Why an actively run portfolio of Japan small cap stocks could be a big winner over the coming years…
Japan is the third largest economy in the world, yet its declining weight in global indices and previous false
dawns have put it out of focus for investors. While enthusiasm for Japanese equities grew in 2023, as evidenced by TOPIX’s +28% return, many allocators remain underweight and sceptical. We think this time is different and the Japanese market has many good years ahead. Companies are prioritising shareholders, business practices are changing and the macroeconomic backdrop is supportive. We believe inefficiently priced Japanese small-cap companies offer the greatest potential returns, and with the effectiveness of shareholder activism having never been higher, active management offers significant alpha generation.
Why Japan?
Until now valuations and earnings potential of Japanese companies had been held back for decades by
practices designed to maintain stability in the wake of the 1990’s bust. In the years following the fortunes lost,
management prioritised high employee retention and cash accumulation, in the absence of growth and
shareholder returns. This changed with the introduction of Abenomics in 2012, which ushered in an era of
structural reforms, shareholder engagement and a focus on improving corporate value. Reinforced by the
subsequent Stewardship and Corporate Governance codes and various interventions since, the environment
towards shareholders has transformed.
Since 2015 cross shareholdings have fallen by -44%, the proportion of outside directors on boards has
increased from 18% to 38%, and shareholder returns are at an all-time high.
Governance reforms are leading to higher earnings. Helped by deleveraging, lower corporation tax and
business restructuring, earnings growth of Japanese companies since 2015 has grown at a compound rate of
6%, only exceeded by companies in the US.
While Japan has generated market-leading earnings growth, it has suffered from a headwind of declining
valuations. Now trading at a discount to the S&P 500, MSCI Europe and MSCI Asia ex Japan, the MSCI Japan
Index’s EV/EBIT has declined from 17x at the start of 2015 to 11x at the end of November 2023. Japan is one
of the cheapest global equity markets.
Coupled with encouraging change at the company level, we see a rosy economic environment. For decades
Japan suffered from lacklustre growth, protectionist business practices and an absence of animal spirits, but
that environment is changing. There is a new generation of younger management who are embracing more
dynamic business practices, want to facilitate growth and aren’t haunted by the collapse of the boom era. This
is being helped by inflation, disrupting the status quo of stagnant prices and wages. Higher inflation also
encourages spending, while penalising the hoarding of cash, adding further incentive for companies to improve
balance sheet efficiency.
The corollary of Japan’s first inflationary environment in three decades, is that with the elusive 2% inflation
target finally within reach, the Bank of Japan (BOJ) has been reluctant to tighten monetary spending. Yield
Curve Control (YCC) and negative rates remain in place, which is causing a widening interest rate differential
with other developed nations and a dramatic decline in the Yen.
The real effective rate of the Yen is at the cheapest level since 1971, and with global rates showing signs of
falling while Japanese rates are ticking higher, the situation is ripe for the Yen to outperform. Having been a
drag for foreign investors, a reverse of the Yen’s weakness would be a huge tailwind.
Company reform, growing earnings, cheap valuations, manageable inflation and an undervalued Yen position
the Japanese stock market for stellar returns.
Why active allocation to small-cap, cash-rich companies?
The purest way to gain exposure to the Japanese economy and the upside of corporate reform is through smallcap companies. While large-cap companies are dominated by global giants, with heavy dependency on exports
and overseas demand, small-cap companies have domestically biased sales. There are a plethora of wonderful
small companies operating in niche markets with enormous barriers to entry. Being smaller, they have greater
growth opportunities, both overseas and domestically as industries consolidate. The returns speak for
themselves, over the past two decades small-cap companies in Japan have generated an annualised 2%
outperformance relative to their large-cap counterparts.
A feature of Japanese small caps is an abundance of excess balance sheet capital, typically in the form of
investment securities, real estate and cash. Balance sheet assets are structurally discounted, some studies
suggesting by up to 50%, and while these assets generate low returns, they provide investors with downside
protection and when the cash is put to better use, or returned to shareholders, a narrowing of the discount.
Overlaying a high cash screen on top of small-cap allocation yields an annualised 12% return over the past two
decades, significantly higher than both the large cap and small cap index.
Active managers in Japan are spoilt for choice with the number of small cap companies. Excluding Hong Kong,
whose stock exchange is home to mainland Chinese companies, only Sweden and Singapore have more
companies proportionally to their respective GDP than Japan. If Japan were to have the same ratio of listed
companies to GDP as other developed nations, then almost 3,000 of the 4,000 listed companies would need
to be taken over/privatised.
The high number of listed companies in Japan leads to poor analyst coverage and in turn more opportunities
for active managers to exploit. On average, listed companies in Japan have two sell-side earnings forecasts,
compared to 7 in the US and 4 in China. Of 23 developed countries defined by MSCI, Japanese companies have
the least coverage.
The poor sell-side coverage is compounded by poor IR disclosure, with information not always translated into
English and access to senior management difficult. A study by the Tokyo Stock Exchange (TSE) found that 41%
of investors discounted Japanese companies that had insufficient English disclosure and 35% excluded them
entirely. Non-fundamental factors like poor disclosure create mispricing opportunities for firms that have the
resources to undertake detailed research and Japanese speakers to overcome the language barrier.
While the Government and Regulators are doing all they can to drive reform, responsibility lies with
shareholders to help management drive change. At no time before has activism in Japan been more prevalent
and effective. Activism not only helps to rectify low valuations through improved shareholder communication
and balance sheet restructuring, but also through strategic initiatives designed to boost margins and growth.
Sitting on the sidelines passively waiting for reform leaves money on the table, and with Japan being the second largest market for activist events, it’s a prime target for engagement.
The purest exposure to Japan reform and the economy is through small companies. They have historically
outperformed larger companies and those with excess cash have generated further outperformance. The
market is primed for consolidation with too many small companies. For active managers, with a broad universe,
pricing inefficiencies and engagement, Japanese small companies offer a huge potential to generate significant alpha.
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Intended Audience
The information on this website is provided to you for informational purposes only and should not be regarded as an offer or solicitation of an offer to buy or sell any investments or related services that may be referenced on this website.The information on this website is subject to change without notice.
This website is primarily intended for UK residents. It is not intended for distribution to, or use by, any U.S. persons or persons in any other country where such distribution or use would be contrary to local law or regulation.
It is your responsibility to observe all applicable laws and regulations of any relevant jurisdiction.
No Tax or Legal Advice
Nothing on this website constitutes investment, legal, tax or other advice nor should it be relied upon in making an investment decision.
Money Laundering
As a result of money laundering regulations, additional documentation for identification purposes may be required when you make your investment. Full details are contained in the relevant subscription documents.
Investment Decisions
As with all financial or investment matters, you should exercise great care in using the information provided on this website or available through links from this website. You should research the facts, opinions and strategies mentioned in this website before making any financial investment decisions. If you are unsure about the meaning of any information provided please consult your financial adviser or other professional adviser.
No Warranty; Limitation on Liability
Whilst all reasonable care has been taken in the preparation of this website, AVI cannot guarantee the accuracy or completeness of such information, either expressly or implied. Neither AVI, any of its directors, officers or employees, nor any third party vendor, will be liable or have any responsibility of any kind for any loss or damage that you incur in the event of any failure or interruption of this site, or resulting from the act or omission of any other party involved in making this site or the data contained therein available to you, or from any other cause relating to your access to, inability to access, or use of the site or these materials, whether or not the circumstances giving rise to such cause may have been within the control of AVI, or of any vendor providing software or services support.
All information and content on this website is, subject to applicable statutes and regulations, furnished “as is”, without warranty of any kind, express or implied, including but not limited to implied warranties of merchantability, fitness for a particular purpose or non-infringement. We make no warranty as to the operation, functionality or availability of this website, that the website will be error-free or that defects will be corrected.
In no event shall AVI be liable to any indirect, incidental, special or consequential damages arising out of or in connection with the use of this website, the inability to use this site or any products or services obtained or stored in or from this website, whether based on contract, tort, strict liability or otherwise. These limitations also apply to any third party claims against users.
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Everything on this website is the valuable intellectual property of Asset Value Investors Limited, or their respective suppliers. We protect our intellectual property rights to the full extent of the law.
Copyright Policy
No permission is granted to copy, distribute, modify, post or frame any text, graphics, video, audio, software code, or user interface design or logos.
Hyperlinks
The existence of hyperlinks should not be construed as an endorsement, approval or verification by AVI of any content available on third party sites. By providing access to other websites, we are not recommending the purchase or sale of products or services provided by the website’s sponsoring organization. We do not review any of these third party sites. AVI reserves the right to require written consent for, or request the removal of, any links to our website.
AVI disclaims all responsibility for the content of third party sites
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For your protection, we require the use of encryption technologies for certain types of communications conducted through this website. While we provide those technologies and use other reasonable precautions to protect confidential information and provide suitable security, we do not guarantee or warrant that information transmitted through the Internet is secure, or that such transmissions will be free from delay, interruption, interception or error.
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AVI Global Trust – General Risk Factors
AVI Global Trust plc is a public company listed and traded on the London Stock Exchange.
Past performance should not be seen as an indication of future performance. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested. The trust uses gearing techniques (leverage) which will exaggerate market movements both down and up which could mean sudden and large falls in market value. Please refer to the Key Features Document for further details effecting affecting your investment.
Applications to invest in AV Global Trust referred to on this Site, must only be made on the basis of the current Key Features Document, or other applicable terms and conditions. Past performance should not be seen as an indication of future performance. Market and exchange rate movements may cause the value of a fund to rise or fall and an investor may not get back the amount invested.
As a result of money laundering regulations, additional documentation for identification purposes may be required when you make your investment. Details are contained in the relevant application documents. If you are unsure about the meaning of any information provided please consult your financial adviser or other professional adviser.
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