2024 Opportunities in Japanese Small-Caps

The Portfolio Managers provide their thoughts on wage increases, book value improvements, and the rebound in tourism. They also possible acquisition candidates in the Fund, potential acquisition candidates, and their bullish outlook.

April 2024
  • Tadahiro Fujimura
    Tadahiro Fujimura, CFA, CMA
    Portfolio Manager
  • Takenari Okumura, CMA
    Takenari Okumura, CMA
    Portfolio Manager

What do you expect in terms of wage increases during the spring negotiation season in smaller domestic companies in Japan?

Significant wage increases are occurring in succession at large corporations, and it is expected that mid- and small-cap companies will also see some degree of wage increase. As wage hikes become more substantial, the disparity between companies, depending on their ability to hire and pass on costs, is expected to widen further.

Of Japanese companies with a book value of 1x, what actions are they taking to improve their book value?

About 45% of the companies in the Tokyo Stock Exchange are valued at less than 1x Price-to-Book (P/B). The awareness of capital efficiency such as return on equity (ROE) was almost non-existent a decade ago. Indeed, this was one of the main reasons for the prolonged under-performance of Japanese equities post-1989 bubble burst.

In recent years, we have begun to observe changes. Since the start of the corporate governance reforms in 2014-2015 under Abenomics, corporate management has come to embrace the basic concept of ROE or returns on capital (ROC) as a key determinant of financial performance. This is evident from the fact that these terms are now frequently used in Investor Relations (IR) materials and annual reports today.

Approximately half of companies trading below book value have disclosed their countermeasures and are showing a proactive stance towards discussions with investors. This leads to positive developments such as the withdrawal from unprofitable businesses and balance sheet reform.

 How are domestic companies taking advantage of the rebound in tourism?

Department stores and hotels are typical examples, where high-end consumption is thriving, partly due to the benefits of a weaker yen. Despite rising operating costs, such as labor and utilities, the hotel industry is actively increasing its Average Daily Rate (ADR), which is improving profitability. We believe this environment contributes to Japan’s escape from deflation through the rise in service prices.

Given the improving macro environment in Japan, what sectors currently look attractive and which sectors are you avoiding for the Hennessy Japan Small Cap Fund?

We are paying attention to the improvement in profitability in industries where a price pass-through was considered challenging, such as transportation and rental services. Additionally, demand for construction and domestic capital investment remains strong, and we believe that construction companies will continue to improve their profit margins through selective order acceptance. However, in the context of increasing geopolitical risks and the higher volatility of commodity markets, we maintain a cautious stance towards market-related companies.

Would you provide examples of Fund holdings that could be considered merger and acquisition (M&A) candidates?

NEC Networks & System Integration Corporation and Nihon Kohden Corporation are two such examples.

NEC Networks & System Integration is a telecommunications construction company under the NEC umbrella and a subsidiary of NEC. The company continues to grow by leveraging its customer network developed through telecommunications construction and expanding its high-value-added service business. For NEC, NEC Networks & System Integration Corporation plays a crucial role within the group business, and there could be a chance of it becoming a wholly-owned subsidiary.

Nihon Kohden Corporation is a medical device manufacturer that leads with a 50% share in Japan for biosignal monitors. With the rising need for improved productivity among medical professionals, the company is expanding its business in overseas markets, including North America. In December 2023, it was revealed that ValueAct Capital held over 5% of the company’s shares. This indicates the growing attention from strategic buyers towards companies with high product competitiveness and potential for overseas growth, making the possibility of an acquisition not negligible.

How have the Fund’s holdings have been affected by the depreciation of the Japanese yen?

Primarily in the manufacturing sector, there has been a positive impact from the weaker yen. The easing of supply chain disruptions and the recovery in production volumes, combined with profit margin improvements due to the weaker yen, have led to a boost in current period performance. For consumer-related companies like apparel, the weaker yen is negative as it directly leads to increased procurement costs. However, the companies held by our Fund have been able to maintain their profit margins through price pass-through and controlling sales promotions.

What is your outlook for domestic small-cap Japanese companies?

We anticipate profit growth for small-cap companies will continue as delayed price pass-through progresses. Furthermore, we expect improvements in the consumption environment due to a positive shift in real wages and a recovery in service demand. We assume the Japanese economy will remain relatively solid, and thus, we continue to maintain a bullish outlook.