Yes. We believe the underperformance of Japanese small-cap stocks in recent years will reverse, boosted by attractive relative valuations, stronger balance sheets, and growing pressure from shareholders and regulators. Further, we expect active managers are unusually well positioned to take advantage of the opportunity, given the limited sell-side coverage of small Japanese companies relative to other markets and the performance they’ve generated in recent years.
Japanese small-cap stocks have underperformed a variety of assets in recent years. The MSCI Japan Small-Cap Index returned an annual 2.1% over the past three years, while the MSCI Japan and MSCI World ex Japan indexes returned 5.5% and 14.8%, respectively, in local currency terms. That underperformance widened the valuation discount of the asset class. The MSCI Japan Small-Cap Index’s price-to-book ratio of 1.1x is in line with its historical median, compared to an elevated 2.2x for the MSCI World Small-Cap Index.
This valuation discount has opened up despite Japanese companies generating similar levels of profitability versus international peers. The return on equity (ROE) of Japanese small caps for calendar year 2020 was around 4.5%, below its long-term median of 5.3. However, many global peers also struggled due to the COVID-19–related downturn. US small caps generated a ROE of just 1.1% last year, compared to a long-term median of 7.7%. Disguised in these statistics is that Japanese small-cap companies run much lower levels of leverage than US equivalents. Long-term debt to assets is about 20% for Japanese small caps, roughly half the US equivalent.
Healthy levels of profitability, moderate leverage, and stagnant share prices have not gone unnoticed by equity investors. A variety of activist hedge funds, as well as traditional long-only funds have engaged Japanese companies in recent years. According to Lazard, in 2020 Japanese corporate boards received nearly 60 formal proposals from shareholders concerning areas such as balance sheet management and governance, almost twice the level in 2019. Meanwhile, the composition of boards is changing, potentially making them more receptive to such proposals. According to the Royal Bank of Canada, around 50% of Japanese companies now have boards that consist of at least one-third independent directors, roughly double the level from four years ago.
The Japanese government and significant stakeholders like the Japanese Government Pension Fund (which has boosted its allocation to domestic equities to 25% of overall assets) are also aligned in pushing for stronger shareholder returns. The Corporate Governance Code was revised again in March 2021 (calling, among other things, for more English language disclosure and additional outside directors), and current changes to the composition of the TOPIX Index will encourage companies to increase tradeable shares by reducing cross shareholdings and shares held by long-term partners.
Critics will point out that while shareholder proposals have increased, few have been accepted, and that waning share buybacks in 2020 suggest activist demands are not always heeded. Others may look at the new TOPIX “Prime” Index and question whether membership in a not so exclusive 1,500+ company index confers any real benefits due to passive investments, etc. Macro risks are also elevated, with long-term growth prospects that were already challenged by demographics and COVID-19–related slowdowns.
Investors can hedge their bets by implementing skilled active managers. According to S&P’s SPIVA database, roughly 80% of Japanese small-/mid-cap managers beat their respective index in 2020, and 70% have beat the index over the past five years. One possible explanation for this high share of outperforming managers is that poor long-term performance may have led to reductions in analyst coverage, making the market less efficient. According to SumiTrust, Japanese companies with market caps between $300 million and $3 billion on average only have around three analysts covering their stock, less than half the US equivalent.
In summary, stakeholders including investors, the government, and small Japanese companies themselves are aligned in their incentives to push already respectable levels of profits and shareholder returns higher. Since the summer of 2020, we have recommended an overweight to developed markets small-cap stocks as a way to capitalize on the global economy staging a post-pandemic recovery. While Japanese small caps have lagged within this category, we believe their prospects remain bright.