Bright Spots in a Tough Year
Amid the equity market rout of 2022, Japanese small caps proved strikingly resilient by finishing the year down just 0.33%, while their U.S. and European peers dropped 7.98% and 18.01%, respectively (see Fig 1)1. Many of these companies entered the downturn trading at a relative discount—and though many boast improving fundamentals and remain comparatively insulated from global macroeconomic and geopolitical risks, their attractive valuation discount persists (Fig 2)2.
Fig 1: 2022 MSCI Japan SC, US SC, EU SC Performance (1/4/2022 indexed to 100)
Fig 2: Price to Book Ratios
In addition to their attractive relative valuations, Japanese small caps have garnered less attention from research analysts than their peers in other markets. For example, nearly 73% of the companies in the MSCI USA Small Cap Index are covered by at least five analysts, compared with just 30% of the MSCI Japan Small Cap Index; likewise, only 2.1% of the U.S. index has drawn zero analyst coverage, versus 15.4% of the Japan index.3 That disparity in coverage, we believe, creates an attractive opportunity for savvy active managers to capitalize on potential mispricing within the universe of smaller Japanese companies.
While we don’t expect Japanese small caps to ‘jump’ in the Year of the Rabbit, a few steady ‘hops’—spurred by a handful of growth catalysts—appears a more likely scenario.
Growth Catalysts in 2023
The first potential catalyst is the reopening of China. In 2022, the uncertainties surrounding the world’s second largest economy’s “Zero Covid” policy was a source of global growth concerns. This year, we believe the reverse may unfold as China removes many of its pandemic restrictions to help resuscitate consumer and business demand.
In our view, one of the key beneficiaries will be Japan, which counts China as its top trading partner (Fig 3)4. As economic interdependence between the two economies has deepened, we believe Japanese companies are in a favorable position to capture pent-up local demand, implied by rising household deposit rates5 . However, we also expect growth opportunities in commoditized mass-market product segments may be limited by intense competition with multinational and emerging local brands.
We believe it is prudent to gain exposure to this burgeoning market through selectively chosen small caps with higher-quality products and other competitive advantages. One compelling category, in our view, is premium motorcycle helmets, which has grown rapidly with the expanding market for higher-displacement bikes in China.
The leader in this space is Shoei, which commands a 60% global market share6. Shoei’s high-performance helmets—well recognized by motorcycle enthusiasts for their comfort, durability and safety—retail for more than twice the price of competing mid-tier brands, driving the company’s strong profitability. Shoei has targeted China as its next growth market and has seen double-digit sales there in recent years.
Fig 3: Japan's Top Trading Partners
|3||South Korea||South Korea||South Korea|
|5||Hong Kong||Hong Kong||Hong Kong|
The second growth catalyst for Japanese small caps, in our view, is the resilience of Japanese domestic demand. According to the Japan Cabinet Office, real GDP is expected to grow 1.5% year-on-year in 2023, led by a 2.2% rise in consumer spending. This is a slight slowdown from 2022 estimates (Fig 4)7, but it bodes favorably compared to anticipated flat year-on-year personal consumption for the U.S. and Europe in 2023.8
Still, after decades of deflationary pressure, we remain skeptical that all consumer-facing Japanese companies will be able to pass along rising input costs. Hence our belief in actively identifying companies that appear to have sustainable pricing power.
One attractive name, in our view, is USS, Japan’s biggest operator of second-hand-car auction centers9. The company has grown mainly by acquiring its competitors and now operates just under half of all auction sites in Japan. Thanks to its scale and broad selection, USS has been able to raise fees on consignments. And as supply-chain disruptions continue to ebb, we believe new-vehicle production could boost USS’ top line by increasing the volume of cars at auction.
Fig 4: Japan Economic Forecasts
Meanwhile, we remain cautious with respect to the Japanese yen (JPY) in light of potential monetary policy adjustments by the Bank of Japan (BOJ) during its changing of the guard. We believe the lack of clarity surrounding wage growth and consumer prices suggests that policy normalization would occur in a phased approach, starting with the removal of Yield Curve Control and/or the negative interest rates introduced in 2016, before gradually shifting to a zero interest rate (Fig 5)10. In other words, we expect similar interest rate differentials between Japan and other central banks (notably the U.S. Federal Reserve) to remain for the foreseeable future. If the JPY did happen to appreciate, we think businesses that are relatively immune to currency fluctuations would prosper over the mid- to long-term.
One company that potentially meets this test is As One, Japan’s biggest wholesaler of medical and laboratory consumables11. We believe the company’s reliable centralized procurement system and product-handling centers have earned deep customer loyalty, making As One the “Amazon” of Japanese labs. And while many of its products are imported, which can introduce foreign-exchange risk, As One has been able to routinely adjust its prices to maintain profitability.
Fig 5: Bank of Japan Monetary Policy Actions
|Apr-13||First Round Qualitative and Quantitative Easing|
|Oct-14||Second Round Qualitative and Quantitative Easing|
|Jan-16||Launch of Negative Interest Rate Policy|
|Sep-16||Launch of Yield Curve Control with 10Y JGB band of +/- 10 BPS|
|Jul-18||Adjustment of Yield Curve Control with 10Y JGB band of +/- 20 BPS|
|Mar-21||Adjustment of Yield Curve Control with 10Y JGB band of +/- 25 BPS|
|Dec-22||Adjustment of Yield Curve Control with 10Y JGB band of +/- 50 BPS|
A third catalyst, in our view, is broad corporate governance reform, including capital-management and sustainability initiatives. For example, over the last several years, we have seen Japanese companies address overcapitalized balance sheets by accelerating dividend payments and stock repurchases (Fig 6)12. We anticipate the next wave of reforms will be led by smaller companies run by more progressive management teams.
Take Okinawa Cellular, a regional telecommunications company that commands half of the mobile phone market13 in Japan’s southern islands. Beginning in 2020, the company launched two rounds of stock buybacks to improve its capital efficiency. More progress came in October 2022 when it announced its first, mid-term business plan that included a specific roadmap to increase earnings per share by 1.5 times over three years. The company also disclosed a budget for capital investment and M&A, including a share buyback program in the same period. Finally, it identified material environment and social improvements, and mapped out specific steps to strengthen its human capital management. We believe Okinawa Cellular is a model example of a small company pursuing sustainable growth by taking cues from larger peers that have undergone similar reforms in recent years.
Fig 6: Topix Dividend and Share Buybacks (JPT Tln)
As investors rethink their asset allocations in the wake of ongoing geopolitical risk, persistent inflation, further monetary tightening and potential recession, we believe mispriced Japanese small caps may be worth a look in 2023 and beyond.
In our view, this deep market is home to a plethora of undervalued companies with attractive business fundamentals, strong management teams and compelling earnings-growth catalysts. As bottom-up, long-term investors, we believe in taking an active approach toward selecting promising targets among this relatively under-researched opportunity set.