Have You Considered This Way to Play the Japanese Recovery?

I’ve already urged you to buy leading Japanese stocks through the iShares MSCI Japan Index ETF (NYSE:EWJ).

I made this recommendation before the devastating earthquake and tsunami struck Japan. Following the earthquake, I believe the investment case for Japan is even stronger.

The logic couldn’t be more straightforward: Japanese stocks are a bargain. You can buy Tokyo’s Topix index—about 1,700 listed companies in all—for a price-to-book ratio of less than 1.

The price-to-book ratio (or P/B) compares a stock market’s value to its book value—what you’d get if you added up all its assets and subtracted its liabilities.

In the case of the Topix, that means you could theoretically buy the entire index, liquidate each company listed on it…and you’d still come out on top.

Basically, the Japanese stock market is priced for several quarters of negative economic growth. And this is highly unlikely.

It’s a very attractive value proposition, in other words. Especially when you consider that the Topix is currently at about a 40% discount to the global average in terms of its price-to-book ratio. And that it’s at a 56% discount to the U.S. stock market.

Japanese stocks are also very attractive from a contrarian investing perspective.

The late, great Sir John Templeton made his fortune in the global stock markets by investing at the point of “maximum pessimism.” What he meant was that you have to go against the crowd to make any real money in the market.

It is not easy to buy when everyone else is selling or when things look darkest. But as Templeton was fond of saying, “If you buy the same securities everyone else is buying, you will have the same results as everyone else.”

What you always want to be is a rational buyer among irrational sellers or a rational seller among irrational buyers. This is a sure way to investment success.

So Japan looks attractive from a value perspective and from a contrarian perspective. But what about risks?

Like with all overseas investments, there is one very important risk associated with investing in Japan: currency risk.

If you invest domestically, there are just two possible outcomes. Either your stock goes up, or it goes down. When you invest in a jurisdiction with a different currency you increase the amount of possible outcomes. Now, you have four possible outcomes:

1) Your stock and the currency go up.

2) Your stock goes up, but the currency goes down.

3) Your stock goes down, but the currency goes up.

4) Your stocks and the currency go down.

The most likely scenario for Japan is outcome #2. Japanese stocks will rise. But the yen will fall, as the Bank of Japan is forced to print money to help stimulate the economy.

This currency risk is a problem because if the yen falls against the dollar, so do any profits you’ll make from Japanese stocks in dollar terms.

In comes the WisdomTree Japan Dividend Fund (NYSE:DXJ). This ETF is designed to give you exposure to Japanese stocks while neutralizing exposure to movements of the yen relative to the dollar.

Put simply, DXJ will give you lower returns than the equivalent unhedged investment when the yen is rising versus the dollar. And it will give you better returns than the equivalent unhedged investment when the yen is weakening versus the dollar.

The expense ratio for DXJ is actually very low—at 0.48%—considering its currency hedging advantage.

This makes it a great low-cost way of investing in the Japanese recovery without exposing yourself to currency losses should the yen fall against the dollar.

For my money, it’s one of the best ways to play Japan right now.