HEWJ: FX-Hedged Japanese Stocks Offer Strong Returns (NYSEARCA:HEWJ)

iShares Currency Hedged MSCI Japan ETF (NYSEARCA:HEWJ) is an exchange-traded fund that invests in Japanese equities with an FX hedge to protect against movements in the USD/JPY exchange rate. There is some cost involved; while the net expense ratio is reported as being 0.50%, this is only to the end of 2025. The regular expense ratio is reported as being 1.02% at present. I will factor this into my calculations. The hedging is done by selling the JPY forward at the one-month forward rate.

Interestingly, beyond the FX-hedging futures derivatives, the fund is basically fully invested in the iShares MSCI Japan ETF (EWJ). This, of course, carries its own expense ratio; 0.50%. I am factoring both expense ratios into my calculations, in this case. Also, in turn we can see that EWJ is based on the MSCI Japan Index. The most recent factsheet for this benchmark index, as of December 30, 2022, reported trailing and forward price/earnings ratios of 13.77x and 12.01x, with a price/book ratio of 1.20x. EWJ’s three- to five-year earnings growth estimate from Morningstar is reported as being 8.17%. I will assume 5%, which I am comfortable with meeting in my forecast. This would keep our return on equity assumption to within 9-10% (on the underlying portfolio, in line with MSCI’s forward one-year assumption).

What about the long-term earnings multiple? I think Japanese equities’ forward earnings multiple is looking very low. At just 12.01x, implicit assumptions are pessimistic. Assume that the long-term nominal earnings growth rate is 0%, while the 10-year yield holds at roughly 50 basis points (just as of recent). This is to assume that inflationary pressures do not continue beyond five years. Assume the equity risk premium is about 4.5% plus the circa 1.2% that Professor Damodaran believes is fair to use as a country risk premium for Japan. That would take our cost of equity to just 6.20%, which would, even with 0% earnings growth, afford an earnings multiple of over 16x.

I will work with this argument, but taper the forward earnings multiple down to 15x gradually over the next 5-6 years, and assume that Japanese equities can grow into this fuller valuation over that time frame. It is not often that I am comfortable with doing this, but I think it is reasonable in this case. The summary of my assumptions, excluding any positive effect of potential buybacks, is illustrated below. The headline IRR implied is over 14%.

Bear in mind that this is after including the heavy burden of ETF expenses, too. The forward IRR is strong, and even without the valuation expansion potential I have included (to 15x), the headline IRR would still be 10%. The benefit of earnings multiple expansion offers a full annualized 400 basis point improvement to the investment thesis, which is significant, but even a 10% IRR without this assumption is strong enough to justify investment.

The Japanese yen has been volatile over the past few years. The Economist’s GDP-adjusted PPP model suggests the yen is undervalued by circa 38% as of January 2023. The Japanese current account is not as strong as before (although it is ticking along), which could suggest some modest over-valuation. Still, with an undervalued currency from a PPP perspective, downside potential is limited. Another factor is that Japanese yields are still low in spite of a recent uplift; this creates a negative bias (as a function of carry trades) which should put pressure on the yen into the next business cycle and/or market cycle. With HEWJ being hedged, investors may benefit indirectly from some currency weakness; the investor will be directly hedged but indirectly benefit (potentially) as Japanese corporate earnings may benefit from the weaker FX effect (with respect to exports). Having said that, Japan is a net-importer of energy, and generally speaking any benefit here is likely to be extremely limited.

On the whole though, I like HEWJ. I am not incredibly keen on the FX-hedged version of the fund, but the volatility of the yen makes the fund worth considering. EWJ is equally interesting; fewer direct/indirect fees, but of course there is the risk of the yen weakening further. FX prices can often seem very random. If as part of a larger portfolio, it may be a better idea to invest directly in EWJ as a hedge against USD; i.e., as an international diversifier, not just from an equity perspective but also an FX perspective. This is up to the individual investor. In any case, I think both HEWJ and EWJ are attractive and likely undervalued at present.