It is debatable whether Abenomics, the broad policy stimulus launched in 2013, has been successful in firing up Japan’s economic growth. The latest vote seems to be “no”, with an estimated ¥5.4 trillion ($68 billion) flowing out of Japan stocks this year, according to Bloomberg, and the Nikkei 225 down 15.2%. Meanwhile, other major stock indices have recovered from the year’s shaky start.
But Japan is a tale of two markets where smaller companies are growing much faster than its global giants. The Topix 30, home to the likes of Toyota Motor, is barely up over three years. In contrast, the Topix Small Index is up nearly 16% and the wilder frontiers of the MOTHERS or “Market of the high growth and emerging stocks” index, a cracking 26%. With around 3,500 companies worth US$4.9 trillion ($6.6 trillion) listed on Japan’s exchanges, the smaller, unknown sections provide vibrant pickings for Japan’s Small/Mid-Cap Equity funds.
YTD, seven of the Morningstar-classified Japan Small/Mid-Cap Equity funds sold in Singapore are among the top 11 of 31 (unhedged) Japan-only funds. The scenario is the same over a three-year period. This outperformance comes from hunting for high-growth companies that cater to local demand rather than large exporters whipsawed by the yen. Small-cap funds avoid big banks and insurers that are being hit by negative interest rates, preferring instead to scout around in the technology, healthcare, leisure, food and factory automation sectors.
Small/mid-cap funds insulated from global macros
The $162 million PineBridge Japan Small Cap Equity fund, which has been in existence for 22 years, captures these dynamics best. The fund is up this year even as the MSCI Japan Small Cap benchmark has fallen. Over three years, its annualised returns of 15.9% have pushed it to the top 5% of 122 global peers. Its holdings include high beta, micro caps such as biotech maker PeptiDream, up 64.4%; services provider Outsourcing, up 14.6%; and fibre maker Toyobo Co, up 7.6%. Midori Katsumi, head of Japanese small cap equities at PineBridge Investments, says, “The common features of these stocks are sound fundamentals and no (or very little) exposure to global macro conditions.”
The fund takes a bottom-up approach to finding promising businesses and is unafraid of adapting its style when prices catch up. “Outperformance is not static; some stocks have lagged in 2015 and then outperformed in 2016, for example, due to the market’s likes/dislikes of some sectors/styles. As a stock picker, we are able to shift our exposure to the most attractive stocks in terms of fundamentals and valuation at the individual- stock level rather than the market/style/sector level. We also need to be patient over a longer-term investment horizon to wait out fluctuations,” says Katsumi.
The $974 million Parvest Equity Japan Small Cap and $412 million United Japan Small & Mid Cap funds fish in even smaller territory, typically buying companies under $800 million in market value. Both funds keep exposure to banks, Japan’s worst-performing sector to date, at under 2%. Only two years old, United Japan, managed by Singapore’s UOB Asset Management, hit the ground running with the best one-year returns (13.4%) among Japan funds. Twenty year- old Parvest Equity Japan Small Cap, offers a longer track record with top-quartile performances over the short and long haul. Fidelity Japan Aggressive roams a wider spectrum of the market. Holdings average $3.6 billion in market cap and range from $1.5 billion kitchen appliance-maker Zojirushi Corp to $88 billion giant SoftBank Group, an early investor in China’s tech giant Alibaba Holding.
JPMorgan Japan Equity’s secret sauce
The risk with small companies is being stuck in niches that prove hard to scale up from. But the $3.1 billion JPMorgan Japan Equity fund successfully navigates the larger market. Holdings average $10 billion in market cap, comparable to Singapore blue chips. The fund’s performance not only tops the large-cap space, but nudges past half the small-cap funds. With annualised returns of 11.3% over three years, it ranks 57 out of 822 peers worldwide. In the quarter to March when foreign money was stampeding out of Japan, it attracted inflows of $500 million.
Seeking growth outside the Nikkei 225, its holdings include $37 billion drug maker Ono Pharmaceutical Co; $33 billion Oriental Land Co, operator of Tokyo’s Disney Resort; and $13 billion medical information services provider M3. The fund was early, after 2013’s macro stimulus fizzled out, to spot the potential of Japan’s domestic- oriented companies.
“After enjoying the strong performance from these positions in 2013, we have been shifting our focus to undiscovered stock-specific quality growth opportunities in areas such as healthcare, increasing in-bound tourism, factory automation and corporate governance, which have been boosting the fund performance since the second half of 2014,” explains Nicholas Weindling, portfolio manager, JPMorgan Asset Management. Also crucial, he says, are insights from local portfolio managers gathered through extensive company visits and the decision to underweight financials in 2016.
In contrast, the performance of more conservative, value-oriented large-cap funds such as the $376 million NN (L) Japan Equity, $817 million Parvest Equity Japan Classic and $54 million Henderson Horizon Japan Opps sank, in part, on their investments in financial heavyweights such as Mitsubishi UFJ Financial and Sumitomo Mitsui Financial. Auto giant Toyota Motor is a common holding among their top 10 picks. Parvest Equity Japan Classic receives only two stars from Morningstar and has ranked in the lowest quartile over the past three years.
Cost varies by share class
Compared with smaller investors, institutional share classes enjoy lower total expense ratios, with front loads sometimes waived. The trade-off, however, is a much higher initial investment. PineBridge Japan Small Cap and Fidelity Japan Aggressive require US$1 million and US$0.5 million, respectively. In contrast, retail investors in JPMorgan Japan and United Japan need only US$10,000 and ¥100,000 ($1,200) respectively to start off.
Funds that only buy Japanese stocks are concentrating risk in a single country whose macros are in the hands of others. The yen waxes and wanes with global risk aversion set off by China, oil or the weaker dollar. In this environment, small/midcap funds are a hedge; if the yen falls and Japan breaks out of false starts, there are bargains to be had across the board. Large caps will lead the rally, but small companies also gain from a stronger economy. If the yen stays firm, stock-picking growth funds can still prosper.
This article appeared in the Personal Wealth of Issue 727 (May 9) of The Edge Singapore.