Japan has been viewed by many investors as one of the most unfavorable markets for at least 20 years. Ever since the 1980s run-up, 1991 crash, subsequent Lost Decade and resulting crippling deflation, Japanese stocks have been stuck in neutral. Even the election of economic reformer Shinzo Abe as prime minister has had only limited success. (For more on this topic, see Comparing The Japanese And U.S. Bubbles.)

However, investors may be overly dour about Japanese stocks. Now could be the best time in over a year to snag-up shares of cheap Japanese equities. First, though, a little history.

A Strong Yen Doesn't Help

Abe’s election and his pro-growth policies, dubbed “Abenomics,” were fast out of the gate. That year, the prime minister announced a $103 billion stimulus package and an annual inflation rate target of 2% as some of his policies to re-ignite the stagnating Japanese economy. As such, the yen fell and Japan’s stock market took off, rising more than 50% last year. (For more on this topic, see Japanese Stocks Continue To Outperform.)

However, Abe’s policies haven’t worked according to plan in 2014.

The key for Japan has been its yen currency. A strong yen has hindered Japan’s export economy over the last twenty years. One of the main aims of Abenomics is the devaluing of the yen to breathe life into Japanese exports. That was working until recent global economic weakness that sent concerned investors back into safe-haven currencies, such as the dollar and yen. As a result, the yen has risen, and some analysts now postulate that Abe’s plans may have been all for naught, as Japanese equities are now down for the year.

Indeed, the MAXIS Nikkei 225 Index ETF (NKY), which tracks the benchmark Nikkei 225, is down about 10.18% so far in 2014.

Yet, there is some hope on the horizon for investors.

Inflation a Positive Sign

First, inflation has once again returned to Japan. Aside from the strong yen, deflation has wreaked havoc on business and consumer spending for some time. According to recent government data, consumer prices in Japan were up 1.5% from a year earlier. That’s important, as inflation suggests stronger demand and lower real interest rates. It also means that firms that have been stockpiling cash for decades must now do something with that cash or risk losing it via inflation. Japanese companies are sitting on some $2.2 trillion in cash.

As for the yen, it’s still about 20% lower than its all-time high and has recently backed-off in recent weeks. What’s more, Japanese firms haven’t been cutting prices on their products despite the overall weaker yen. While that’s hindered some export growth, it means that they are making more per sale than before. Earnings should actually be better for these firms.

And Japanese equities are among the cheapest on the planet – especially after the recent plunge. According to analysts at BlackRock Inc. (BLK), Japanese equities are trading at just 1.17x book value, a 56% discount to U.S. stocks and a 43% discount versus the developed market MSCI EAFE Index.

Betting On Undervalued Stock

For investors, Japan’s recent weakness could be a great buying opportunity. The $13 billion iShares MSCI Japan ETF (EWJ) has traditionally been the go-to investment. However, the WisdomTree Japan Hedged Equity (DXJ) may be a better buy. The basic idea behind the ETF is that a depreciating yen will diminish the performance of Japanese equities once converted back into U.S. dollars.

DXJ uses futures contracts to essentially take the yen out of the equation. Investors just get the stock returns. That provides “pure” exposure to Japan's leaders like Honda Motor Co Ltd. (HMC) and Japan Tobacco Inc. (JAPAF). Another ETF worth considering is the new WisdomTree Japan Hedged Capital Goods Fund (DXJC), which bets directly on Japan’s exporters. (For more on this topic, see Five ETFs To Cash In On Japan's Rise.)

Speaking of those exporters, Japan’s various sogo shoshas (general diversified trading companies) continue to be cheap. These multinational giants have their hands in everything from natural gas production and heavy manufacturing, to textiles and fruit production. Both Sumitomo Corp. (SSUMY) and Mitsui & Co. Ltd. (MITSY) are two of the biggest, sit on plenty of cash for expansion and could be great long-term buys.

Finally, rising inflation and consumer spending is wonderful news for Japan’s domestic economy, and small-caps are the best way to play “the real” Japan. The SPDR Russell/Nomura Small Cap Japan (JSC) tracks 464 Japanese small-caps and features a 30% exposure to consumer names.

The Bottom Line

After a stellar 2013, Japanese equities haven’t lived up to their promise this year. However, the situation in the developed nation will still bear fruit for longer term investors. The recent underperformance in Japanese equities could be a great buying opportunity for the next leg-up.

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