iShares MSCI Japan Value ETF (NASDAQ:EWJV) is an exchange-traded fund allowing investors to gain exposure to mid- and large-cap Japanese stocks that trade at relatively low valuations. The fund had assets under management of $94.57 million as of February 18, 2022 (out of 156 holdings), indicating a low level of popularity, although the fund is also relatively new to the market, having launched in March 2019. The expense ratio is currently quite low. for an iShares fund; 0.15%.
Japanese stocks are not known to perform well. The broader Japanese stock index, the Nikkei 225, peaked in a stock market bubble (which later collapsed) at the very end of 1989.
Since then, performance has been poor. It is not fair to compare current prices to the 1989/90 peak, which was the result of ridiculous valuation multiples applied to Japanese corporate earnings. Nevertheless, Japan has never been known to generate particularly high returns on equity. For example, the MSCI Japan Index implies a forward ROE of 10.27% currently, while the MSCI US Index has an implied forward ROE of 22.74%. So, on a market cap-weighted basis, “Corporate America” is more than 2 times more efficient than Japanese companies (in total).
The United States is home to many highly productive companies, including some of the most well-known growth stocks. Japan also has its technology sector, but generally speaking, the corporate culture is more about cost reduction, efficiency and stability (rather than innovation via risky research and development expenditure). , investments in software and intangible assets, platform construction, network effects, etc.). Specifically, EWJV’s fund tracks the MSCI Japan Value indexwhich shows an even weaker forward ROE of 9.27%.
This is a big part of the problem of investing in “cheap” stocks or regions. Japan’s interest rates may be low, but the equity risk premium is still roughly equal to that of the rest of the developed world. Investors demand returns, and if companies aren’t productive enough to grow earnings and compound book values at certain rates, stock prices won’t budge much. EWJV has recovered from its March 2020 lows (following the emergence of COVID-19), but I wouldn’t expect a spectacular performance.
Still, the dividend yield is quite good; 2.55% on a 30-day SEC yield basis, calculated by iShares as of January 31, 2022 (rolling yield over 12 months: 2.40%). However, to reiterate, the fund is not a “growth fund”; at higher dividend yields, you can probably expect to see less capital appreciation.
On the other hand, while I would have expected a value-oriented portfolio, comprising mostly low-growth sectors, EWJV has a decent exposure to “cyclical” and “sensitive” sectors (20.23% cyclical consumption, 18.77% industry, etc.). Since the fund is “underweight” on defensives, I feel more confident in the fund’s potential to perform well cyclically, outside of recessionary periods.
Yet, while these sector exposures are welcome, any “optimism” should be massively tempered by the modest underlying return on equity (as mentioned: less than 10% going forward). While the price-to-book ratio of the MSCI Japan Value Index was below 1.00x as of January 31, 2022, it is generally unrealistic to expect a portfolio to grow at a rate greater than its underlying long-term return on equity. This would require a steady increase in the average price to book value ratio. If EWJV’s underlying price-to-book ratio were to increase to 1.00x, this would lead to a rise of more than 7% by January 31, 2022, but this may well be a one-time benefit for EWJV shareholders only.
Still, it’s nice to see a fund that not only generates positive returns, but also trades below an average price/book value of 1.00x. These are really “cheap”; likely to generate fairly low rates of return over the long term, but still positive. There is no bubble in Japanese value stocks, that’s for sure. The past year has seen consistently positive fund inflows into EWJV, showing at least some initial support for the fund after its inception.
With tech stocks highly valued in other developed markets like the US, funds like EWJV are perhaps a welcome breath of fresh air for global investors looking to maintain equity exposure, but without costly valuations. . Moreover, according to Fidelity’s research, it would seem that Japan is economically “behind” Europe and the United States.
This could mean that EWJV could (continue to) benefit from a continued economic recovery during the middle phase of the business cycle. The United States is comparatively much closer to the “advanced phase” (while China, for example, is entering a period of recession). So this could potentially help support new flows to EWJV and similar funds.
Professor Damodaran currently estimates the equity risk premium for mature markets to be 5.17%. The current Japanese 10 years bond yield of 0.214%. However, Damodaran also assigned a suggested country risk premium of 0.59% for Japan specifically. Thus, the sum of these components gives a net cost of capital of 5.974%.
the morning star also puts analyst consensus estimate of three to five year earnings growth at 15.58% as of February 17, 2022. However, I am also referring to the fund’s benchmark fact sheet for price-earnings ratio data, implying forward year-over-year earnings growth of 10.95%. To be on the safe side, I’m instead implying a growth rate that would suit an average return on equity in line with the (implied) first year and a dividend payout rate of 35% (in line with the implied payout rate, given price/earnings and dividend yield data on the benchmark). This results in the following short-term valuation gauge.
Based on the above, EWJV is significantly undervalued, with more than 100% upside potential. However, this is based on comparing the net present value of the projected forward earnings stream against a relatively low cost of equity of just 5.97%. My earnings stream projection may well be conservative, not aggressive, as I’m actually underestimating Morningstar consensus estimates (focusing on more likely stock returns). Nonetheless, we are coming to a high upside potential, which really means that the current cost of equity is well above our 5.97% suggestion.
To bring EWJV shares in line with the expected earnings stream above, we would need to increase our cost of equity to 12.01%. Therefore, right now, I would say that EWJV is definitely trading at an inexpensive valuation. The conclusion is that forward yields should be around 12% at current prices if we assume that investors demand that return of at least 12% (given current valuations). But 12% is more likely to be too high for a developed-world stock market, which should mean EWJV deserves a fairly immediate valuation boost.
Therefore, while I’m not bullish on Japanese stocks overall and over the long term, I can’t help but conclude that EWJV is undervalued and should perform well. The fund looks like an excellent hedge against higher valuations elsewhere, for more risk averse investors.