Tailwinds that drove Japanese stocks to new highs in 2024 were paradoxically headwinds for small- and mid-cap1 stocks on the Tokyo Stock Exchange. These tailwinds included a weak yen, liquidity, geopolitical tensions and corporate reforms. Some of these factors could change in 2025.
To an extent, Japanese (mainly large cap) equities as measured by the Nikkei 225 benefitted from the rise in the US Federal Funds Rate (FFR), the central interest rate in the US financial market, which rose from near zero as of end-2021 to 5.25% to 5.5% by mid-2023 (Source: US Federal Reserve Bank, July 26, 2023). As US rates reached a plateau in 2024, global investors viewed Japan as an attractive investment destination due to its low interest rates.
The weak yen and low interest rates in Japan attracted liquidity. The differential in interest rates between the US and Japan encouraged investors to borrow in yen, creating an influx of capital into Japan which made their way to Japanese equities.
Secondly, the Japanese government and financial authorities implemented a series of reforms aimed at improving corporate governance and increasing accountability to shareholders. These reforms included stricter listing criteria on the Tokyo Stock Exchange and a focus on enhancing capital efficiency and sustainability practices. Such measures have made Japanese companies more appealing to global investors.
Thirdly, throughout 2023 and into 2024, many Japanese companies reported robust earnings, which bolstered investor confidence and contributed to rising stock prices, supported by economic reforms and a favourable business environment.
Additionally, as geopolitical tensions between the US and China increased, many banks and hedge funds began to divest from the Chinese markets, redirecting their investments towards Japan. While this was initially evident in real estate, it broadened to other asset classes. This geographical shift contributed to the inflow of capital into Japanese equities, enhancing their performance.
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According to Nikko Asset Management (Nikko AM), small and mid-cap stocks have been underperforming large cap2 stocks for a couple of years, impacted by the factors that were a tailwind to big-cap stocks on Japanese exchanges.
For instance, despite the influx of liquidity into Japan, both the weaker yen in 2023 to mid-2024 and the liquidity influx supported larger-cap stocks due to their visibility and higher overseas exposure among local and foreign investors.
“The Tokyo Stock Exchange’s guideline on capital efficiency supported value stocks, especially larger cap stocks, so far as investors expected immediate actions to improve corporate governance,” Nikko AM says. The rally driven by the new tax exemption scheme, the new Nippon Individual Savings Account (NISA), was also a drag on the relative performance of small and mid-cap in early 2024, Nikko AM adds.
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Headwinds to dissipate
These headwinds for the small and mid-cap segment are expected to moderate in 2025, driven by improving global liquidity conditions, a peaking depreciation of JPY and improving corporate governance extended to smaller cap stocks.
Historically, there have been rotations between large and small-cap stocks. The underperformance of small-cap stocks in the last couple of years will likely provide a good entry point, Nikko AM observes.
Despite the relative price underperformance of small and mid-cap stocks, the sectors in the economy represented by these companies are doing well. The small and mid-cap sectors of the market are in a better position to capture the recovering domestic demand and these sectors benefit from the exit of Japan’s lost decades. They have a higher exposure to the domestic market than larger-cap Japanese corporates which tend to be multinational corporations.
Wage growth is expected to drive the economy as more workers are looking to switch jobs putting pressure on companies to raise wages with the aim of retaining talent.
IT services, construction and real estate are likely beneficiaries of a recovery in domestic demand. Sustained wage growth is also expected to filter through to domestic demand through consumption, benefitting the retail sector and consumer goods.
By industry, a variety of growth opportunities abound. These include R&D and manufacture of semiconductors for different forms of artificial intelligence (AI), changing regulations in auto safety and environment by country, and automation. Digitalisation of the economy, sustainability and the green economy are also opportunities for small and mid-cap companies.
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As an example, MODEC, an operator of floating offshore oil and gas production facilities, has performed well and still has room for growth. This company has established a strong position in the industry with its cost competitiveness. It has been increasing projects worldwide by investing capital and orders are expected to continue to increase.
Elsewhere, Nichias, a producer of materials for construction and semiconductors, is also capturing structural drivers such as rising demand for AI chips and R&D on safety measures for nuclear power. Nichias also has its eye on total shareholder return with a target dividend payout policy. Share buybacks are also possible since it has excess cash as a funding source.
Regulatory environment
A key driver to uplift the valuation of small and mid-cap stocks is their potential for improving capital efficiency. More small- and mid-cap companies have the potential for further capital management initiatives than large-cap companies.
“While Tokyo Stock Exchange’s actions are not explicitly targeted at small- or mid-cap companies, one of the reasons the regulators introduced the guidance to call for higher capital efficiency is that too many companies are trading below price-to-book3 of 1x (Source: Bloomberg and Nikko AM, as of Nov 30, 2024) in Japan, many of them being small-caps,” Nikko AM says. From that view, the impact on the small-cap value segment is likely to be larger than for the rest of the market.
“We are starting to see companies with more sophisticated financial targets, and they have much to improve in terms of business operation and capital management,” Nikko AM indicates.
Other catalysts are expected to be specific to the industry and individual companies, as small- and mid-cap stock selections often represent bottom-up investment opportunities, which are focused on analysing individual companies.
Best-placed to identify small and mid-cap stocks
Primarily, Japan’s exit from its lost decades is expected to drive a recovery in domestic demand, where small and mid-cap stocks are more exposed than large-cap corporates. Improving shareholder returns are expected to drive small and mid-cap stocks because the opportunities for higher capital efficiency within this segment are greater than other market segments, with many stocks trading below a price-to-book ratio of 1x.
“We believe there are more undervalued small and mid-cap companies compared to large-cap companies due to a lack of sell-side research coverage. Furthermore, more small and mid-cap companies have excess capital,” Nikko AM says.
Nikko AM covers around 1,000 Japanese stocks, which include small and mid-cap stocks, with expertise that averages 16 years of experience in the Japan equity market. One of Japan’s largest asset managers, Nikko AM’s portfolio managers and analysts have direct access to management teams of companies and they have had over 9,000 meetings in a year, of which around half are one-on-one meetings (Source: Nikko AM, March 31, 2024).
Glossary
1 Market capitalisation indicates the value of a company. Nikko AM defines Japanese small- and medium-sized companies as those with a market cap of about JPY50 billion to 200 billion and large companies as those with a market cap of above JPY200 billion.
2 Net cash to equity ratio refers to cash a company has after excluding debt and divided by shareholders’ equity.
3 Price-to-book ratio: A company’s stock price per share divided by its book value per share. It shows the market valuation of a company compared to its book value.
