Look to Attractively Valued Japanese Small Caps as Japan's Economy Rebounds

The Portfolio Managers of the Hennessy Japan Small Cap Fund provide their thoughts on the new Bank of Japan (BOJ) Governor’s policies, increased tourism, current valuations, changes to the portfolio, and an outlook for the rest of 2023.

May 2023
  • Tadahiro Fujimura
    Tadahiro Fujimura, CFA, CMA
    Portfolio Manager
  • Takenari Okumura, CMA
    Takenari Okumura, CMA
    Portfolio Manager

How could the new BOJ Governor Kazuo Ueda’s policies impact domestic companies in Japan? 

We believe Kazuo Ueda, who started as the BOJ Governor in April 2023, is a flexible person who makes decisions by adapting to the situation. He may modify the zero interest rate policy and yield curve control in an efficient way, which could prove beneficial to financial institutions by normalizing the yield curve. We anticipate the yield curve control to be revised in the second half of this year at earliest or next year to restore market functionality. Moreover, Japanese banks have sufficient funds available for mortgage interest rates, and we do not expect a sudden increase in mortgage rates to negatively impact the housing market or credit.

How has increased tourism in Japan affected domestic companies?

In the latter half of March 2023, there was a rapid increase in the number of overseas tourists, leading to higher hotel occupancy rates and sales recoveries in the food service, retail, and leisure-related industries. We anticipate the recovery of tourism from China is still in its early stages, and that there will be further improvements in the hotel, railroad, and other service-related sectors. We believe the overall domestic demand will continue to be strong, fueled by the construction of hotels and other factors, along with the expectation for ongoing wage increases.

Would you please discuss current portfolio valuations and the Fund’s earnings growth rate as of 4/30/23?

We believe the Fund is attractively priced relative to its benchmark Index. As of April 30, 2023, the Fund’s price to book ratio (P/B) was 1.0x while that of the Russell/Nomura Small Cap™ Index was 1.15x. In terms of price-to-earnings ratio (P/E) for the next fiscal year ending March 2025, the Fund was currently trading at 11.4x earnings, lower than the Index’s 14.4x 

The earnings growth rate of the portfolio is expected to be about 10%, which is at about the same level as that of the benchmark. In other words, the portfolio invests in stocks with the same growth rate at an attractive valuation.

Would you please discuss a new holding added to the portfolio this year and one that was removed? 

We initiated our investment in Onward Holdings Co., Ltd., an apparel company. We expect to see a continued growth in clothing sales on the back of the recovery from COVID-19. The company’s hybrid services, which allow customers to order a wide range of brands of clothing online and then try them on in actual stores before making a purchase, have been well received. That is why we believe the company is ahead of its competitors and its sales keeps improving. We think the effects of the restructuring that has been ongoing for the past three years will manifest themselves in near future, and that sustainable profit growth can be expected post COVID-19.

We sold Sugi Holdings Co., Ltd., a major drugstore operator. While sales increased due to the strong demand for healthcare supplies during the pandemic, we expected sales post-COVID-19 would slow down. Also, we anticipated the government’s drug price reductions would be more severe than expected which could lead to margin shrinkage.

What sectors in the Japanese market might outperform in 2023? 

We expect construction and domestic service-related stocks to perform well as there is still much room for a rebound after COVID-19 and earnings improvement through price pass-through. In addition, we pay close attention to capital investment-related stocks in the medium term as those names could benefit from the supply chain shift despite a short-term risk of currency appreciation.

Would you please provide an outlook for the Fund for the rest of 2023? 

The Fund invests in small and mid-cap stocks and has more domestic-oriented names with attractive valuations compared to larger companies. Since the Tokyo Stock Exchange has recently encouraged companies with a P/B below 1x to improve, share buybacks, for example, have become more prevalent. As 40% of the Fund has a P/B below 1x, we believe these portfolio companies will follow this trend.