1. Investors’ interest in Japanese equities has grown in the last couple of years. Why? Which macroeconomic factors have favoured this trend?
Several factors have contributed to the appetite for Japanese equities. A stable government and improving corporate governance are among the leading ones. Asian growth and, more broadly, changes in consumption patterns throughout the globe, are clearly favouring Japan’s edge in automation and robotisation. The current pandemic is only accelerating this trend and the global economic recovery should boost foreign investors’ appetite for successful Japanese entrepreneurs. Valuations continue to be very supportive in Japan, compared to the US in particular, and despite the pandemic Japanese consumers and corporates remain confident in the future.
2. What about the fundamentals of Japanese companies? Are they encouraging? Have they been supported by certain government measures?
Valuations are generally lower than in other equity markets and the market is also held less by foreigners than in the past. The last three years have seen record outflows and the trend is only just starting to reverse. But investors should remain selective as we see some pockets of overvaluation, mainly in large caps active in robotisation and automation. The government has increased its allocation to Japanese equities in its large pension funds. This has provided the market with an unprecedented buffer. But given that those inflows have been matched by large outflows of foreigners giving up on Japan, most investors haven’t really noticed this structural change in the market.
3. Have there been changes in their ESG mindset?
Yes, a meaningful change. The launch of the Corporate Governance Code in 2015 could be a real, long-term game-changer for Japan, as historically poor corporate governance has been considered a key reason for local companies’ low ROE and global investors’ underweights. Before the introduction of the Corporate Governance Code in 2015, most companies in Japan looked the same in terms of their board structures:
- The majority had either one or two outside directors, who were often not independent;
- Only a small minority of companies had any meaningful presence of independent directors before 2014;
- Very few companies had board committees and almost none had stock incentive plans.
What came first was a sharp increase in the number of independent directors, although the increase was not across the board.
While a majority of companies quickly followed the requirement to have at least two independent directors, there were still many companies that were slow to comply. On the flip side, there was a significant number of companies that quickly exceeded the minimum requirements.
We do believe that companies with good governance have the means to have the right impact on E and S in ESG –environmental and social challenges. That’s the reason why our scrutiny is on G – governance.
4. Taking this into account, why Japanese small caps? What can they offer?
By nature, small caps are less covered by the sell-side, providing seasoned investors with more market inefficiencies and very often higher growth compared to large caps, such as banks and car manufacturers. Japan has managed to maintain an edge in several key industries like robotics and digitalisation but is also constantly adjusting to millennials’ new consumption patterns, like in gaming for example. With domestic consumption growth resuming in several key sectors, this contributes to the revival of Japanese smaller companies. Last but not least, Japanese yen dependency is much lower than in large-cap portfolios given the currency’s bias towards more domestically-oriented industries and business models. Small cap is by nature less cyclical, which is very important during a global slowdown where most countries are looking at protecting their industries.
5. In which sectors do Japanese small caps stand out? Where can you find opportunities?
The Japanese health care system is also highly valued in Asia and we’ve seen increasing health-related tourism over the years. Last but not least, precision instruments and high-end industrials also represent opportunities for seasoned stock-pickers. When investing in small caps we believe opportunities come with innovation and that’s why we think successful fund managers must focus on entrepreneurs with innovative services or products.
6. What are your expectations for this year? Will Japanese small caps continue growing?
We are cautiously optimistic. Hopefully, the pandemic will not last forever, and the path towards global economic recovery could well favour Japanese equities. Smaller Japanese companies continue to represent a large pool of firms where active managers can discriminate between well-managed companies and their poorly run counterparts. The often-limited coverage from the sell side offers countless inefficiencies for seasoned bottom-up stock-pickers. In addition, it provides investors with more domestic exposure to Japanese growth and, more importantly, to innovation.