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NEW YORK (

RealMoney

) --Two decades ago, Japan attracted the frenzied admiration of the world. Harvard professor Ezra Vogel penned "Japan as Number One: Lessons for America." Japanese investors were buying up U.S. trophy assets like New York's Rockefeller Center. Tokyo was one of the world's great trading centers, alongside Wall Street, and the value of the land under Japan's Imperial Palace in Tokyo was worth more than all of California.

I hadn't even been to Japan myself, nor did I speak a word of Japanese. Yet one of my Japanese Harvard professors offered me a job at his law firm in Tokyo, coming straight out of law school, as a

gaijin

face to his American clients. I don't think he'd do that today.

Twenty years later, the picture could hardly be more different. Far from becoming the global "Number One," Japan's economy has been overtaken by China as the world's second-largest economy. Instead of offering a model to the world, Japan's decline from economic preeminence is fated to mirror that of Argentina over the 20th century.

The March earthquake and Fukushima nuclear accident only confirms that the gods are not smiling on Japan.

Twenty years ago, not owning Japanese stocks was a career-threatening move. Today, it's the opposite. A Merrill Lynch survey found that 29% of fund managers across the globe were underweight Japan.

And can you blame them? Despite an occasional burst of optimism, more than two decades later the Japanese bear is still with us. Having kicked off in 1989 with the bursting of economic history's largest real-estate bubble, the great Japanese bear market now has lasted twice as long as any other secular bear market on record.

If the opposite of love is not hate, but indifference, then you'd be hard pressed to find an asset class that U.S. investors are more indifferent to than Japanese small-cap stocks.

Since the collapse of the Nikkei in 1989, trading volumes in Japanese small caps has all but evaporated. Investment banks and brokerages produce next-to-no research on the sector. And what little research there is rarely gets translated into English.

What's left of the market is dominated by domestic Japanese investors. While foreign investors still dominate trading on the Tokyo Stock Exchange, individual Japanese investors dominate the small-cap sector, accounting for 60% to 80% of trading on JASDAQ, Japan's version of NASDAQ.

Yet, by any objective measure, you'd be hard pressed to find a better deal in any developed stock market than Japanese small caps. Hundreds of Japanese small caps meet Ben Graham's criteria for "cigarette butt" cheapness. Today, Japan has as many as 200 listed companies trading below cash on the books. That means you can buy these companies for free. Investors may have never seen such low valuations in the history of a developed economy.

Luckily, you can get in on the action through the

Wisdomtree Japan SmallCap Dividend ETF

(DFJ) - Get Report

, which also boasts some stunningly low valuations.

As of June 30, 2010, the companies in this ETF were valued at a mere 0.36x price-to-sales and 0.87x book value.

By way of comparison, Nasdaq stocks traded at roughly 3.4 times book value on the same date. Japanese small caps would have to rise fourfold to equal U.S. valuations.

Warren Buffett's objection to Graham's "cigarette butt" approach to investing was that you end up with a slew of lousy companies. I think the Wisdomtree Japan SmallCap Dividend (DFJ) answers that objection. Dividend-paying companies in this ETF are, by definition, cash-generating companies. Companies on the verge of going out of business don't pay dividends.

Yet, despite the compelling investment case, I bet you won't invest in Japanese small caps.

Did you buy commodities in 1998 and gold in 2002? Neither did I. Instead, I fell in love with Russia and CMGI (remember them?) and lost my shirt in both.

Meanwhile, gold is up almost 500% since it bottomed and U.K. Chancellor Gordon Brown sold off half of the Bank of England's gold reserves between 1999 and 2002. Today, you can buy gold in a vending machine at the Dubai airport.

But I don't intend to make that mistake again.

--

Written by Nicholas Vardy, chief investment officer, Global Guru Capital; Editor of Bull Market Alert and The Alpha Investor Letter

At the time of publication, the author owned DFJ personally and for clients.