Seeking diversification? Japan’s smaller companies offer big opportunities.

• Japan’s smaller companies generate a substantial share of their revenues domestically, making them well-positioned to capitalise on the country's improving economic fundamentals.

• A rebound in the Japanese yen from higher domestic rates may provide support for the earnings of smaller companies.

• Japanese small companies have strong balance sheets, making them less vulnerable to rising interest rates and capable of investing in growth to produce higher shareholder returns.

• Unlike large-caps, smaller companies in Japan receive significantly less sell-side coverage, creating opportunities for active managers to uncover mispriced opportunities.

• We project an upside potential of approximately 42% by 2026 for Japanese smaller companies, gauged by the MSCI Japan Small Cap Index. Investors may view smaller companies as a tactical allocation for diversification and the potential for outsized returns.

We have been positive on Japan in light of the structural changes to its economy and stock market. Much of the investor focus has naturally gravitated toward Japan’s largest and most well-known companies, with the Nikkei 225 Index hitting record highs in 2024. As much as these giants deserve attention, it is essential to recognise that Japan’s market offers more than that.

Smaller Japanese companies, often flying under the radar, can represent a tactical complement to large caps. These firms, while less well-known internationally, are benefitting from the same structural changes that are transforming Japan.

A direct beneficiary of Japan’s economic revival

One of the key traits of Japan’s smaller companies – typically defined as those with market capitalisations between JPY 10 billion and JPY 200 billion – is their domestic orientation. Unlike the export-driven nature of several large-cap firms, smaller companies derive a significant portion of their revenues from within Japan, positioning them to benefit directly from the country’s improving economic fundamentals. Based on our compilations of over 1,000 Japanese smaller companies, 70% of them generate all their revenue domestically, while another 18% derive at least half of their revenue from within Japan (Figure 1).

Figure 1: Smaller companies are domestically-oriented

Japan’s economy has been undergoing a structural transformation, marked by entrenched inflation. Coupled with a tight labour market and an ageing population, Japan looks to be a path towards a structural rise in real wages. Firms, which offered the biggest pay hike in three decades in 2024, are expected to maintain the strong momentum this year. Smaller companies stand to benefit directly from rising consumption as higher real wages translate into greater spending power for Japanese households.

A rebound in the Japanese yen from higher domestic rates may also provide support for the earnings of smaller companies. While the BOJ kept rates unchanged in December 2024, Governor Ueda signalled readiness to raise rates if the economy and prices continue to align with the bank’s forecasts. The meeting minutes also showed that some policymakers saw conditions falling into place for an imminent rate hike. Smaller companies tend to rely on imported materials and components. A stronger yen thus reduces the cost of these imports, easing margin pressures and improving profitability.

Solid balance sheets underpin resilience

When one hears the term “small caps”, what often comes to mind are companies burdened by debt. Contrary to this popular belief, Japan’s smaller companies stand out as a notable exception as they tend to maintain considerably strong balance sheets. Years of conservative financial management have led Japanese companies – both large and small – to build substantial cash reserves.

Roughly 60% of Japan’s non-financial smaller companies are in net cash positions. This is notably higher compared to other developed markets, such as the US, where about 40% of non-financial companies in the Russell 2000 Index maintain net cash positions.

With minimal debt obligations, smaller companies in Japan are less vulnerable to rising interest rates. Moreover, their cash reserves provide the flexibility to invest in growth initiatives and increase shareholder returns, whether through higher capital expenditures, increased dividends or share buybacks.

In fact, corporate governance reforms are likely to support growth within smaller Japanese companies. Following its push for higher capital efficiency, the Tokyo Stock Exchange (TSE) has observed significant progress among smaller companies in enhancing their disclosures. The TSE has also adopted a "name-and-shame" strategy for non-compliant companies – an approach that has proven particularly effective in Japan’s corporate culture.

For instance, 96% of companies with market capitalisations between JPY 25 and 100 billion and a price-to-book (PB) ratio of less than one have already disclosed or considered initiatives to improve capital efficiency as of 30 November 2024 (Table 1). This marks a notable 37 percentage-point increase from 31 December 2023.

Table 1: Percentage of companies who are making progress in disclosures

	PB Ratio Less Than 1.0		PB Ratio More Than 1.0
	As of 30 Nov 24	As of 31 Dec 23	As of 30 Nov 24	As of 31 Dec 23
JPY 100 billion or more	98% (n = 298)	78% (n = 293)	91% (n = 495)	46% (n = 482)
JPY 25 to 100 billion	96% (n = 330)	59% (n = 330)	80% (n = 321)	32% (n = 330)
Less than JPY 25 billion	86% (n = 101)	37% (n = 92)	69% (n = 95)	22% (n = 108)
“n” refers to the number of companies within the particular category Data as of 30 November 2024 Source: Tokyo Stock Exchange

Why does this matter for investors? Better capital efficiency can translate to stronger shareholder returns. Based on indices tracking Japanese smaller companies, return on equity (ROE) is projected to continue its upward trend. Higher ROE would support multiple expansion of companies – a driver of share price appreciation.

The MSCI Japan Small Cap Index and the S&P Japan SmallCap Index are expected to see ROE increase from around 7% to north of 8% by 2026 (Figure 2). Meanwhile, the JPX-Nikkei Mid and Small Cap Index boasts a higher ROE of 12%, which is anticipated to remain relatively stable. This is largely attributable to the JPX-Nikkei index's selection criteria, which include factors such as ROE ranking scores unlike the MSCI and S&P indices.

Figure 2: Japan’s smaller companies are projected to deliver higher ROE

Capitalise on mispriced opportunities with an active investment approach

Unlike large-caps, smaller companies in Japan receive significantly less sell-side coverage, creating opportunities for active managers to uncover mispriced opportunities. On average, less than one sell-side analyst covers companies with market capitalisation between JPY 10 and 200 billion. Smaller companies often provide limited investor relations (IR) disclosure, with information not always available in English.

As such, active managers could help to uncover mispriced opportunities in Japan’s smaller companies. Our recommended fund to gain exposure to this segment is the Janus Henderson Horizon Japanese Smaller Companies A2 USD. The strategy invests at least two-thirds of total assets in smaller Japanese companies, which are usually those falling within the bottom 25% of their relevant market by way of market capitalisation or with a market cap of JPY 10 to 200 billion.

From the investable universe of stocks, the investment team typically curates 50 best ideas. They are driven by thorough financial analysis to measure upside potential as well as a deep understanding of company management. To ensure alignment, the team holds regular meetings with senior management, meeting multiple times before taking a position and conducting quarterly follow-ups to validate the investment thesis and adjust position sizes.

The fund has demonstrated consistency in the strength of its returns, which likely speaks to its robust investment strategy and the expertise of its investment team. It delivered excess returns against the benchmark Russell/Nomura Small Cap Index in the last four out of five calendar years. Relative to its peer group, a substantial outperformance occurred from 2021 to 2023.

While 2024 saw a brief setback with underperformance, the fund’s longer term track record remains one of the best in its class, accompanied by a lower maximum drawdown of -31.2% (benchmark: -31.7%, peer average: -36.5%).

Figure 3: Janus Henderson Horizon Japanese Smaller Companies tends to outperform

Attractive valuations suggest potential for upside

Japanese smaller companies are particularly attractive due to their inexpensive valuations. For instance, approximately 45% of these companies are trading at a PB ratio below one.  Moreover, since 2023, the valuation gap in forward PE ratios between large caps and smaller companies has continued to widen.

This divergence in forward PE ratios coincides with the resurgence of Japan’s largest and most prominent companies reflected by indices like the Nikkei 225. Despite benefitting from the same structural changes reshaping Japan, smaller companies gauged by indices like the MSCI Japan Small Cap Index (average market cap of JPY 184 billion) remain underappreciated, currently trading at a substantial 32% valuation discount to large caps (Figure 4). This is notably larger than their 10-year historical discount of 15%, highlighting a compelling opportunity for investors.

Figure 4: Valuation dispersion between small and large caps

In addition, comparing the MSCI Japan Small Cap Index and developed market (DM) peers, Japan’s smaller companies are also discounted (Figure 5). Its forward PE ratio trades at a 14% discount to the historical average. On the other hand, developed market peers – represented by the MSCI Kokusai Small Cap Index which capture small cap representation across DMs excluding Japan – and the Russell 2000 Index trade at a discount of 13% and a premium of 12% respectively.

Figure 5: Japan’s small caps are also attractive relative to DM peers

We believe that Japan’s smaller companies warrant attention for their attractive fundamentals and relative undervaluation. These come alongside positive forward earnings growth, with the MSCI Japan Small Cap Index expected to achieve an average annual growth of 11% through 2026. Applying a fair PE ratio of 17X to the 2026 earnings, we project an upside potential of approximately 42%.

In short, investors may view smaller companies as a tactical allocation for diversification and the potential for outsized returns, complementing large cap stocks which have hit record highs in 2024, to achieve comprehensive exposure to Japan.

Table 2: MSCI Japan Small Cap Index

MSCI Japan Small Cap Index	FY23	FY24	FY25	FY26
Earnings Per Share	7.7	9.5	10.6	11.5
Earnings Growth YoY	-6.1%	22.7%	11.9%	9.1%
PE Ratio	18.0	14.9	13.0	11.9
Upside Potential (based on fair PE Ratio of 17X)				42%
Source: Bloomberg Finance L.P., iFAST Compilations Data as of 10 January 2025

Figure 6: Earnings growth drive share price in the long run

(Related article: Invest in Japan: A structural opportunity with promising earnings prospects)

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the abovementioned securities.