The Japanese stock market has not been kind to small, growth-focused businesses, or those who invest in them, over the past couple of years. Value has been favoured over growth since 2022, and concerns about US interest rates remaining higher for longer meant Japanese small caps were further shunned this summer.
It’s been a challenging environment for the JPMorgan Japan Small Cap Growth & Income (JSGI), with both stock and sector allocation meaning the trust has underperformed the benchmark, MSCI Japan Small Cap index, year to date.
For example, lack of exposure to banks (which benefit from higher rates) detracted from performance, as did holdings dependent on increasingly expensive raw materials.
Tokyo Stock Exchange acts to improve valuations of Japanese stocks
Nonetheless, portfolio manager Miyako Urabe and her team remain very upbeat about the long-term outlook for Japanese small cap stocks. Urabe points to factors such as continuing healthy corporate earnings and signs of Japan’s emergence from chronic deflation as cause for cheer.
She is particularly excited about the changing face of corporate governance in Japan. The past decade since the government’s implementation of its corporate governance and stewardship codes has seen growing numbers of independent board directors, better disclosure, more engagement from domestic institutional shareholders and increasing shareholder activism.
But the pace of governance change has accelerated markedly this year, since the Tokyo stock market started to require companies consistently trading at less than book value (which account for more than a quarter of the market, compared with, say, 8% of US stocks1) to set out policies for improvement.
“This domestic pressure on domestic companies is a very big deal in Japan, and it simply wasn’t there in the past,” Urabe says. “We’re starting to see companies changing that we wouldn’t have expected to change: cash-rich businesses are introducing measures to improve shareholder returns; others are specifically producing roadmaps to address balance sheet inefficiency.”
Nor, importantly, are these developments confined to the substantial segment of the market trading below book value. Around 50% of Japanese non-financial companies have net cash positions, compared with around 15-20% for the US and Europe, so Urabe sees this trend as a very big deal.
Moreover, stocks right across the quality spectrum are sitting on excess cash. “Even some of the highest-quality, most profitable and well-positioned companies in Japan have over-capitalised balance sheets, so there’s much more that can be done on a broad basis,” she emphasises.
Japanese small caps: a potential gold mine for active managers
Within JSGI’s portfolio there are certainly many companies that have been taking steps to improve shareholder returns, including buybacks. “We strongly believe these changes will support both the wider market and JSGI over the long term,” Urabe adds.
A further consideration makes mid and small cap stocks particularly interesting for Japan-watchers. Although Japan is the world’s third largest economy2, the market as a whole is very under-researched, with 70% of stocks followed by fewer than three analysts3; at the small-cap end that rises to more than 85%. (To put that into perspective, across the US S&P 1500 only 1-2% are similarly under-covered.)
For active managers, then, the small-cap end of the Japanese market is a potential gold mine – rich in innovative growth stories with a tech or structural growth theme, enhanced by rapidly improving corporate governance, yet largely ignored.
“JPMorgan’s large team of 20 plus experienced managers and analysts on the ground in Tokyo, backed by the wider JPM wealth of resources, puts us in a strong position to dig out long-term growth winners,” Urabe says.
JSGI’s portfolio remains focused, as it always has been, on growth-oriented small and medium sized companies at the high-quality end of the spectrum in terms of metrics such as return on equity and earnings growth.
The largest overweight, perhaps surprisingly, is to materials, but as she explains, these are “highly profitable and exciting specialist chemical companies” rather than conventional low-growth commodity exposure.
A good example is MEC, a global leader in advanced adhesion enhancing products for printed circuit boards. It’s a niche player with growing demand and a loyal customer base grounded in high-quality products and very reliable profitability (even through the 2008 financial crisis it achieved double-digit operating profit margins and its operating profit margin now stands at over 20%4).
Clearly, JSGI’s small-cap growth focus means it currently faces economic obstacles; but over the longer term there are powerful reasons for optimism, particularly as the profitable, high-quality businesses in which it invests sharpen up their agendas on corporate governance.