Talking Points. 1. Japan Small Cap outperforms All Cap and Large Cap over the long term

Transcription

1 Talking Points October 2016 Author: Takahiro UENO Senior Product Manager Japanese equities: Small is Beautiful Summary By investing in Japanese Small Cap equities, you could potentially get higher alpha relative to Large Cap, because: 1. Small Cap outperforms All Cap and Large Cap over the long term 2. Small Cap market return is generally less volatile 3. Small Cap market is less efficient, hence a goldmine for higher alpha.and now is a very good time to enter the Small Cap market 1. Japan Small Cap outperforms All Cap and Large Cap over the long term As the graph below shows, the 10 year returns to September 2016 of different market caps diverge over time and ultimately Small Cap* leaves Large Cap* behind by some margin. Source: FactSet, DSBI as at 30 September 2016 *Please note: in this article Large Cap refers to companies with a market cap >JPY10,000bn; Mid Cap >JPY1,000bn; Small Cap >JPY200m; and Micro Cap <JPY200m 1 P a g e

2 The table also shows significant outperformance over 5 and 10 years and similar returns across different market caps over 3 years. Return 1Y 3Y 5Y 10Y TOPIX -4.15% 17.77% 92.86% -0.98% TOPIX % 14.00% 89.65% % TOPIX Small -1.14% 24.55% % 25.96% Source: FactSet, DSBI as at 30 September Japan Small Cap market return is generally less volatile Source: Bloomberg, FactSet, DSBI as at 30 September 2016 The above graph shows that the outperformance of Japan Small Cap over Japan Large Cap does not come at the expense of higher volatility. Large Cap is often more sensitive to the macro economy and to external (non-domestic) events, and active foreign investors market participation adds extra volatility to its performance. This is not the case for Small Cap, as the majority of these stocks are domestically oriented, and the liquidity of the Small Cap market is considerably lower than the Large Cap market (see next section). In summary, the above data suggests that you can get better risk-adjusted returns from the Small Cap market than the Large Cap market. 2 P a g e

3 3. Japan Small Cap market is less efficient, hence a goldmine for higher alpha Source: Nomura Securities, as at 30 September 2016, others include TSE 2 nd section, TSE Mothers, JASDAQ, etc. Based on the TOPIX indices, there are only 500 stocks in Large and Mid-Caps. Whereas there are 3,144 in Small Cap and off-benchmark (Small/Micro Cap); Small Cap represents 86% of all listed stocks. However, Small Cap representation comes down to less than 20% on a market capitalisation basis and this drops down further to about 10% on an average daily trading volume basis. Hence, not surprisingly, the number of sell-side analysts that cover Small Cap stocks is small (see below). Source: Nomura Securities as at 30 September 2016, others include TSE 2 nd section, TSE Mothers, JASDAQ, etc This in turn means that, with limited sell-side analyst information, the only way to identify alpha generating stocks is to carry out your own research. This provides active managers with an opportunity to shine by getting their feet on the ground and truly understanding these businesses, how they operate, and where there is crossover between them; thus providing a truly holistic view of the market that cannot be obtained through research alone. With comparatively few managers or analysts undertaking this work, alpha can be higher for Small Cap when compared to Large Cap, because of much greater market inefficiency.. 3 P a g e

4 The following 3 charts show cumulative information coefficient (IC) of TOPIX 100 and TOPIX Small between 2004 to July 2016 for some well-recognised valuation and earnings related factors. Source: DSBI, Toyo Keizai as at 31 July 2016 *Using recurring profits in Japan GAAP as earnings It can be easily observed that the IC numbers of TOPIX Small are above those of TOPIX 100, which support our earlier statement that the Small Cap market is less efficient than the Large Cap, hence more alpha opportunities exist. A crucial part of this is obtaining an accurate earnings forecast from the companies management. As the chart below shows they can often swing quite wildly in comparison to Large- and Mid-Cap companies. Note: using changes in operating profits in the past 10 years. Calculates frequency of the changes by market cap. Source: QUICK, SMBC Nikko Securities, as at 26 July P a g e

5 Why now is the time to enter the Japan Small Cap market Despite the buzz surrounding Abenomics since late 2012, the Japanese equity market has struggled lately to regain the highs of 2014 despite quantitative easing by BOJ and an expansionary fiscal policy. Admittedly, the Third Arrow of Abenomics, structural reforms, will take longer to materialise than some of the institutional investors would like and as a result some foreign investors who tend to invest in large- and mid-cap stocks have been selling Japanese stocks in recent months. Japanese large cap stocks have seen high volatility mainly due to selling by foreign investors, because the constituents include traditional exporters seen to be affected by foreign exchange rates and mega banks that are adversely affected by the Bank of Japan s negative interest rate policy. The stock prices of these larger global stocks are also affected by the direction of the global economy and other exogenous events such as the Brexit vote in June We are however bullish on domestic demand-oriented Japanese stocks that are not swayed by the activities in other economies and also not largely held by non-japanese investors. Abenomics has outlined a growth strategy that has the potential to benefit the local economy and industries which will be a significant tailwind for Japanese small companies. How can Daiwa SB Investments assist? As mentioned above, when it comes to the Japanese small cap market, it is impossible to overstate the importance of research and company meetings. As the CEO or management team are often the DNA of these companies, one can glean so much more from a company meeting in this sector than compared to meeting an investor relations team from a large-cap company. This is why our small cap portfolio managers insist on meeting every company they are invested in face-to-face. This is where the experience and expertise of our team differentiates us from our competition. In particular we have a multi-award winning fund manager in Mr Nigauri who has over 25 years experience in this sector. Not content to rest on this, he meets roughly 800 companies a year or more than 3 a day to maintain his advantage in what can be a fast-changing sector. Available to assist him is a research team which contains analysts, many of whom have over 20 years experience. The resultant wealth of knowledge and expertise has led our Small Cap Absolute Value fund to achieve annualised returns of 10.18% since inception in April 2004, compared to the TOPIX which has returned just 2.72% over the same period, exhibiting the strong alpha 7.46% on an annualised basis* - that we believe active management can deliver in this space. *Source: DSBI (Tokyo) as at 31 August 2016 Contact Details Yuhki Sophia KING Head of Business Development & Client Relations Phone: +44 (0) yuhki.king@daiwasbi.co.uk Luke BURDESS Business Development Manager Phone: +44 (0) luke.burdess@daiwasbi.co.uk Pierre GIANNINI Business Development Manager Phone: +44 (0) pierre.giannini@daiwasbi.co.uk This document may not be copied, redistributed or reproduced in whole or in part without prior written approval from Daiwa SB Investments (UK) Ltd. The content of this document should not be interpreted as a solicitation for business and is intended as background information for professional institutional investors only. Please contact us should you require further information. Daiwa SB Investments (UK) Ltd. is authorised and regulated by the Financial Conduct Authority.