The rally for large-caps was mostly driven by foreign investors who are more inclined towards investing in large-cap names due to familiarity. Smaller caps tend to lag behind in a rally as they are usually domestic companies that support the large-cap names and thus benefit from the trickle-down effect. However, we see more opportunities for them to do better in the longer term as their rally will be sustained by domestic retail investors who typically participate in the market by investing in small mid-cap names, as these are more familiar to them.
In the recent sell-off, small-caps fared better as shown in the graph below. Between 20 May and 5 June 2013, small caps declined only 13.2% as compared to large-caps, which declined 15.3% over the same period.
Small-cap companies have benefited from consumption and capex (capital expenditure) recovery as a result of large-caps doing well. During the rally large-cap companies started to boost the wages of workers, supporting domestic consumption as the workers then had a higher disposable income and spending power. Furthermore, large-cap companies were spending more on capex, which in turn benefited the smaller companies who support them in business.
We are of the view that the recent market correction is healthy as the market did run up too much, too fast, and that the Japanese market will continue to outperform other major markets.
Reasons why we believe that small-caps will continue to do well:
(1) Robust corporate earnings due to a weaker yen: Japan is a mostly export-driven economy and the weaker yen creates a favourable export situation as Japanese goods are now relatively cheaper. Small/mid-cap Japanese companies will continue to benefit as they supply to exporters.
(2) Favourable political environment: due to Abe and Kuroda’s aggressive reflationary policies. We expect that the current ruling party (the Liberal Democratic Party, LDP) is likely to win a majority in the upper house elections on July 21 and hence Abe will have the power to implement his economic reforms for the next three years until the next election. We also believe that the market will react favourably to the victory of the ruling party in the July election.
(3) Increasing participation of Japanese individual investors: Japanese individual investors prefer to invest in small mid-cap companies as these names are more familiar to them. We believe that the momentum of retail investors shifting their assets from savings to the equity market will be accelerated as real interest rates eventually turn negative due to inflation.
(4) Recovery of the US economy: with the strengthening of the US dollar, the yen will weaken and this in turn will benefit the export economy of Japan.
We currently favour stocks that will benefit from consumption and private capex recovery. Over the last couple of weeks, we have seen positive macroeconomic and company data to indicate the recovery in both consumption and private capital expenditure. For example, year-on-year growth for average cash earnings per regular employee rose 0.3% in April 2013, the biggest increase since March 2012. Furthermore, results from the Japan Business Federation’s survey of major listed corporations showed that mid-year bonuses are likely to rise by 7.4% in 2013 — the largest increase for more than a decade since 1990.
Among the top five companies that we hold as of end May 2013, Saizeriya (restaurants operator) is a consumption recovery beneficiary, while Meisei Industrial (construction) and Sumitomo Osaka Cement are private capex related.
In conclusion, we believe in the further upside potential of Japanese small-cap companies and do not expect the market correction to be prolonged. However, it is unavoidable that there would be risks and opportunities as a result of Abe’s reflationary policy, and market volatility might be high. The yen-dollar exchange rate looks to be range bound for the rest of the year, and as it is likely to be the last major country to exit quantitative easing (QE), it will decline in the medium term but at a gradual pace.
Yun Young Lee
Henderson Horizon Japanese Smaller Companies Fund
