Japanese smaller companies: An active approach key to identify growth catalysts

After a strong run since April 2023, and posting new highs in July, Japanese equities suffered sharp one-day losses in August, from a surprise Bank of Japan rate hike, US recession fears and the rapid unwinding of the yen carry trade due to yen strength. Since then, at the time of writing (early September) the market has recovered most of the sharp losses.

Where next for Japanese equities?

We believe that we have only seen the beginnings of a resurgence in Japanese equities’ performance. There are mainly two reasons for this. The first is a moderate inflation environment driven by rising labour costs. Historically, moderate inflation tends to lead to improved valuations. Second, is changes in the macro environment, such as expanding production bases globally against the backdrop of US-China trade tensions.

Adding to the backdrop of automation utilising AI technology and expected yen weakness compared to three years ago, there are signs of domestic repatriation of manufacturing bases, especially in the semiconductor and medical device sectors. This is expected to lead to the construction of new supply chains and have a ripple effect on domestic demand.

Potential for small and mid-cap stocks to outperform large-caps

It is important for investors to note that the Japanese equities rally was driven primarily by the performance of large-cap Japanese stocks. Yet if the fundamentals of the economy are the same, it would be strange if small and mid-cap stocks did not grow as well as large-cap stocks. Growth in domestic demand generally brings greater benefits to small and medium-sized enterprises than their larger peers. If the domestic economy continues to improve, there is a strong case to argue that small and mid-cap stocks are well positioned to perform too.

From a broader global perspective, small and mid-cap stocks are trading at attractive valuations at present, reflective of current geopolitical uncertainties, among other factors. Small and mid-cap stocks tend to have higher credit and liquidity risk compared to large-cap stocks, making them more likely to be laggards when investors are feeling more cautious. As a result, selective stock selection can lead to the expected “small and mid-cap stock effect” of generating attractive returns, ie. the theory that smaller companies have stronger growth potential and are more likely to be undervalued by the market. Now, with risk premiums excessively factored in and following a period of relative strength for large-cap stocks, we believe that small and mid-cap stocks will have an opportunity to shine too.

The power of discovery

A feature of the smaller caps market is the scarcity of in-depth analysis. Japanese small-and mid-cap stocks are not sufficiently researched to be priced as accurately as large caps. Compared to US stocks, for example, the coverage of Japanese small and mid-cap stocks by analysts is very low, and many stocks are not covered at all, particularly those that have a market capitalisation of less than ¥200 billion. Stocks that are already covered often turn out to be past their prime or have lost their popularity. By casting a wide net and analysing a broad range of stocks, we believe it is possible to capture the attractive opportunities that the market is overlooking, while steering clear of those companies that justify their low valuations.

This means that time-sensitive or factor-specific investment opportunities, such as companies impacted by negative short-term news, are not overlooked. Even if a stock’s price falls temporarily, if there is a promising catalyst for price upside, the potential for the stock price to bounce back is significant once the catalyst materialises.

It is crucial to identify the anticipated catalysts that can be linked with higher potential future revenues. We believe that for smaller companies where information is king, regular communication and interaction with management teams is key to obtaining a firsthand view of where the opportunities for long-term growth lie, understand sector dynamics and the strength of a company’s competitive advantage.

Identifying growth opportunities in cash-rich firms

We focus on seeking out cash-rich companies to find potential growth outliers in the small- and mid-cap space. While it is hardly unusual to see Japanese companies focus on accumulating cash, more recently, the focus has shifted to “improving capital efficiency”, in response to corporate governance improvement measures. Those companies with ample cash, that are utilising that cash for capital investment or human capital investment, are those that we expect to have the greatest potential to deliver future growth and shareholder returns. This is supported by the fact that Japanese companies have relatively strong balance sheets compared to their global peers. Small caps also tend to have lower levels of debt, meaning their ample cash reserves can be deployed to fund capital expenditure, research and development (R&D) and to reward shareholders via dividends or share buybacks.

The argument in favour of small- and mid-cap stocks is not just focused on internal change and management decisions. Cash-rich small and mid-sized companies are more likely to be targets for merger and acquisition (M&A) activity from their larger peers, be subject to privatisation through Management Buyouts (MBOs), or to generate significant returns through Tender Offer Bids (TOBs). Their returns are also arguably more predictable, creating a favourable tailwind for stocks carrying plenty of cash on their books.

Strong stock selection can help mitigate the impact of event-based volatility

In the latter half of 2024, with the US presidential election and various geopolitical risks simmering in the background, further uncertainty and volatility can be expected. In this market environment, via active management, discerning the winners and losers of market shifts via stock selection could play a crucial role in determining the outcome for investors in the latter half of 2024. Through strong stock selection, we believe it is possible to identify those small-and mid-sized companies that are capable of delivering strong performance on an absolute or relative basis, instead of relying on timing the market to enter or exit an investment, which has historically proven can be a futile endeavour.

IMPORTANT INFORMATION

There is no guarantee that past trends will continue, or forecasts will be realised.