling local corporate governance of quoted businesses. How on earth can a society in such a state of retreat' possibly be a good place to invest?

Yet having said that, even a hardened cynic like me accepts that what may be a concern over the next ten to 20 years shouldn't blind you to any short- to medium-term opportunities that may arise.

So in true contrarian style, I've long had a decent holding in the most volatile of Japanese assets local smaller-cap equities. I've been using a UK-listed iShares exchange-traded fund (ETF) to do so the iShares MSCI Japan SmallCap ETF (LSE: ISJP).

I can't complain about the performance of this ETF in the last few years. But I found myself wondering last week whether I had the right fund.If there's some short-term opportunity out there (despite the long-term risks), then is a passive market tracker really the best way to access this toughest of markets?

This musing was sparked by another of what I call my investment bus moments': getting one note from a respected commentator on a relatively unpopular subject is usually of interest, two is worth investigating, but three well, that warrants a proper look.

The best-value market in town

Andy Lapthorne at French bank Socit Gnrale sparked my interest he's a well-respected quant' type, who, deep down, is a good old-fashioned value investor. In a recent note to clients he observed that Japanese equities look compellingly cheap.

The bank regularly publishes lists of stocks that pass its version of Benjamin Graham's deep value' screen. (Graham is acknowledged as the father' of value investing and the screen basically tests for stocks that are extremely cheap compared to the value of their underlying assets.)

According to Lapthorne, the screen shows that "the only developed market region seeing value emerge is Japan". If you "throw in the potential for more central bank action in response to the lacklustre impact of Abenomics' arrows" on top of that, then "a yen-hedged foray back into Japanese equities may be the better choice than simply continuing to pay over the odds for more expensive US and European equity names".

It all sounds very appealing. Then came Greg Fisher, who runs the Halley Asian Prosperity Fund for London-based Asian equity specialist Samarang Capital.He's another deep-value, contrarian sort of guy I have a lot of time for. His latest note to investors explains why his fund has underperformed in 2014 it's because Japanese small-cap equities have collapsed in price.

"Overall the Topix [a key Japanese equity benchmark] valuation is right back down to just over one times book [value], as the share price rally that began in autumn 2012 has failed to keep up with companies' real worth.

"How different this is to most Western markets, or indeed others in Asia.No surprise then that stock buybacks, mergers and acquisitions, even activist investing are on the rise in 2014.

At these levels the Japanese equity market but especially our holdings are the very definition of investments with a good margin of safety" (a margin of safety' is the term value investors use to describe the gap between what the market values the stock at and what they believe its genuine value to be).

Even more compellingly, Fisher says many of the small firms in his portfolio are trading at close to bankruptcy value levels, even though key parts of their business (selling into places such as China and the US) are still growing at a fair clip.

Tax rises and volatility

With my interest firmly piqued, I alighted on another note, this time from one of the best investment trust analysts around Paul Locke at Westhouse Securities. Locke has clearly just spent a great deal of time talking to his preferred Japanese equities manager, Curtis Freeze of the Prospect Japan Fund (LSE: PJF).

By way of background, all of this investment chatter is arising right now because Japan is at a fascinating inflexion point. Abenomics' has delivered a huge amount of progress, and local inflation rates are at long last picking up.

But we're also about to learn just how much impact a rise in the local consumption tax (from 5% to 8%) will have on the domestic economy.

The government desperately hopes that any slowdown will be mitigated by Abe's third arrow' of reform labour market and agricultural reform, raising private-sector investment, and enacting broader market deregulation and fiscal reform.

But all of this talk of increased taxes has resulted in a marked rise in volatility in the Japanese equity market in 2014, notes Locke.

Some specific sectors property in particular have benefited from the big change in monetary policy and asset price reflation. But as a whole, the market is down around 6% in sterling terms.

"More than this, however," notes Locke, "the market has been subject to significant and frequent swings in sentiment in 2014, making investment decision-making that much more difficult."

Japanese small caps are the way to go

However, I suspect this volatility has been overdone, and that the real opportunities now lie in the smaller-cap sector, where you'll find businesses with several very attractive traits.

Firstly, they are better than their larger rivals at doing the right thing by their shareholders through raising dividends or buying back their shares.

Secondly, smaller companies often offer a better way to play domestic consumer growth, or alternatively, to buy into high-margin, internationally focused export businesses that are the Japanese equivalent of Germany's Mittelstand the small and medium-sized global industrial leaders that Germany is famed for.

Finally, there is almost no decent analyst coverage of these stocks, meaning there is more opportunity to find undervalued gems.

This is the narrative I buy into for the next few years at least, although I'm also a bit wary about ongoing short-term volatility. And all of this nicely coincides with the views of Freeze, a very focused stock picker who's been running the Prospect investment trust for a long time. Experience has made him a cautious man and he's currently running high levels of cash (29% of assets) because he thinks the aforementioned volatility will continue.

However, he's also selectively buying into beaten-down smaller-cap stocks. In his list of top stocks, you'll find industrial businesses such as Katakura and Showa Aircraft, as well as real-estate businesses such as Yasuda Warehouse. It's a very focused portfolio, where the top 15 names account for about 70% of its assets.

According to Locke, the Prospect portfolio is dominated by companies offering a range of attractive traits. There are those such as Katakura, which stand at a discount to their effective break-up value. In other words, you could in theory buy the whole company, break it up, sell off the bits, and still make a profit.

Or there are those that offer "attractively priced cash flows", such as direct marketing specialist Tri-Stage. Or finally, there "are companies where new growth dynamics have come into play (Shaklee Global following its entry into the Chinese vitamin market)".

What's even better is that you get that hefty cash buffer which Freeze can deploy to buy cheap businesses in future and a manager who has been catching up with the undisputed sector leader Baillie Gifford Shin Nippon (LSE: BGS). (Disclosure: MoneyWeek editor-in-chief Merryn Somerset Webb is a director of BG Shin Nippon.)

Shin Nippon has a great long-term record, but it also trades at a premium to its net asset value. In other words, you're paying more than the underlying portfolio is worth. The Prospect fund trades at an unprecedented 20% discount you're getting £1 of assets for 80p.

The patient long-term investor might be more tempted by the consistent record of BG's fund. But for more flighty souls myself included I suspect there may be more short-term upside potential in the Prospect fund.

I'd also love to suggest putting some money to work in that Samarang Asian Prosperity Fund I mentioned earlier but it's closed to new money. I'd also like to offer a lower-cost ETF as an alternative I own the iShares one previously mentioned.

But this probably doesn't make much sense small-cap Japan is a stockpickers' market par excellence and requires real research and diligent analysis of the risks. Put it this way if an active manager can't add value here, they can't add it anywhere.

The numbers in the table opposite speak for themselves actively-managed investment trusts have consistently beaten the ETF. This is one case where I'd pay for active management. So if you agree that Japanese small caps look good value, Prospect Japan Fund (LSE: PJF) is the way to go.