Miyuki Kashima, Head of Japanese Investments, BNY Mellon Japan, explains the current case for Japanese small caps.
1. The positive economic background
Japan has experienced impressive economic growth in recent years. For Miyuki Kashima, this growth spurt is a milestone: "GDP has recovered very well since Abenomics began, and we are finally back to the level of 1997, when deflation began."
2. Small caps have greater domestic focus
If one believes that the macro backdrop in Japan is improving, then the small-cap index is just the ticket. This is because Japanese small caps are far more domestically oriented than their large cap counterparts.
3. Small caps tend to outperform large caps as equity markets rise
The Topix rose in the period between 31. January 2017 and the 31. January 2018 by 20.7%. An analysis of the Russell Nomura Index from 1984 to 2017 suggests that small caps have outperformed large caps in the vast majority of periods when markets have risen.
4. Low correlation
Especially in light of the current market turmoil, there is another argument in favor of Japanese small-cap stocks: the correlation of Japanese equities to European and other Asian markets, as well as emerging market and U.S. indices, is low overall and especially low compared to small caps. For example, the correlation of the Russell Nomura Small Cap Index with the MSCI US or MSCI Europe over the ten years between January 2008 and December 2017 was only 0.60 and 0.61, respectively.
5. Good hunting ground
The large cap index includes only 350 stocks, while the small cap index includes 1250. In addition, small-cap opportunities are often overlooked by international investors.
6. More winners
There are significantly more stocks in the small cap sector that have outperformed than in the large cap sector. To reduce the "outperformers to find it, it needs local expertise. "Generally, the smaller the company, the less information is available – and if it is, it's in Japanese, not English", explains Miyuki Kashima.
7. Political stability
Japan has evolved from a political problem case in the mid-2000s to a country with exemplary stability. Between 2006 and 2012, Japan experienced no fewer than seven prime ministers. This changed after the election of Shinzo Abe in December 2012. "For smaller companies, this stability is a blessing", says Kashima.
8. Wage growth for SMEs
"Until recently, it was large corporations and multinationals that were responsible for the lion's share of wage growth. In recent years, however, more and more small cap companies have begun to raise the salaries of their employees", explains Miyuki Kashima.
9. Bank loans: The lifeblood of SMEs
Japanese banks have significantly more capacity to lend than many of their global counterparts. "When small and medium-sized Japanese companies want to borrow money to maximize their growth potential, capital is available", says Kashima.
10. The cash pile of the companies
Because of Japan's history of deflation, companies hoard a lot of cash. Assuming that deflation has ended and sentiment continues to improve, corporations may be more willing to spend that "cash pile." to reduce. Because large companies are already so highly capitalized, there is less competition for smaller companies to get financing from banks.
11. Tailwind for shares
Not only international investors are underweight in the Japanese stock market, but also Japanese households. Kashima: "Given the performance of Japanese equities over the past 20 years, this low allocation is hardly surprising. However, we believe that as the economy continues to improve and companies continue to perform well, Japanese savers will be more interested in buying stocks, which will provide additional tailwind for equities."
12. Good news not yet priced in
Japanese stocks seem undervalued. At least if you consider the relative lag between the performance of Japanese indices and the improvement in corporate earnings.