Japan’s improving economic outlook has attracted investor interest. Larger, value-oriented companies have been quicker to benefit, but the smaller, higher-growth stocks that JGSI focuses on offer particularly strong longer-term potential.
Historically, investors have under owned the Japanese equity market, but that’s starting to change. The headline Nikkei Index reached its highest levels in 34 years earlier this year with investors encouraged by signs that the economy is normalising and by corporate governance reforms, which continue to gain traction.
After years of deflation, modest upward pressure on prices and wages prompted the Bank of Japan (BoJ) to raise interest rates in March 2024 for the first time in 17 years. Rising wages should also encourage consumer spending, while exporters are enjoying the competitive benefits of the yen, which remains cheaper than many developed market currencies.
At the same time, corporate governance reforms are improving shareholder returns via increased dividends and share buybacks, and by encouraging greater board independence and transparency. Among the more recent initiatives, the Tokyo Stock Exchange has required companies whose valuations are consistently below book value to take steps to raise their valuations, and the Financial Services Authority has urged non-life insurance companies to sell their strategic shareholdings, following a price fixing scandal.
Value and large caps recently outperformed in Japan
Within the broader Japanese equity market value-oriented and large cap stocks have outperformed recently, in part due to demand from foreign buyers. The weaker Japanese yen has increased the appeal of exporters, which are mainly large cap stocks.
JPMorgan Japan Small Cap Growth & Income plc (JSGI) focuses on the innovative and fast-growing smaller companies that are operating at the core of the Japanese economy. The investment approach favours quality and structural growth, targeting companies the portfolio managers believe can compound earnings growth over the long term, supported by strong competitive advantages, good management teams and judicious capital allocation. The result is a portfolio that will differ substantially from the benchmark.
Recent value and large cap outperformance has been a headwind for the trust in the short term. The portfolio, for example, is underweight banks, which have performed strongly in response to the BoJ’s gradual monetary policy normalisation. However, there are also many areas where JGSI has benefited. For example, the trust’s portfolio managers have been positive on the semiconductor supply chain, expecting the sector to see sustained growth in demand over the long term, backed by the rapid spread of artificial intelligence (AI), the growth of the internet of things (IoT) and the increasing use of electronics in vehicles. This positioning has been contributing positively to the portfolio’s returns.
Several companies in the portfolio provide good examples of stocks that have underperformed in the near term but that the portfolio managers continue to believe have strong long-term prospects. Milbon is Japan’s number one manufacturer of salon exclusive hair care products. In the near term, rising raw material costs have dampened profitability, but Milbon’s positioning and its scope to expand both domestically and overseas, remains unchanged.
Taiyo Yuden manufactures electronic components, such as multi-layer ceramic capacitors (MLCCs), that are used in cars and industrial equipment. In the near-term, however, demand has been sluggish for all MLCC makers due to an inventory correction, but Taiyo Yuden continues to benefit from rapid technological innovation in the auto industry, including electric vehicle and autonomous driving.
Small caps have high exposure to long-term growth themes
Valuations for the Japanese equity market are still relatively low compared to their historical levels, and compared to other markets. The portfolio managers continue to believe that small cap growth stocks offer high exposure to some of the secular themes that will drive long-term growth in Japan, including changing demographics, digitalisation, technological innovation and decarbonisation. JSGI is positioned towards companies that can benefit from these themes.
Japan’s ageing and declining population is creating significant challenges for Japanese policymakers. The government is addressing the issue through regulatory reforms and greater use of technology. One area of focus is reducing the need for face-to-face medical consultations, an area that Medley, a telemedicine company held in the portfolio, is involved in.
Technology is also being used to raise labour productivity from a shrinking labour force. Digitalising the operations of national and local governments, as well as Japan’s education and healthcare systems, is currently a high national priority. Rakus, a cloud services provider, and Infomart, a business-to-business trading platform for the food industry, are two portfolio positions that are benefiting from this long-term trend.
While Japan has lagged other countries in digitalisation, the country is a leading global supplier of factory automation equipment, robots, electronics parts and materials. The portfolio holds MEC and Rorze, which both specialise in niche technology markets.
Another focus of the Japanese government is reducing carbon emissions to net zero by 2050. Some smaller Japanese companies possess unique technologies related to the production of electric vehicles, solar and wind power, and other forms of clean energy, such as the trust’s holding in Canadian Solar Infrastructure Fund.
JGSI is positioned for the next investment wave
The macroeconomic backdrop for Japan has improved significantly in recent years. While investors have been focused on larger cap and more cyclical stocks, JGSI’s portfolio of smaller companies with strong growth prospects is well positioned to capture the next wave of investment.