While we remain confident in the overall longer-term opportunity for Japanese equities, we believe smaller companies present a particularly exciting prospect in the short term.
In their debut single Big in Japan, from the 1984 album Forever Young, German synth-pop band Alphaville, proclaimed: “Things are easy when you’re big in Japan.” They weren’t wrong – well, not if equity market performance over the past five years is anything to go by (and I assume that’s what they were talking about).
Below are the relative performances of small and large cap stocks in the TOPIX index of the Tokyo Stock Exchange. In a shorter time frame, large caps have outperformed their smaller compatriots. But over a 20-year time frame, the reverse is true. “Why the recent outperformance of large caps?” I hear you ask.
Following 30 years in the doldrums, the Tokyo Stock Exchange (TSE) applied a defibrillator to Japan Inc in 2023 and a sleeping giant was awakened. With solid earnings growth and low valuations as the starting point, suddenly Japanese companies were mandated by the TSE to enhance capital returns and improve corporate governance. International investors piled in, with Warren Buffet leading the charge[1].
Naturally the largest, most liquid (and least risky) names were the first port of call for trepidatious international investors returning to a former investing graveyard. The largest companies also tend to have significant overseas operations that have benefited from the currency translation effects of a weak Yen.
So, what now? The Bank of Japan has already started raising interest rates[2] and at some stage this should translate into a stronger Yen. A reversal of the currency effect – combined with stronger domestic economic growth from higher real wage-growth fuelled consumption – should turn attention to the domestic earners, which tend to be smaller companies. As liquidity improves in this part of the market, it could lead to a virtuous upcycle and restore the longer-term trend of smaller companies outperforming larger ones.
Also, last year the TOPIX index declined ~20% over three trading days in what was the second largest drawdown in history[3], due to spooked retail investors and thin seasonal volumes (following the unwinding of the Yen carry trade). This presents an interesting timing opportunity as the rebound in smaller companies since the sell-off has been more muted than larger ones.