There are approximately 3,700 stocks listed on the Japanese stock markets in total. Among them, as many as 3,500 stocks can be categorised as small or mid cap, if we draw a line at a market cap of 300 billion yen ($3.5bn). These companies spread across a wide range of industries from agriculture to the internet.
This vast number and their variety not only offers a wide selection of investments, it is also the main cause of the ‘inefficiencies’ observed in Japanese small and mid cap stocks. There are simply too many companies for investors to follow. Stocks will lanquish at low valuations, unnoticed by investors. As an example of information inefficiency, let us look at the average number of so-called sell-side analysts covering Large, Mid and Small Cap stocks. According to our analysis using Bloomberg data, the average number is 15.4 for TOPIX 100 Large Caps and 7.5 for TOPIX MID 400 stocks. However, there is just 1 analyst covering the TOPIX Small stocks on average, and the figure is a mere 0.3 for the JASDAQ! This means the majority of the stocks listed on the JASDAQ are not covered by any analyst at all.
The inefficiency might have been amplified by the prolonged stagnation in the Japanese economy. It is worthwhile to note that many foreign-owned brokers and investment banks have closed their Japanese operations in recent years. So the current research gap is even wider than normal. It presents a lucrative investment opportunity for investors, especially for those applying research-oriented active investment styles.
Small and mid cap stocks are undervalued compared to large cap stocks in Japan. The average PERs for TSE1, TSE2 and JASDAQ are 15.8x, 12.4x and 13.2x respectively. Likewise, average PBRs are 1.04x, 0.63x and 1.13x respectively. The figures for JASDAQ become substantially lower if we exclude the few larger cap stocks. By global standards, PBR valuations for Japanese stocks seems unreasonably low.
PER valuation, however, does not indicate clear difference at the moment. Average PER of TSE1 is more or less in line with those of the U.S. and European markets and average PER for TSE2 and JASDAQ look marginally lower than those of the U.S. and European peers, though the difference is not significant.
Let us take a closer look at PBR and PER for Japanese stocks in relation to their market cap. The table shows the percentage of the stocks with PER below 10x and PBR below 1x by the size of market caps.
For stocks with a market cap of less than 100bn yen, the percentage of these low valued stocks are quite large and more importantly, it gets larger as the market cap goes down. The companies with PER below 10x account for a quarter of the total. Among the groups with market cap below 10bn yen, the companies with PER below 10x amount to as much as 30% to 40%.
If you look at the PBR, the relative undervaluation of smaller caps compared to larger ones is even clearer. There is, however, one thing I would like to draw your attention. This relative undervaluation in PBR is partly due to the fact that these small cap stocks tend to have high level of own equity capital ratio compared to larger ones. If you look at small & mid cap stocks as a whole, ROE is lower than larger ones and hence PBR is lower.
Considering this fact, it would not be enough to simply buy overall small cap stock market in order to achieve good investment performance. For a talented and skilled active investment manager, however, this small & mid cap stock market, with its inherent inefficiencies, offers abundant opportunities to find unnoticed excellent investments.
Lastly, I should not forget to mention positive developments. Even in the small & mid cap segment, many companies are serious about improving profitability by cutting fixed costs. They are using their capital more efficiently by M&A, share buyback, and increasing dividend payout.
One of the characteristics of the Japanese industry is a pyramid-shaped hierarchy, which can complete the production chain from materials and parts to manufacturing and assembly within the circle of Japanese companies in most cases. The potential negative side of this industry structure could be that the large companies are slow in adopting global supply chain management, beyond the confines of their formalised ‘business group’ (keiretsu). This, however, illustrates that companies big and small have a high level of product quality and technology which is competitive in global markets. It is the technology of Japanese small companies that supports the multinationals such as Toyota and Panasonic. Also, many of these small companies have high market share in their products, even though their markets might not be so large in size. These companies often enjoy excellent profitability.
Many Japanese small companies, especially in manufacturing sectors, have already set their business targets in Asian markets. Revenues coming from Asia ex Japan have been increasing for these companies, and we expect to see increasing numbers of Japanese small companies significantly benefit from Asian growth.
Once they step into Asia, the boundaries of ‘keiretsu’ will not be as limiting as they are in Japan. In Asia, many Japanese small cap companies enjoy more freedom in dealing with various counterparties in global markets, without the restriction of their business groups.
Even in the Japanese domestic market, which is suffering from a deflationary economic environment, there are still many rapidly growing small companies, which have innovative business models and strategies. Some internet related companies are good examples. The advanced technology and adaptability to different needs is something which have been developed for many years on the vast industrial base in Japan. The proven history of corporate management and sound financial backbone could be a strong competitive edge in winning through the fierce competition in Asia.
Currently, the Japanese stocks, especially small & mid cap stocks are left extremely undervalued affected by slowing global economic growth momentum and strengthening yen. What, do you think, will happen once the momentum of economic growth turns-around? In my view, these stocks are highly likely to show excellent performance in such circumstances. Let’s see who is right.
Shunsuke Matsushima is Head of the Japanese Equity Active Group at Sumitomo Mitsui Asset Management in Tokyo