Considerable Potential in Japanese Small-Caps

Key Takeaways

»    Japan’s wages and prices are rising simultaneously, supported by a recovery in personal consumption and robust capital investment.
»    In response to the recent currency volatility, we are adjusting the allocation between stocks that benefit from a stronger yen and those that perform well in a weaker yen environment.
»    We believe the current impact of tariff increases on the Japanese economy remains limited because Japanese automakers continue to maintain their domestic production systems, and corporate business conditions have remained resilient.
»    Small-cap stocks appear undervalued compared to large-cap stocks, and we believe there are many investment opportunities.
»    The Japanese economy is expected to maintain steady growth due to a recovery in domestic consumption, sustained wage increases, and rising capital and investment to mitigate a labor shortage.

With a focus on smaller, domestically oriented companies, would you please summarize the overall Japanese market in the first half of 2025?   

Japan’s economy is entering a new phase where both wages and prices are rising simultaneously, supported by a recovery in personal consumption and robust capital investment. Although rising prices continue to put pressure on household budgets, consumer sentiment is improving, likely due to declines in rice and energy prices. Capital expenditure remains robust as companies accelerate automation and digital transformation to address labor constraints.

In the Japanese stock market, small- and mid-cap stocks have recently outperformed their large-cap counterparts. For example, the Russell/Nomura Small CapTM Index has risen over 22% compared to the Russell/Nomura Total MarketTM Index, which has increased nearly 17%. This outperformance is particularly evident in sectors tied to domestic demand—such as information and communications, banking, and retail—which have seen notable gains. A key driver behind this trend is the rebound from last year’s sharp depreciation of the yen.

Would you please provide an update on the BoJ’s monetary policy and its focus on sustained inflation?

Bank of Japan (BoJ) Governor Kazuo Ueda continues to emphasize a gradual path toward the 2% inflation target, but he remains cautious in light of persistent global uncertainties, particularly surrounding U.S. trade policy and external economic conditions. Reflecting this prudence, market expectations for additional rate hikes within 2025 have somewhat softened.

Given the recent Upper House election, which reduced the ruling coalition’s majority, it is likely that the BoJ will maintain its cautious stance in the short term. 

Inflation growth slowed in June, and looking ahead, a key question will be whether price increases can shift from being cost-push driven to demand-pull driven.

How does the team assess and manage currency risk, especially as the yen remains volatile?

As a basic approach, we seek to construct our portfolio with stocks that are neutral to currency fluctuations or have limited exposure to them. However, in response to the recent increase in currency volatility, we are adopting a more balanced stance—intentionally adjusting the allocation between stocks that we believe could benefit from a stronger yen and those that perform well in a weaker yen environment. This strategy is designed to mitigate overall currency risk while maintaining exposure to a broad range of market drivers.

What specific policy changes or government initiatives could disproportionately benefit your portfolio?

Policy Changes Regarding the Labor Market

Amid a worsening labor shortage, revisions to the employment insurance system are planned. The aim is to expand benefits to part-time workers who were previously not covered under existing requirements, which could lead to increased labor costs for companies. It is expected that companies will strengthen efforts to focus their workforce on core business activities, accelerating the demand for outsourcing indirect operations. Currently, we have invested in Relo Group, Inc. which operates business process outsourcing (BPO) services related to human resources.

Revision of Logistics-Related Law

The amended Motor Truck Transportation Business Act, which came into effect in April 2025, requires shippers and transport companies to take measures to correct the deeply rooted multi-tier subcontracting structure. Resolving this issue is expected to take considerable time. However, the revision will require shipper companies to work toward logistics efficiency, potentially promoting a healthier industry structure. Expecting improved profitability through proper freight rate adjustments, investments have been made in Fukuyama Transporting Ltd., one of the major truck transport companies.

How are Japanese domestic companies affected by the tariff uncertainty?

The impact of tariff increases is significant, especially on the automobile and auto parts industries that export heavily to the U.S. While the recently announced tariff deal marks progress in Japan-U.S. trade relations, the absence of comprehensive details means that a certain degree of uncertainty persists. We therefore consider aggressive investment in these sectors to carry high risk.

On the other hand, we believe the current impact on the Japanese economy remains limited. This is because Japanese automakers continue to maintain their domestic production systems, and corporate business conditions have remained resilient contrary to expectations.

Japanese automakers are pursuing a strategy of maintaining domestic production while implementing price increases. The automobile industry has a broad industrial base, with supply chains including parts manufacturers playing a crucial role in the competitiveness of Japanese cars. Continued production of competitive products such as hybrid vehicles (HVs) is expected to help mitigate the economic impact through employment retention.

Moreover, the recently released BoJ Tankan survey—expected to be the first to fully reflect tariff impacts—showed an improvement rather than the slight deterioration forecasted, indicating that corporate sentiment remains on an improving trend. Capital investment plans were also revised upward from the previous survey, suggesting that the Japanese economy is maintaining a solid condition overall.

How do the recent pay hikes help Japan’s overall economic growth? How are small companies responding to these wage increases?

The average wage increase rate this spring exceeded 5% for the second consecutive year, indicating that steady wage growth is becoming firmly established in the Japanese economy. Notably, the increase was particularly significant among small and medium-sized enterprises (SMEs with 300 or fewer employees), leading to a narrowing of the wage gap between companies of different sizes. With wage increases becoming more entrenched, consumer sentiment is improving, raising expectations for a recovery in domestic personal consumption, which has long been sluggish.

Furthermore, the process of corporate “survival of the fittest” driven by wage hikes is also a positive trend for the Japanese economy. The exit of low-profit companies from the market and the expansion of market share by highly profitable companies are expected to foster economic growth through healthy inflation.

What significant changes were made to the portfolio in 2Q25?

While investing in stocks in the information and communications sector, where profit growth is expected due to delayed progress in passing on the increased costs to customers along with business value enhancement, we sold retail stocks that had risen in price as well as manufacturing stocks exposed to risks from U.S. tariffs. As a result, the portfolio’s weighting of domestic demand-related stocks has increased compared to the previous quarter.

What is an example of a company looking to bolster its value by improving its profitability or undergoing corporate reforms?

Sankyu, Inc. handles maintenance of chemical plants and large factories, as well as a wide range of logistics services. While it has long operated both plant maintenance and logistics businesses, the logistics segment—characterized by persistently low profitability—has been a drag on overall earnings growth. However, profit margins in the plant maintenance business have improved due to its progress in passing on costs to its customers.

Recently, the company announced structural reforms in its logistics business aimed at improving capital efficiency. This includes reducing fixed costs in its unprofitable China operations. Additionally, shareholder returns have been strengthened to achieve an optimal capital structure, contributing to enhanced corporate value.

Where are you finding opportunity in Japanese small companies?

As a starting point, small-cap stocks appear undervalued compared to large-cap stocks, and we believe there are many investment opportunities. In particular, corporate governance reforms in the small-cap market are still in the early stages. As a result, there is considerable potential for stock prices to be revalued through initiatives such as business portfolio streamlining, strategic focus, and balance sheet restructuring.

From a fundamentals perspective in the services sector, we are focusing on profitability improvements driven by companies’ ability to pass on increased costs to their customers. While price increases have already advanced in areas like food and consumer goods, many service industries have yet to fully reflect rising costs in their pricing. Given the worsening labor shortage and upward pressure on wages, it appears inevitable that companies will need to increase their prices. We expect profitability to improve as companies with strong market positions lead price revisions. This should accelerate a “survival of the fittest” dynamic within industries, with more competitive firms gaining market share and enhancing margins.

What is your outlook for the rest of 2025?

While tensions in the Middle East have recently shown signs of easing, global geopolitical risks remain elevated due to ongoing uncertainty surrounding U.S. tariff policies and limited clarity following the announcement of the Japan-U.S. tariff deal.

Despite these external risks, the Japanese economy is expected to maintain steady growth. This outlook is underpinned by a recovery in domestic consumption, supported by sustained wage increases, along with rising capital and technology investment aimed at mitigating the effects of a worsening labor shortage.

In this context, Japanese small- and mid-cap stocks are becoming increasingly attractive relative to their counterparts in Europe and the U.S. This is driven by more compelling valuations, ongoing progress in corporate governance reforms—particularly in areas that have lagged behind large caps—and improving capital efficiency.

We will continue to take a bottom-up approach, focusing on identifying investment opportunities that may be overlooked by the broader market.