June 2024SPARX Japan Equity Small & Mid Cap Strategy Undervalued and Overlooked: Why Now is the Time to Invest in Japanese Small and Mid-Cap Stocks

Key Points

In the intricate tapestry of global markets, Japanese small and mid-cap stocks present a particularly compelling narrative. Often overshadowed by their larger counterparts, these stocks offer unique growth opportunities that savvy investors are starting to notice.

The Undervalued Potential

Japanese small and mid-cap stocks are currently in an intriguing position. Despite showing significant growth potential, they remain undervalued compared to large-cap stocks. Over the past three years, while small-cap stocks have been consistently undervalued, they are demonstrating higher profit growth expectations than large-caps going forward. This dichotomy suggests a misalignment in market valuation that could present lucrative opportunities for savvy investors.

Historical Context and Long-term Performance

Historically, Japanese small-cap stocks have not only provided substantial returns but have also outperformed large-cap stocks. This trend is largely attributed to their higher earnings per share (EPS) growth rates. Despite this, the market's hesitance to value these stocks appropriately may stem from a prolonged period of economic stagnation, exacerbated by the impacts of the global pandemic on the Japanese economy.

The Untapped Potential of Japanese Small and Mid-Cap Stocks

One of the most significant characteristics of Japanese small and mid-cap stocks is that they are overwhelmingly under-covered by analysts. This chart shows the analyst coverage ratio for major indices in Japan, the US, and Europe. For the TOPIX Small Index, over 70% of the stocks have no analyst coverage. Additionally, the table below highlights the low number of analyst coverage per stock. This indicates that there are numerous hidden investment opportunities in the Japanese small-cap market.

Economic Challenges and Opportunities

Due to the impact of COVID-19, the Japanese economy has faced significant headwinds led by disruptions in supply chains and a lag in economic activities, especially among small to medium-sized enterprises. Notably, the industrial production has not rebounded to pre-pandemic levels yet, lagging Western counterparts. However, with the pandemic-related constraints resolving and the earnings environment improving, it is expected there is a shift coming that could reinvigorate interest in these undervalued stocks.

Investment Strategies and Stock Picking

At SPARX, our strategy is to actively seek out undervalued stocks that the market has overlooked. Through meticulous bottom-up research, we identify companies poised for growth, focusing on those that can navigate through current economic challenges and capitalize on emerging opportunities. For instance, companies like Tadano have demonstrated resilience and strategic foresight by adjusting their business models to overcome supply chain disruptions and are now poised for recovery.

Case Studies

Tadano, a leading company in lifting equipment, holds an approximately 40% market share in Japan and 20% globally. In 2019, they acquired Demag, a major crane business operator in Germany, aiming to accelerate growth as a comprehensive lifting equipment company. However, the COVID-19 pandemic brought significant challenges, including difficulties in procuring parts and rising costs, which severely impacted their productivity and profitability, leading to substantial profit declines.

It took three years to improve productivity due to the need to find alternative suppliers and redesign products to use substitute components. Additionally, delays in passing on costs further deteriorated their performance. While price revisions were made for new orders, it was challenging to adjust prices for existing backorders, resulting in continued profit margin decline.

By the 2023 fiscal year, supply chain issues were nearly resolved, and Tadano is returning to its original profitability. The remaining challenge is their European business, which is still projected to be unprofitable this fiscal year. However, eliminating these losses alone implies a potential profit increase, providing significant upside potential for future earnings, in my view. Although the stock price has seen some recovery, the price-to-book ratio is still below one time. I believe the stock price will rise with continued performance improvement.

Conclusion

Japanese small and mid-cap stocks offer unique growth opportunities, despite being undervalued compared to large-cap stocks. Historically, these stocks have outperformed against large cap led by higher earnings growth. Companies like Tadano, which have faced significant challenges during the COVID-19 pandemic, are now poised for recovery.

As supply chain issues resolve and economic conditions improve, these stocks would present significant upside potential. At SPARX, our bottom-up research identifies companies ready for growth, making Japanese small and mid-cap stocks a compelling investment opportunity.

Important Disclaimer

This content has been prepared by SPARX Asset Management Co., Ltd. (SAM) for information purpose only. Certain information contains economic trends and performance, however, SAM does not warrant the accuracy or completeness of such information, and accept no liability whatsoever for any direct or consequential loss arising from any use of this content. The views and opinions contained herein are based on then-current beliefs of the authors and are subject to change without notice. Furthermore, it should not be assumed that past performance is an indication of future results. Reference to particular securities and their issues are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell securities. Opinions are based on current market conditions and are subject to change without prior notice.