Japanese Small-Caps’ Earnings Resilience and Improving Returns on Capital

Key Takeaways

» Several factors supported Japanese small-caps’ outperformance versus their larger peers in 2025 including lower tariff exposure and attractive valuations.

» A pro-growth fiscal stance and a revision to the corporate governance code could be positive for Japanese domestic companies in 2026.

» Consumer spending habits reflect a structural shift driving bifurcation between essentials and discretionary spending in the retail sector.

» The portfolio underwent targeted adjustments to capitalize on shifting opportunity potential and attempt to lock in gains.

» Amid Japan’s shift to inflation, we see a widening gap in operating conditions and a focus on capital efficiency, reinforcing long-term earnings resilience and improving returns on capital.

» We believe Japan’s economic shift to inflation and ongoing corporate governance reforms will remain key themes throughout 2026.

Would you please summarize the trends that drove the outperformance of the Russell/Nomura Small Cap™ Index over the TOPIX in 2025?

The Russell/Nomura Small Cap Index outperformed the TOPIX due to both the small-cap size effect and the outperformance of value stocks. Factors that supported small-cap performance included limited impact from tariffs and exchange rate fluctuations compared with large-cap stocks, an expansion of corporate governance reforms to smaller companies, and attractive small-cap valuations.

Additionally, the small-cap index has a higher weight in value stocks relative to large-cap indices, which also contributed to its relative outperformance — as small-cap value names performed well, even though small-cap growth stocks significantly underperformed.

Would you please discuss the new administration’s policies that may positively affect Japanese domestic companies?

With the election of Prime Minister Sanae Takaichi, we expect the new administration’s policies will be positive for Japanese domestic companies. The administration will be taking a pro-growth fiscal stance, with Takaichi expressing a firm commitment to revitalizing Japan’s economy. This active fiscal approach, likely involving increased government spending or stimulus, should be broadly seen as good news by Japanese companies, as it could stimulate demand, investment, and overall economic momentum.

We also anticipate a revision to the corporate governance code by mid-2026. As many Japanese companies still hold large cash balances, stronger pressure to improve capital efficiency and returns could become a catalyst for a re-rating and renewed appreciation of Japanese equities.

How are you thinking about the impact of ongoing yen volatility on domestically oriented small-cap companies?

While some investors are concerned that the Takaichi administration’s policies could weaken Japan’s fiscal position and heighten yen volatility, we are not overly concerned about impacts on domestically oriented small-cap companies. Prime Minister Takaichi’s emphasis on a “responsible active fiscal policy” makes reckless fiscal expansion unlikely. Her recent comments on foreign exchange (FX) and interest rates reflect a cautious and pragmatic approach to market management following the Truss shock, the market turmoil triggered by the U.K. government’s 2022 mini-budget under Prime Minister Liz Truss. We view the current yen volatility as short-lived and not likely to have any meaningful impact on the long-term fundamentals of domestic small-cap names.

Would you please discuss your view on retail stocks given consumer spending habits?

Consumer spending habits reflect a structural shift driving bifurcation between essentials and discretionary spending in the retail sector, rather than a temporary phenomenon.

• Essentials: Cost efficiency wins. Consumers show stronger penny-pinching in daily necessities like groceries and household goods. Companies excelling in private-label (PB) development over national brands (NB), or those perfecting store operations, logistics, and delivery for low-price provision, steadily gain share from traditional supermarkets and convenience stores. Price competitiveness stems from holistic operational efficiency, creating enduring structural advantages.

• Discretionary: Premium experiences thrive. Luxury department stores handling high-end goods maintain solid performance, buoyed by inbound tourism recovery. In areas prioritizing experience, quality, and brand over price, firms delivering “value beyond cheapness” gain clear preference. We have initiated new investments in select discretionary consumption names with mid-to-long-term growth potential.

What significant changes were made to the portfolio in 4Q25?

In 4Q25, the portfolio underwent targeted adjustments to capitalize on shifting opportunity potential and attempt to lock in gains.

We initiated positions in financial and real estate stocks previously underweight. Banks were added due to expectations of strong profit growth amid rising interest rates, while real estate firms were selected to benefit from improving market conditions.

Further, we exited positions in stocks approaching target prices after share price re-ratings, focusing on companies advancing capital efficiency through expanded shareholder returns and profitability enhancements.

What trends are you seeing among small-cap companies in terms of improving profitability, cost control, and capital efficiency?

Amid Japan’s shift to inflation, corporate performance shows clear winner-takes-all dynamics. We see a widening gap in operating conditions. For example, small and medium-sized enterprises (SMEs), which make up over 99% of Japan’s economy, face intensifying pressures from rising costs and persistent labor shortages. In contrast, listed small- and mid-cap firms—many affiliated with larger corporate groups—benefit from stronger balance sheets and strategic flexibility. This backdrop is enabling well-managed players to accelerate growth through consolidation, selective merger and acquisition (M&A) activity, and market share gains as weaker competitors exit.

There is also a capital efficiency focus. Continuous price pass-through remains central to margin defense, while divesting low-yield segments supports sharper business focus and improved returns. Governance reform continues to drive more disciplined capital allocation, enabling productive use of cash reserves.

These combined initiatives are reinforcing long-term earnings resilience and improving returns on capital. Stronger small caps appear well positioned to sustain profitability and enhance value creation despite ongoing macro volatility.

As we head into 2026, how do valuations of Japanese small-cap companies compare to large-cap stocks in Japan? What might cause this gap to narrow?

Despite outperforming, Japanese small-cap valuations remain attractively cheap relative to large-caps, both currently and historically. Small-caps continue to trade at a discount to large-caps due to lower profitability and reduced liquidity. These structural factors perpetuate the gap even after recent relative gains.

Ongoing capital efficiency improvements, as discussed earlier, should drive higher investor attention and multiple expansion. We expect these efforts to gradually close the valuation disparity as results materialize.

What is your outlook for domestic companies in Japan in 2026?

We believe Japan’s economic shift to inflation and ongoing corporate governance reforms will remain key themes throughout 2026.

The Takaichi administration’s high-pressure economic policies raise lingering worries about fiscal deterioration, but they signal determination to complete Japan’s re-growth, which may act as a tailwind for domestic stocks. Even industries long plagued by deflationary mindsets should see mindset shifts, creating more re-rating opportunities through profitability gains.

We believe attractive investment opportunities will continue to be uncovered to generate mid- to long-term returns.