Japanese smaller companies: An active approach key to identify growth catalysts
Strong performance from Japanese larger companies is setting the scene for small and mid-cap stocks to shine given their potential for relatively higher growth. Portfolio Managers Yun Young Lee and Nick Sheridan discuss the key criteria that they believe is needed for strong stock selection.
6 minute read
Key takeaways:
- Small-and-medium sized Japanese companies currently trade at attractive valuations and look well positioned to outperform following the rally in their larger counterparts.
- Stock selection focusing on cash-rich companies, the identification of growth catalysts and regular management interaction is essential to capture undervalued opportunities in this under-researched asset class.
- An active investment approach can help deliver better absolute and relative returns as well as reduce risk in times of economic and geopolitical uncertainty.
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.
Figure 1: Japanese small and mid-caps are under-researched
Source: Janus Henderson Investors, Bloomberg, as at 31 December 2023. Based on TSE1, TSE2, TSE Mothers, and JASDAQ companies. TSE Growth Market Index.
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.
Figure 2: Japanese companies tend to have strong balance sheets
Average cash to market cap ratio for companies included in each index and Japanese firm’s cash balances
LHR: Source: Janus Henderson Investors, Bloomberg, as at 31 December 2023.
RHS: Source: Janus Henderson Investors, Bloomberg, as at 31 December 2022. Based on 1,228 TSE1 companies, for which consolidated financial data are consistently available from FY3/02. Past performance does not predict future returns.
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.
Balance sheet: a financial statement that summarises a company’s assets, liabilities and shareholders’ equity at a particular point in time. Each segment gives investors an idea as to what the company owns and owes, as well as the amount invested by shareholders.
Capital expenditure: funds invested to acquire or upgrade fixed assets such as buildings, machinery, equipment or vehicles in order to maintain or improve operations and foster future growth.
Dividend: a variable discretionary payment made by a company to its shareholders.
Liquidity: a measure of how easily an asset can be bought or sold in the market.
Risk premium: the additional return an investment is expected to provide in excess of the risk-free rate. The riskier an asset is deemed to be, the higher its risk premium, to compensate investors for the additional risk.
Share buyback: when a company buys back their own shares from the market, thereby reducing the number of shares in circulation, with a consequent increase in the value of each remaining share. Signals the company’s optimism about the future and a possible undervaluation of the company’s equity.
Small and medium-sized (mid caps) companies: can be classified as listed companies with a market capitalisation of ¥200 bn and below. Larger companies (large caps) can be classified as well-established companies with a market capitalisation of >¥200 billion.
TOPIX Index: short for Tokyo Price Index, the index tracks stock prices on the Tokyo Stock Exchange (TSE). TOPIX is a capitalisation-weighted index that lists all firms in the “first section” of the TSE (large companies); TSE 2 tracks the smaller remaining companies. TSE Mothers tracks domestic common stocks listed on the former Mothers market and domestic common stocks listed on the Growth Market.
TSE Growth Market Index: reflects companies listed on the Tokyo Stock Exchange (TSE) that have a certain level of market value by disclosing business plans for realizing high growth potential and their progress towards these appropriately and in a timely manner, but at the same time pose a relatively high investment risk from the perspective of their business track record.
Volatility: the rate and extent at which the price of a portfolio, security or index, moves up and down.
These are the views of the author at the time of publication and may differ from the views of other individuals/teams at Janus Henderson Investors. References made to individual securities do not constitute a recommendation to buy, sell or hold any security, investment strategy or market sector, and should not be assumed to be profitable. Janus Henderson Investors, its affiliated advisor, or its employees, may have a position in the securities mentioned.
Past performance does not predict future returns. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested.
The information in this article does not qualify as an investment recommendation.
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Important information
Please read the following important information regarding funds related to this article.
- Shares/Units can lose value rapidly, and typically involve higher risks than bonds or money market instruments. The value of your investment may fall as a result.
- Shares of small and mid-size companies can be more volatile than shares of larger companies, and at times it may be difficult to value or to sell shares at desired times and prices, increasing the risk of losses.
- The Fund may use derivatives with the aim of reducing risk or managing the portfolio more efficiently. However this introduces other risks, in particular, that a derivative counterparty may not meet its contractual obligations.
- If the Fund holds assets in currencies other than the base currency of the Fund, or you invest in a share/unit class of a different currency to the Fund (unless hedged, i.e. mitigated by taking an offsetting position in a related security), the value of your investment may be impacted by changes in exchange rates.
- Securities within the Fund could become hard to value or to sell at a desired time and price, especially in extreme market conditions when asset prices may be falling, increasing the risk of investment losses.
- The Fund could lose money if a counterparty with which the Fund trades becomes unwilling or unable to meet its obligations, or as a result of failure or delay in operational processes or the failure of a third party provider.
- The Fund follows a value investment style that creates a bias towards certain types of companies. This may result in the Fund significantly underperforming or outperforming the wider market.
Specific risks
- Shares/Units can lose value rapidly, and typically involve higher risks than bonds or money market instruments. The value of your investment may fall as a result.
- Shares of small and mid-size companies can be more volatile than shares of larger companies, and at times it may be difficult to value or to sell shares at desired times and prices, increasing the risk of losses.
- If a Fund has a high exposure to a particular country or geographical region it carries a higher level of risk than a Fund which is more broadly diversified.
- The Fund may use derivatives with the aim of reducing risk or managing the portfolio more efficiently. However this introduces other risks, in particular, that a derivative counterparty may not meet its contractual obligations.
- If the Fund holds assets in currencies other than the base currency of the Fund, or you invest in a share/unit class of a different currency to the Fund (unless hedged, i.e. mitigated by taking an offsetting position in a related security), the value of your investment may be impacted by changes in exchange rates.
- When the Fund, or a share/unit class, seeks to mitigate exchange rate movements of a currency relative to the base currency (hedge), the hedging strategy itself may positively or negatively impact the value of the Fund due to differences in short-term interest rates between the currencies.
- Securities within the Fund could become hard to value or to sell at a desired time and price, especially in extreme market conditions when asset prices may be falling, increasing the risk of investment losses.
- The Fund could lose money if a counterparty with which the Fund trades becomes unwilling or unable to meet its obligations, or as a result of failure or delay in operational processes or the failure of a third party provider.
Specific risks
6 minute read
Key takeaways:
- Small-and-medium sized Japanese companies currently trade at attractive valuations and look well positioned to outperform following the rally in their larger counterparts.
- Stock selection focusing on cash-rich companies, the identification of growth catalysts and regular management interaction is essential to capture undervalued opportunities in this under-researched asset class.
- An active investment approach can help deliver better absolute and relative returns as well as reduce risk in times of economic and geopolitical uncertainty.