Japan's small caps could well be next
Japanese equities have once again captured investors' attention after finally surpassing the highs of the bubble era. Naturally, the primary question for new investors now is whether they have missed the boat or not. From our perspective, the journey is just beginning.
In our view, drawing parallels between these two periods 30 years apart lacks merit as they share few fundamental similarities. In the 1990s, the market was built on very little earnings support as well as unsustainable valuations, buoyed by a real estate bubble. In contrast, today's market rests on a robust foundation of strong earnings and undervalued assets.
Is the Japanese market rally sustainable?
As with any stock market rally, there have been several drivers, the combination of which has caught the attention of global investors and resulted in increased demand for Japanese equities.
The first of these, the transition out of a deflationary environment, has been a long time coming. After decades of trying, it appears the Bank of Japan (BoJ) is finally set to begin its journey to policy normalisation, and the positive impact that will come from a normal inflationary environment cannot be emphasised enough. It is highly likely to drive long-term changes in consumer behaviour and create a virtuous cycle between wages and prices, all of which are positive for the economy and stock market in the long run.
The second key driver, corporate reform, has also been a long time coming. Efforts to improve corporate governance in Japan started just over 10 years ago when the late Shinzo Abe took office in 2012. The past decade has been about setting the landscape for the improvements we are seeing today. The combined effect of the Stewardship Code and the Corporate Governance Code has resulted in a more financially motivated shareholder base. The friendly cross-shareholders, who often protected failing management teams, have made way for a more engaged shareholder.
The coming decade will pivot on leveraging this new landscape to effect change. The Tokyo Stock Exchange (TSE) entered the fray last year, emerging as a potent agent for change. Their message is unequivocal: Japanese companies boast operational excellence but must refine their capital structures. Returns on invested capital often rival the best in class, however the crux lies in how management teams deploy these returns. Historically, they have accrued, dampening returns on equity and yielding subdued valuations.
The TSE's request for companies to implement management plans addressing stock valuations and capital structures is the most significant development in the Japanese equity market in many years. As of now, many companies are formulating plans, and the vast majority will be disclosing them alongside full-year earnings results in the May reporting season.
Japanese large caps have been popular so far; small caps could be next
It is no surprise the Japanese market has attracted attention given these two long-term drivers. It has resulted in international investors quickly increasing exposure and, naturally, they have used the more liquid large caps to do so.
Ironically, the most significant opportunity for reform-driven benefits lies within the small-cap arena, which has underperformed. In our view, this area of the market teems with corporations boasting operational excellence but suffering from financial mismanagement. Unlike some of their debt-laden large-cap counterparts, they often harbour substantial cash reserves awaiting deployment.
As such, while we believe the long-term outlook for Japanese equities is extremely strong, in our view the case for focussing on small-cap, cash-rich companies is even stronger.
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