DFJ ETF: Priced For A Crisis That Isn’t Coming

In a world of overpriced assets, the WisdomTree Japan SmallCap Dividend ETF (DFJ) stands out as being extremely cheap. This despite the index’s strong track record of sales, profit, and dividend growth. The index, and the broader Japan Small Cap Value space, is priced for a crisis that there is no sign of on the horizon. On top of this, the Japanese yen is deeply undervalued in purchasing power parity terms and its future appreciation will likely contribute significantly to DFJ returns.

The DFJ tracks an index of Japanese small-cap stocks selected and weighted based on dividends. Stocks are weighted based on cash dividends paid over the preceding year and the index is constructed by removing 300 of the largest companies by market cap from a universe of eligible dividend-paying Japanese firms. The index rebalances annually so that no individual security has a weight greater than 2% and each sector has a maximum weight of 25%, which creates a high degree of diversification. Unlike many dividend-focused ETFs, the DFJ does not have a particularly high weighting of financials, which make up just 14% of the index. Industrials are the largest sector at 25%, while consumer discretionary and materials make up 16% and 15% respectively.

Valuations Are Below The 2020 Lows

Thanks to rapid growth in sales and earnings, the underlying index is actually cheaper now than at the March 2020 lows, despite the index being up almost 50% since then. The trailing P/E ratio is just 9.4x, while the EV/EBITDA ratio is just 7.7x and the dividend yield is 3.2%. All these figures are at or close to their cheapest levels since 2012, where my availability of the data begins.

Not only is the DFJ cheap relative to its own history, it is also cheap relative to the rest of the small cap markets in Asia and the Developed World. The following table shows the extent of the WisdomTree Japan SmallCap Dividend index relative to its peers.

DJF Valuations Versus Peers

While it is often said that Japanese stocks are always undervalued, and this has indeed been the case over the past few decades, what is different about this time is that the undervaluation has been caused by rapid growth in the fundamentals. The table below shows sales, earnings, and dividends, rebased to 2012. The compound annual growth rate over this period has been 8.7%, 17.9%, and 14.2% respectively. The exceptional fundamental outperformance of Japanese corporates has been well documented by investment managers at GMO, with their Q32021 Quarterly Letter noting that Japan’s earnings growth has actually exceeded the U.S. over the past two decades.

The Japanese Discount Is No Longer Warranted

In my precious articles on Japanese stocks I have noted the strong outlook for Japanese earnings and dividends owing to the generational shift taking place in terms of corporate governance in favor of minority shareholders. With this in mind, the sector’s undervaluation may reflect Japan’s slow macroeconomic growth outlook or perceived financial risks relating to elevated energy costs.

While it is true that demographic factors will likely constrain real GDP growth to below 1% over the coming years, the outlook is not materially different to all other developed countries whose populations are now ageing and shrinking. Corporate governance reforms may even help provide a much-needed boost to Japanese productivity.

As for the impact of elevated energy costs, from a macroeconomic perspective this poses very little risk given the country’s status as a net creditor. Thanks to the country’s past excess savings, the rise in energy import costs has not made a dent in the country’s current account surplus as net income inflows far exceed the trade deficit.

This reflects the fact that Japan’s national savings rate is more than double that of the U.S. As I have argued in previous U.S.-focused articles, corporate profits are just one part of national savings, and while they are the lion’s share of such savings in the U.S., they are a tiny fraction in Japan. This creates the potential for Japanese profit margins to rise even in a stagnant economy, which is in stark contrast to the U.S.

The Currency Factor Is Another Reason To Be Bullish

The case for the DFJ would be strong regardless of the currency outlook, but the potential for yen appreciation adds to the appeal. According to Bloomberg the Japanese yen is 49% undervalued relative to the U.S. dollar in purchasing power parity terms meaning the scope for mean reversion is huge. This undervaluation has resulted primarily from low levels of inflation in Japan relative to the U.S. even as the currency pair has remained relatively stable. While Japan’s slightly lower level of GDP per capita may suggest some degree of yen undervaluation is appropriate, the current magnitude is simply not sustainable over the long term. As rising international competitiveness feeds through into yen strength, this provides an additional headwind to DFJ returns.