Macro Events' Effect on Japanese Small-Caps

Portfolio Manager Tad Fujimura provides insights on how smaller or more domestically focused Japanese companies have been affected by the trade discussions, the sales tax increase, increased tourism, and corporate governance.

November 2019
  • Tadahiro Fujimura
    Tadahiro Fujimura, CFA, CMA
    Portfolio Manager

What impact has trade discussions had on smaller or more domestically focused Japanese companies?

Ongoing trade conflicts have been a burden for the Japanese market, both directly and indirectly. Technology stocks are influenced directly by the Chinese technology sectors (e.g., Huawei problems). Both semiconductor- and telecommunication-related sectors, such as smartphones, have also been directly affected.

The Japan Small Cap Fund currently has about 15% of tech-related exposure, which we recently increased from 12%. The Fund has a 6% exposure to auto-related sectors, which are influenced partially by the global economy and partially by U.S.-Japan trade negotiations. We believe these sectors look attractive, considering both earnings momentum and valuations.

What early effects have you seen from the recent sales tax increase?

We believe the impact will be much smaller this time compared to the previous tax hike in April 2014. Like the last time, we expected a pre-tax increase So far by looking at retail data and discussion with related industries, the positive pre-tax impact appeared only for one month in September 2019. This is quite different from the last time in April 2014 when the positive impact started more than six months prior to the sales tax increase, and the negative impact on consumer demand that followed lasted almost for one year.

Therefore, we can expect that the post-tax negative impact will be much smaller than the last time, possibly less than three months at most. The government offered several countermeasures such as a consumer loyalty reward program and exemptions on groceries that will remain in effect for more than six months to support consumption. We will have to be careful about whether consumer sentiment will recover or not when these exemptions come to an end after six months.

Would you please discuss the projected economic impact of the 2020 Tokyo Olympics, in terms of infrastructure spending and increased tourism?

The number of tourists visiting Japan has continued to increase, and it was exceeding the government forecast until the second quarter of 2019. The negative growth occurred last month, however, due to a sharp decline in the number of tourists from South Korea. The overall growth rate should recover toward the 2020 Tokyo Olympics led by other countries such as China and other Asian countries, even if there is no recovery in the number of tourists from South Korea. Looking at the recent development with the Rugby World Cup 2019 in Japan, it seems that many people visited a variety of destinations in Japan, not just major cities or prime tourist destinations. We can, therefore, expect continuous growth in tourism. If we just consider consumption from tourists, the effect from the growth in visitors is about 0.05% of GDP per year.

Regarding infrastructure and construction, the direct demand from the 2020 Tokyo Olympics has already peaked. However, we are very positive on infrastructure-related sectors because the Japanese government has to increase spending to cope with natural disasters such as typhoons and earthquakes, and more generally aging infrastructures. In addition, the valuations of related stocks are relatively more attractive than other sectors. The Fund has about 26% weighting in companies related to infrastructure and construction. These companies have opportunities to grow in the Asian infrastructure market as well, which is another reason for our investments in them.

How does the corporate governance differ between small-cap Japanese companies and their larger counterparts?

Thanks to the various initiatives set forth by both the Japanese government and Tokyo Stock Exchange, corporate governance became a major issue even among small-cap management teams. Most small-cap management teams have already recognized the importance of capital efficiency, and share buybacks have become very popular among both large caps and small caps. However, the absolute amount of cash holding remains huge and the average return on equity (ROE) of Japanese companies remains lower than that of other countries. We believe this is primarily due to legacy large-cap companies and not to small-cap ones. We think most Japanese companies are now on the track to improve governance.

What surprised you the most so far in 2019? What are your thoughts on the Japanese equity market looking ahead?

I was surprised that consumer sentiment in Japan did not recover this year. We expected the recovery in early 2019 but subsequently became pessimistic about it. We started reducing weights on related stocks and increasing some manufacturers and infrastructure related stocks instead. However, we are not pessimistic about the Japanese stock market. Rather, we are encouraged by the steady advance of the stock market despite challenging environments both domestically and internationally. Under the current market environment, where we can expect a recovery in overseas demand and where low domestic demand has been priced in, we think the supply-demand balance is getting better, and corporate earnings should also get better in the coming few quarters, which should support the market.