The strong share price growth of Japanese small caps during the past year reflects a confidence among some investors that Abenomics, the “three arrow” reform program of Prime Minister Shinzo Abe, is poised to lift the Japanese economy onto a new growth trajectory after two decades of malaise.
The mothers index, a gauge of small-growth stocks listed on the Tokyo Stock Exchange, was up 134.6 percent for the year, closing at 896.15 on November 26 — more than double the 64 percent increase in the Nikkei 225 index of large-cap stocks. The question for institutional investors is whether small caps can build on those gains and rise further — and if so, which of them will do so.
Takashi Maruyama, head of equities and alternative investments at Tokyo-based Nikko Asset Management, which has $163 billion in assets, thinks the improving underlying economic picture will mean further gains for many small-cap sectors. He points to the Bank of Japan’s closely watched Tankan survey of business conditions, which hit a 21-year high for small enterprises in the nonmanufacturing sector, the segment that accounts for the vast bulk of small-cap stocks. “Typically, Japan’s economic recoveries are led by manufacturing; then nonmanufacturing follows,” he says. “But this time it’s the other way round.”
The growth in service sector output reflects increasing confidence among Japanese consumers. Household spending rose during the first half of 2013, although growth slowed somewhat in the third quarter.
One consumer play is Resorttrust, a company that sells time-shares in upscale apartment complexes in popular Japanese resorts such as Hakone and Karuizawa. “The company’s shares have risen sharply this year because of customers’ greater optimism about the economy, helped by the fact that the stock market is doing a little better,” says Kwok Chern Yeh, head of investment management and Japanese equities at the Singapore office of Aberdeen Asset Management, a U.K.-based firm that manages £200 billion ($325 billion) . Resorttrust is the third-largest holding in the Aberdeen Global Japanese Smaller Companies Fund, accounting for 4.6 percent of the fund’s ¥58 billion ($572 million) value. On November 26, Resorttrust was up 140.44 percent for the year at ¥3,835.
After serving a brief and unsuccessful term as prime minister in 2006 and 2007, Abe won election in December 2012 by promising bold steps to boost Japan’s growth rate and end deflation. He referred to his three-plank platform as “arrows” because of a Japanese proverb that suggests while one or two arrows can be broken, three arrows bound together are hard to shatter.
The first two arrows, already fired, consist of monetary stimulus through the Bank of Japan’s increased bond buying and fiscal stimulus through extra government spending on social and public works. The third arrow, structural reforms intended to spur investment and accelerate growth, will take much longer to work. Abe announced an outline reform agenda in June, but many analysts are skeptical that the government will succeed in implementing it. The team at Nikko Asset Management is optimistic, though.
Maruyama says Abe is expected to encourage corporate restructuring through mergers and acquisitions. M&A will get a further impetus, he contends, from Japan’s low birth rate, which makes it hard for the owners of small and midsize enterprises to pass their companies on to their children. Maruyama sees M&A advisory and recruitment small caps as a good play on this trend. Some asset managers still see value in Nihon M&A Center, which provides M&A advisory services to small and mid-sized companies, even though it is already 163 percent up on the year at Y7,000.
Investors who believe Abenomics is working can be forgiven for asking whether the heady share price growth of the past year, driven largely by domestic retail investors, can be sustained. Japanese small caps trade at an average projected price-earnings ratio of 15, which is not exactly cheap, even if it is below the average large-cap multiple of 17.5.
Investors have responded by repositioning themselves within the small-cap universe. “We used to favor consumption-related sectors, like speciality retail,” says Taku Arai, product manager, Japanese equities, for the ¥16.5 billion Schroder International Selection Fund Smaller Japanese Companies fund. “But valuations are becoming a little expensive, so we have recently had a preference for stocks related to corporate demand.” The fund’s biggest investment is in NEC Networks & System Integration, a computer service provider that is up 84.54 percent during the past 52 weeks as of market close November 26. By weakening the yen through monetary stimulus, Abenomics has boosted exporters’ profits — raising hopes, albeit not yet fulfilled, of higher corporate investment, a desired outcome of Abe’s third arrow.
Some investors remain skeptical of Abe’s economic program, which is hardly surprising given the two-decade-long record of failed stimulus and reform initiatives.
Although he acknowledges that the economy is improving, Kwok cautions against investing on the basis of Abenomics. “If you select companies that you think will do well because of government policy, you will be disappointed,” he says, “because government policy has been stop-start for many years.”
Much of Japan’s manufacturing sector focuses heavily on exports. Some exporters have admittedly begun to see benefits from Japan’s looser monetary policy. Yet many small-cap exporters are not greatly affected by the yen’s strength or weakness, either because they have a powerful niche in specialty products for which competition is primarily based on expertise rather than price, or because much of their production is located, as well as sold in, overseas markets.
Pigeon Corp., the largest single holding in the Aberdeen fund, is a good example. Investing in a nursing and baby product manufacturer in a country with a birth rate of only 1.2 children per woman may not seem like a savvy investment. But Pigeon is a big player in China, where 16 million babies are born every year. When the Chinese government announced a partial relaxation of its one-child-per-couple policy this month, the company’s stock price leaped 7 percent in a day. With such growth opportunities abroad, Abenomics does not always loom large in the consciousness of export-focused small caps.
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