Chikara: It’s time to re-visit ‘undervalued and overlooked’ Japanese small caps

Small caps lagged in the Japan rally, but now offer some of the highest re-rate potential, writes Theo Wyld

A crowded street at night in Shinjuku, Tokyo, Japan.
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By Theo Wyld, analyst on the Chikara Japan Income and Growth fund and trust

Japanese large-cap stocks have delivered strong returns over the last couple of years, with the Nikkei continuing to power forward.

While we expect to see more upside at the larger end of the market, we also believe Japan’s long tail of smaller-cap stocks now offer some unique opportunities.

A lack of benchmark representation and analyst coverage means these names have not experienced the same level of outperformance as their larger peers in recent times.

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Investors can gain exposure to the very best this overlooked end of the market has to offer by taking a selective, active approach to asset allocation in Japan.

More upside than large-caps

Small caps have underperformed large caps at an increasing rate throughout Japan’s bull market of the last few years, which isn’t necessarily surprising.

Large-cap stocks make up a much larger portion of the index, meaning they tend to enjoy the greatest share of passive investment flows – particularly among global investors defaulting towards benchmark names as they look to secure exposure to Japanese equities.

At 36%, large caps in Japan have the highest percentage of foreign ownership, followed by mid caps with 28% and small caps with 12%.

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Likewise, large caps are also by far the most well covered Japanese stocks, with 100% being covered by an average of 15 analysts. In comparison, just 42% of small-cap stocks have any sell-side coverage at all, and those that do are covered by an average of just three analysts.

But what does this dislocation mean for investors today?

Japanese large caps still have room to grow, but because they have now advanced to higher valuations, they could present less upside than they did a few years ago and attractive entry points are becoming more difficult to find.

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Small caps, on the other hand, have a great deal of re-rate potential yet to offer because they have been somewhat forgotten as the market has lifted.

Valuations among Japanese small caps have actually fallen over the past decade. From just below 16x in January 2015, the 1-year forward estimated P/E ratio of the Topix Small index currently sits at 11.2x.

Similarly, while the 12–month forward P/E gap between small caps and large caps has narrowed from 12.2% in Japan recently, small caps are still trading at a considerable relative discount of 9.9%.

Investing beyond the large-caps

Investors can take advantage of the small-cap discount by embracing an all-cap approach to investing in Japan.

Uncovered stocks residing beyond the benchmark can offer valuation opportunities on the market. They can also provide access to compelling opportunities for shareholder return growth.

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Around 44% of the 51 large-cap Japanese companies listed on the Topix currently yield more than 2.5%. That increases to 69% for the 1,192 small-cap stocks listed on the index – a lot of potential upside for diligent bottom-up investors willing to do their research.

All-in-all, the Japanese market remains solid with plenty to look forward to as policy normalisation continues to unfold and inflation persists.

To generate the greatest returns possible against this backdrop, investors must embrace the entire market cap spectrum rather than limiting themselves to the larger end alone.