March 2024SPARX Japan Equity Small & Mid Cap Strategy Beyond Large Caps: Uncovering Value and Potential in Small-Cap Stocks

I continued to increase the holdings in my portfolio companies while selling stocks with rising share prices that no longer seemed undervalued. I also sold stocks that have fundamentally diverged from my initial investment hypotheses. I made several new investments, including a construction-related service provider that has been slow to act due to industry practices but is progressing in passing on prices against the backdrop of solid construction demand and other factors.

The relative performance of small-cap stocks has remained challenging as large caps have led the equities rally, partly due to foreign investors buying Japanese stocks. However, I see small caps as not necessarily inferior to large-cap stocks in terms of corporate performance. Moreover, the small-cap market appears to have relatively more stable performance due to the high proportion of domestic demand stocks amid rising geopolitical risks.

My current focus is on industries with the following characteristics as I seek specific investment opportunities.

• Progress in long-delayed price pass-through

Since mid-2022, companies have frequently implemented price pass-through amid high raw material prices, a weak yen, and rising labor costs. Prices for a wide range of products and services--including food, steel, and accommodation--have increased, driving inflation, and contributing to corporate earnings growth. Meanwhile, rentals and B2B logistics are among the industries that have not sufficiently passed prices through. Still, the trend of improving profitability through price pass-through should spread to these industries as inflation normalizes. Small-caps have lagged in price pass-through compared to large-caps, so I believe that they have much more room for earnings recovery.

• Consumption polarization

Lives have become more difficult in households with low annual incomes due to rising prices, but the wealthy continue their robust consumption due to the wealth effect of high stock prices and the increase in households with two high incomes. This polarization is likely to continue amid inflation normalization. Therefore, performance should remain relatively strong in both the discount store and department store sectors, as the former benefits from consumers cutting back on spending and the latter from high-cost consumption.

• Serving an increasingly severe labor shortage

The labor shortage is a structural issue in Japan, given the declining working population and the long-diminishing birth rate. This situation should become a business opportunity for industries that can help address this issue. Examples include recruitment support services and the IT industry, which helps improve productivity through DX.

• Undervalued stocks in growing semiconductor-related industries

Demand for semiconductor production equipment among semiconductor manufacturers is snowballing against a backdrop of expanding demand for generative AI. Expectations for earnings growth and rising share prices among related stocks are becoming more apparent. On the other hand, the chemical and electronic component companies that supply the consumables to the same semiconductor industry are often undervalued despite their expectations for earnings growth. These stocks should offer significant potential for investment due to how undervalued they are compared to the semiconductor production equipment manufacturers whose share prices have rallied.

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