Industry Voice: Finding growth in Japanese small and mid-cap companies

The sustained growth of Asia and Japan's increasing integration with the rest of Asia is what makes Japan's equity markets attractive. From our 20 years' experience of investing exclusively in Asia, we have deepened our conviction that Japan's ties with the rest of Asia are becoming stronger.

That relationship has changed substantially. Once, Asia was considered as a low-cost manufacturing hub for Japan's global brand titans. Labour was cheap but low wages meant few Asian economies were big or rich enough to be considered as important end markets for goods. The rise of the middle classes has changed all that. As incomes rise, consumers are eager to seek out the quality, yet now affordable, branded goods that Japan excels at. With Asian growth expected to outpace that of developed Western markets, the opportunity for corporate Japan to benefit from its integration with the rest of Asia has a multi-year horizon.

It's important to look beyond Japan's global titans. For the last 15 years or so, most Japanese equity investors have considered the market as a "large-cap value" play, investing in big names at low prices. But we believe the market still represents an element of value on a price-to-earnings and price-to-book basis when compared with American and European peers, although the gap has been significantly closed in the recent Japanese market rally. Importantly, active Japan investors can find many long-term growth opportunities across the market-cap spectrum.

We look for growth irrespective of company size. Japan certainly has some global champions, but there are many undiscovered companies to invest in, besides the titans. Japan's lost decade depleted the talent pool of analysts covering Japanese small-cap and mid-cap companies.

Sell-side analyst coverage is patchy, with a larger number of companies worth US$3 billion or less covered by just one analyst or no analysts at all. Less coverage leads to more undiscovered gems lower down the cap scale.

International investors have powered the Japanese equity market rally since Prime Minister Shinzo Abe unveiled "Abenomics," or his monetary, economic and reform policies to drag the economy out of deflation. Against a backdrop of weakness in global markets, Japan's equity markets corrected sharply over the past two months. Japan is not immune to sentiment and in other markets; small caps tend to fall fairly hard and fast in such circumstances. That may be the case for some smaller Japanese companies, but not necessarily for all. In our experience, quality, steadier growth stocks that do not attract much attention on the way up tend to fall less hard on the way down, particularly if foreign ownership levels are low.

Given the increasing importance of Asia as a market for Japanese goods, the slowing economy in China is a direct issue for many firms. However companies that operate in China in the consumer-orientated space continue to do fairly well. Chinese wages are rising at 10% per year, as are retail sales. Other areas of the Chinese economy are genuinely slowing. Having been a good source of investment ideas, the Japanese automation sector faces a tougher sales environment as capital goods investment is scaled back. The Chinese auto industry was a good customer of niche Japanese robot manufacturers until recently. Over-capacity has led them to scale back their expansion plans; Japanese machinery exports are already in retreat.

Governance is a perennial question mark for investors in Japan too. The situation is improving year-on-year, recently nudged along by the country's new corporate governance code. Small-cap and mid-cap governance levels are often surprisingly high in our experience, as many firms are relative newcomers to the market and far more attuned to shareholder values.

Investors need to focus on the long-term potential of companies that will continue to grow over the next five years. I believe the prospects for select Japanese companies remain strong. Long-term investors should have some patience and let the evolu¬tion play out.

For our latest perspective on investing in Japan, visit global.matthewsasia.com/japanfund

For institutional/professional/eligible counterparty use only.

_{The views and information discussed in this article are as of the date of publication, are subject to change and may not reflect the writers' current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. Investing in international and emerging markets may involve additional risks, such as social and political instability, market illiquidity, exchange-rate fluctuations, a high level of volatility and limited regulation. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation, but no representation or warranty (express or implied) is made as to the accuracy or completeness of any of this information. Matthews International Capital Management, LLC ("Matthews Asia") does not accept any liability for losses either direct or consequential caused by the use of this information.
BY074}