It’s no secret small-caps across the globe have taken a pounding in recent years, as the rise in a narrow set of mega-caps – coupled with rising interest rates – have made them an unpalatable choice for investors.
The numbers reflect this harsh reality. Global equities have returned 23.6% to investors in the past three years, compared with 2.5% for the MSCI World Small Cap index.
The squeeze in appetite is apparent. Small-caps account for roughly two-thirds of all global companies (68%). That figure is significant when you consider that global smaller companies normally account for 7-8% of the global stock market valuation but recent underperformance has seen this fall closer to 4%, a 50-year valuation low.
But there are hopes the headwinds are gradually becoming tailwinds, with rate cuts and increased buybacks in the small-cap universe indicating an upswing is not far away.
We have seen a lot of discussion about the opportunities in the UK small-cap market, but another market being overlooked, despite huge valuation discrepancies, is Japan.
Like many other parts of the world, Japanese small-caps have faced a raft of challenges since 2021. The largest of these being the fall in the yen (it has been down as much as 30% versus the US dollar between June 2021 and 2024), which has been good for exporters such as large tech and artificial intelligence (AI) companies, electric vehicles, semiconductor-related businesses and renewables.
By contrast, high growth, small-cap companies have become almost untouchable for investors, despite many continuing to bring in strong sales and grow rapidly. A recent research update from Hennessy Funds says the market’s hesitance to value these stocks appropriately may stem from a prolonged period of economic stagnation, exacerbated by the impacts of the global pandemic on the Japanese economy.
Why now for unloved Japanese small-caps?
Since the start of 2023, Japanese equity markets have recorded strong returns, heavily driven by large-caps, many of which are exporters benefitting from the depreciation in the yen.
Janus Henderson portfolio manager Yunyoung Lee believes we have only seen the beginning of a resurgence in the region, citing moderate inflation driven by rising labour costs – a move which tends to improve valuations. He also pointed to changes in the macro-environment, such as the reorganization of global supply chains due to rising US-China trade tensions. There are already signs of domestic repatriation of manufacturing bases, particularly in the semiconductor and medical device sectors.
Given current market fundamentals and the growth in Japan's domestic economy, he said he would be surprised if small- and mid-caps did not grow as fast as large-caps.
There are signs of a turnaround; the yen has started to strengthen against the US dollar in recent months, albeit from low levels, traditionally a good sign for small-caps.
Baillie Gifford Shin Nippon trust manager Praveen Kumar also believes domestic retail investors – often a key indicator for wider appetite for Japanese stocks – are starting to take an interest in small-caps.
Why Japan versus other global markets?
In addition to attractive valuations, Kumar said small to medium-sized businesses are the ones facilitating change in the country – allowing them to tackle structural issues, such as software technology gaps, labour market demographic challenges and cyber security concerns. By contrast, the larger firms have global footprints and do not have as great a focus on these longer-term domestic challenges.
Then there is the research angle – compared to many of its global peers, Japanese small-caps are thoroughly under-researched. The Topix small-cap index has 1,649 companies with an average of three analysts covering each company, in contrast to the Russell 2000 (5.9) and the BBG DM Europe small-cap (8.4). It should be noted that companies with a market-cap of less than ¥200bn are seldom covered at all.
As a result, strong corporate results are often not reflected in price-to-sales figures, Kumar said, which was the case for online real estate company GA Technologies and food retailer Oisix. This creates opportunities for active managers to step in.
With supply chain issues being resolved and economic conditions improving, now might be the ideal time to tap into this sector of the market. It has been a challenging period, but rebounds tend to be hard and fast for small-caps.
Investors may want to consider a specialist Japanese small-cap vehicle such as Baillie Gifford Shin Nippon or the M&G Japan Smaller Companies fund. The latter is a bottom-up, valuation-sensitive fund that aims to provide a combination of strong capital growth and income by investing in mid and small-caps.
For an all-cap Japanese strategy, the Comgest Growth Japan fund historically held 30% in small-caps but the current allocation is only 13% as a pragmatic response to the market’s preference for liquidity.
Those wanting exposure within a global offering might prefer the Global Smaller Companies Trust managed by Nish Patel, which currently has around 10% in Japanese small-caps.
Chris Salih is head of investment trust and multi-asset research at FundCalibre. The views expressed above should not be taken as investment advice.