How to Bet on Japan's New Boom

NEW YORK ( TheStreet ) -- After languishing for years, Japanese stocks have become red-hot.

During the past year, the Tokyo Stock Price Index climbed 25.0%. Seeing the gains, investors have flocked to Japan ETFs. In the past two months, iShares MSCI Japan Index ETF ( EWJ) has recorded more than $1 billion in inflows, while WisdomTree Japan Hedged Equity ( DXJ) had $800 million in flows, according to IndexUniverse.com.

The rally gained steam as it began to seem likely that Shinzo Abe would win the December election for Prime Minister. Since Abe claimed a resounding victory, stocks have soared.

Investors have applauded the new prime minister because he has pledged to lift Japan out of the stagnation that has plagued the country for decades. In his speeches, Abe has promised a massive spending program to stimulate the economy. He has also called on the Bank of Japan to increase its purchases of government bonds, a process that could lower interest rates.

Can the stock rally continue? Yes, argues Jeremy Schwartz, WisdomTree's research director. Schwartz says that Japanese stocks have reached bargain prices. During the past decade, prices of the Tokyo market fell from 2.5 times book value to about one times book. In contrast, the S&P 500 trades for 2.3 times book. "Even after the rally of the last few months, Japanese stocks are still relatively cheap," Schwartz says.

Part of what makes Schwartz bullish is the weakness of the yen, which has fallen steeply since November. Traders have been dumping the currency because they figure that bond purchases by the Bank of Japan will lower interest rates, a process that would make yen investments less appealing to foreigners.

In the past, Japanese stocks have tended to rise whenever the yen fell. The reason is that a decline in the currency makes Japanese exports cheaper for foreigners. That is an important boost for an economy that relies on many giant exporters, such as Toyota ( TM) and Canon ( CAJ).

In recent years, the yen has soared as investors sought a safe alternative to the euro and other shaky currencies. The strong currency punished Japanese exporters. But now that the yen is sinking, Japan has emerged as one of the top-performing stock markets in the world.

While the falling yen may help export sales, it can be a mixed blessing for U.S. investors. The problem is the weak currency makes Japanese stocks less valuable for foreigners. So if the yen drops 10%, as it did in recent months, the value of a Japanese stock would decline by that amount for a U.S. investor.

To bet on Japan at a time of a falling yen, investors should prefer WisdomTree Japan Hedged Equity, says Dennis Hudachek, an analyst for IndexUniverse.com. Using futures and other tools, the fund neutralizes the impact of the currency moves on U.S. investors. "With the yen weakening, the currency hedge could have tremendous value," says Hudacheck.

Because it did not suffer from the falling currency, the WisdomTree fund has outperformed unhedged competitors recently. During the past three months, the WisdomTree fund returned 25.6%, while iShares MSCI Japan, an unhedged fund, returned 12.1%.

Last year, WisdomTree took steps to magnify the impact of the weak yen on returns. In the past, the fund held a cross section of Japanese dividend payers. Big holdings included telecom and utilities companies. But WisdomTree reckoned that such stocks are unaffected much by currency moves because the companies obtain little or none of their sales from exports.

To eliminate the domestic businesses, the portfolio managers instituted a rule that all stocks in the fund must obtain at least 20% of their sales from exports. The change eliminated some telecom and utilities stocks. Now big holdings include Honda Motor ( HMC), which has 81% of its sales from exports, and Nissan ( NSANY), which gets 79% abroad.

While the outlook for exports remains positive, the picture could change if a crisis in Europe or the U.S. sends investors scurrying back to the safety of the yen. A rise in the currency would hurt Japanese stocks. But odds seem good, that the new Japanese regime will carry through on its program to weaken the yen and pump up the export economy.

This article was written by an independent contributor, separate from TheStreet's regular news coverage.
Stan Luxenberg is a freelance writer specializing in mutual funds and investing. He was executive editor of Individual Investor magazine.