SPARX Japan Equity Small & Mid Cap Strategy Uncovering opportunities in Japan's Small & Mid Cap space
Portfolio Manager
Despite the heightened geopolitical risks, I think that many small & mid-cap stocks in Japan can accelerate growth through structural changes in society. I would like to discuss the investment opportunities I anticipate through a focus on three social changes: inflation, corporate governance reform, and manufacturing returning to Japan.
The first change is inflation. After the bubble bust, deflation continued for 30 years in Japan, and the economy remained stagnant. Finally, in recent years, high resource prices and other external factors have triggered a momentum shift toward inflation, and wage hikes are beginning to follow suit. This turnaround represents a monumental change in the Japanese economy and should produce business opportunities for many companies. I am especially monitoring increased investment in productivity improvements. The current wage hikes and labor shortages are directly linked to the need to improve productivity, even at higher costs than before. IT will become more prevalent in office work, continuing to create business opportunities for IT solution providers. Production sites will see increased labor savings and improved working conditions through mechanization. I think that this trend will generate direct business opportunities for machinery manufacturers.
During the long deflationary period after the bubble economy burst, Japanese companies were forced to curtail capital, human, and development investments to generate profits. As a result, the Japanese economy has remained underinvested, becoming less competitive than other countries.
However, Japanese companies have accumulated cash on their balance sheets and ample investment capacity. I believe Japan's productivity will finally improve by utilizing these abundant retained earnings.
I expect that Corporate Governance Reform in Japan would accelerate such improvements. The government formulated Japan's Corporate Governance Code, guidelines for corporate investment, in 2015. However, the reality is that it has not been very well received, especially in the markets with small & mid-cap stocks. Changes began to take place in large measures with the Tokyo Stock Exchange (TSE)'s initiative which requires management to be aware of the cost of capital. The TSE recognized the problem of having more listed companies with P/B ratios below 1x than other countries and requested that all listed companies disclose their policies for increasing corporate value. Japanese society has a powerful sense of uniformity. If some leading companies begin to disclose information, thereby enhancing their reputation, it is highly likely that this trend will gradually permeate the entire market. That should provide investment opportunities, especially for small & mid-cap stocks that have not been active in IR. In response to the TSE's requirement, some companies have begun to formulate medium-term management plans that include ROE targets. I have also had the opportunity to meet with a president of one of those companies to discuss IR, and I am confident about their high growth potential over the medium to long term. Robust IR policies should prove that management considers market participants important stakeholders. Small & mid-cap stocks, many of which are not particularly active in IR, should become more attractive investment opportunities than large-caps.
The final change is manufacturing returning to Japan. Prolonged deflation and a weak yen have made Japan more attractive than ever as a manufacturing base. Additionally, intensifying trade friction between the US and China has created a dire need to diversify manufacturing bases depending on China. The most prominent example is Taiwanese semiconductor manufacturer TSMC's construction of a new plant in Kumamoto. TSMC is also planning to build the second plant in Kumamoto. These plants promise an economic impact of JPY 5-6 trillion including the effects on peripheral industries.
Manufacturing returning to Japan is not limited to semiconductors. It is also spreading to a wide range of industries, including automobiles and industrial equipment, which could be a driving factor for increased capital investment into Japan. Typical examples of industries that will benefit are the construction industry discussed earlier, machinery and equipment, human resource services, and various other industries. Despite the heightened geopolitical risks due to intensifying trade friction between the US and China and other factors, I believe Japan is in a position to benefit from the downstream effects of these risks. Again, I believe that small & mid-cap stocks with a high proportion of domestic demand should remain attractive.
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.
