Is this the next phase of Japan’s growth story?

The Japanese market has been having a moment. Its recent strength has brought to an end a long period of disappointing returns as the country wrestled with deflation, a sclerotic corporate culture and a stagnant economy.

The Japanese were hailed as one of the masters of modern capitalism in the 1980s – on 29 December 1989, the Nikkei 225 stood at 38,957 – it didn’t exceed 30,000 again until February 2021*. While investors have become rightly sceptical about false dawns for the Japanese market, this time really does appear to be different.

The country’s stock market has outpaced global markets for the year to date, helped by the endorsement of high profile investors, such as Warren Buffett. In fact, 2023 has seen both major Japanese indices, the Topix and the Nikkei 225, hit their highest levels since 1989**. However, amid all the excitement, one segment has been conspicuously left behind – the small and mid-cap sector. Yet this may be where some of Japan’s most interesting growth stories reside.

The MSCI Japan is up 26.4% over the 12 months to 29 September, compared to a rise of 20.8% for the MSCI ACWI***. This is perhaps more remarkable because the MSCI ACWI has significant weights in the technology and consumer heavyweights of Apple, Amazon, Microsoft, Alphabet and Meta****, which have been tearing ahead on the back of the artificial intelligence trend. Outpacing these growth giants is a notable feat.

Yet Japanese small caps have lagged. In particular, a number of the growth-focused trusts have really struggled and none more so than former superstar Shin Nippon. Run by Baillie Gifford’s well-respected Japan team, the trust is now on a discount of 13%^, a steady decline from a near 10% premium in early 2021^^ and its widest level in more than a decade.

The trust’s NAV has fallen 40% over the past three years^^^, but the widening of the discount has made the share price performance even worse. The problem has been that the trust is the punchiest of the growth trusts – a Scottish Mortgage for the Japan sector – and this part of the market has been notably out of favour across the world, but particularly in Japan.

However, it is worth noting Shin Nippon’s long-term performance. In spite of its recent run of weakness, the NAV of the trust is up 140% over 10 years, compared to 108% for the wider sector^^^^. Other trusts in the AIC Japan Smaller Companies sector, which offer a more sanitised exposure to the sector have generally done better in the short-term and their discounts to NAV are less extreme. However, they cannot claim Shin Nippon’s long-term track record, nor the opportunity created by its wide discount.

The best moment for growth?

Shin Nippon manager Praveen Kumar is not notably downhearted: “This is probably the best time to be a growth investor, and I say that because absolutely everyone hates this part of the market. We are explicitly investing in the fastest growing companies run by young entrepreneurs. People don’t want to go anywhere near those types of businesses in the current environment.

“Valuations have fallen to an extent that just seems absolutely bonkers. Companies in the Shin Nippon portfolio are being priced as if they’re going out of business – and we know they’re not.”

He says the rally in Japanese stock markets to date has been focused on dull, ‘old economy’ areas: “Shipping companies, chemical companies, electronic trading companies. It is the businesses of yesterday that have been leading the market. This rally has come from a combination of activism from overseas investors, who have had a lot of success in driving corporate governance changes, and some significant changes in shareholder return policies. But it is tough to argue that these are companies investors would want to own for the next decade.”

In many areas, the market’s analysis is unsophisticated: “For example, the market is making a straight line correlation for the banking sector, saying ‘interest rates are going up, valuations are cheap, let’s have some banks’. Companies that have gone nowhere for 15 years are having their moment in the sun.”

Structural trends

Praveen believes there will come a point when investors start to look more broadly. Shin Nippon is looking at businesses led by dynamic entrepreneurs, and across major long-term themes such as digitisation, the spread of e-commerce, or AI in healthcare. The trust has a big skew to the domestic Japanese economy and he sees areas that are ripe for disruption. The Japanese economy continues to lag in areas such as digitisation or e-commerce, so there is a strong runway of growth.

The trust’s top holdings are eclectic and include, for example, Nakanishi, which makes precision equipment for dental, surgical and industrial products, and Toyo Tanso, which makes carbon and graphite products^. The trust also holds Cosmos Pharmaceutical, a chain of local drugs stores, and Litalico, an educational support services company^. All have their own idiosyncratic growth story.

Praveen adds: “Life insurance, e-commerce, healthcare, digital payments – in these areas, the companies that are driving the disruption are smaller businesses. Larger companies are struggling to protect their turf.” Many of the companies in which he invests have leaders that have trained overseas, “they have seen how things can be done with a bit more dynamism.”

The problem, for the time being, is that no-one is interested. While Japan is drawing interest from international investors, it remains focused on larger index heavyweights. However, for the contrarian, there is increasing value emerging in this part of the market. Praveen believes this won’t go unnoticed indefinitely.

He adds: “Even domestic investors aren’t interested in small caps. It’s a question of time, because those investors are quite valuation sensitive, quite savvy and these small caps are now getting to a level where the value seems really obvious. Once they’ve exhausted the whole corporate governance, activism-type trade in the market, they will start looking for something new.”

Shin Nippon has undoubtedly been a great trust in its time. Baillie Gifford’s Japan team have been considered the benchmark for excellence in Japanese investing, eking out strong returns in a dull market.

Alternatives to consider for Japan small caps

AXA Framlington Japan

AXA Framlington Japan manager Chisako Hardie looks for firms with long-term growth prospects which are independent of short-term news flow or what is going on in the wider economy. The portfolio usually contains around 100 holdings which limits the impact of any one stock. The fund currently has over 42% in Japanese companies worth $3bn or less*^.

T. Rowe Price Japanese Equity 

Manager Archie Ciganer invests in around 60-100 Japanese companies of all sizes, although with a notable overweight to smaller firms. He targets companies he believes can deliver sustainable growth before others see their potential and will adapt his investing style to suit changing market conditions. The fund currently has 15.6% in companies worth $3bn or less*^.

M&G Japan

This is a multi-cap fund where manager Carl Vine looks to understand how a company works; how it generates profit; whether those returns are sustainable; its potential upside and downside; and its value proposition. The team’s differentiated stock-picking approach aims to identify a large, exploitable gap between the price the market ascribes to a stock and its own estimated value of that stock, based on proprietary research. The fund has a slight value bias, with the final portfolio consisting of around 50 stocks. 10% of the fund is currently in companies worth $2bn or less*^.

*Source: Baillie Gifford, The history of the Baillie Gifford Japan Trust, February 2023

**Source: Schroders, Japanese shares have hit 33-year highs – but why?, June 2023 

***Source: MSCI Japan Index Factsheet, September 2023

****Source: MSCI ACWI Index Factsheet, September 2023

^Source: Baillie Gifford Shin Nippon, October 2023

^^Source: FE fundinfo, data at 1 January 2021

^^^Source: FE fundinfo, NAV total return, data from 10 October 2020 to 10 October 2023

^^^^Source: FE fundinfo, NAV total return, data from 10 October 2013 to 10 October 2023

_{Image by yoshitaka2 from Pixabay}