Japan Small-Caps Seen Overheating After Yen-Led Shift

Japan’s smaller stocks surged too far, too fast after investors turned away from larger exporters as the yen slowed its slide, said Daiwa SB Investments Ltd.

Markets overheated as investors shifted into small and mid-cap shares that benefit from domestic demand amid an improving economic outlook, Tatsuro Nigauri, a senior portfolio manager at the investment company, said in an interview in Tokyo on Oct. 25. Construction, real-estate and Internet-game stocks look particularly unappealing, while opportunities remain to buy cheaper equities in other industries, he said.

“Investors are now seeking growth-oriented shares,” said Nigauri, whose small-cap fund was ranked seventh in the nation as of the end of September for five-year performance by Morningstar Japan K.K. “The yen has slowed its decline and overseas economies aren’t as good as we’d hoped. It’s natural then to turn to Japan’s emerging stocks. But the trend has gone too far and I for one won’t be following it.”

While the initial benefits of Prime Minister Shinzo Abe’s three-pronged policy program of monetary easing, fiscal stimulus

and reforms were felt by the country’s big exporters, investor attention has been shifting to smaller companies as the large-cap rally slows. Trading volume on the TSE Mothers Index of emerging companies reached a record in October, according to Tokyo Stock Exchange data, after the gauge surged 30 percent in September.

The TSE Mothers advanced 109 percent this year through yesterday, while the Jasdaq Index, another measure of smaller equities, rose 68 percent. That compares to a 39 percent advance for the Topix. Even after the gains, analysts remain optimistic about the prospects for small-cap shares. Stocks on the TSE Mothers will boost earnings by 95 percent in the next 12 months, compared with a 20 percent increase seen for the Topix index, estimates compiled by Bloomberg show.

Yen Stabilizes

The yen advanced 0.9 percent against the dollar in the three months ended September after weakening 21 percent the previous three quarters. Japan’s currency held steady against the greenback last month, slipping less than 0.1 percent, amid speculation a partial shutdown of the U.S. government would prolong Federal Reserve stimulus and weaken the dollar.

A Topix subgroup tracking carmakers added just 1.2 percent in October, compared to a surge of 28 percent in the last two months of 2012, suggesting larger exporters have lost some of their appeal to investors.

Construction companies may trail the broader market as investor confidence that the government will spend the proceeds from a sales-tax increase on public-works projects is misplaced, Nigauri said. Developers also lack appeal amid the risk of a property bubble, he said.

Fund Returns

Nigauri’s Daiwa SB Japan Small Cap Fund returned 47 percent from its establishment in June 2004 through the end of October this year, assuming reinvestment of dividends, according to data compiled by Bloomberg. That compares to a total gain of 20 percent for the Topix.

The fund had holdings in 83 companies as of the end of September, according to Daiwa SB’s website. Its biggest investments include Asukanet Co., which provides photo-album creation services; Watts Co., a 100 yen store operator; and Step Co., which runs preparatory schools. Asukanet has surged more than seven-fold this year through yesterday, Watts is up 56 percent and Step has gained 20 percent.

The Jasdaq’s rally this year drove its price-to-earnings multiple to 16.1 times estimated profits as of yesterday, compared with 12.2 a year before. The Topix traded at a multiple of 14.8 times yesterday, from 13.8 at the same time last year.

Overlooked Equities

Outsized gains for the TSE Mothers and Jasdaq indexes were led by surges in stocks with larger market capitalizations, with some shares being bought without any clear reason, according to Nigauri. That means there’s still cheap equities that have been overlooked, he said.

Rakuten Inc., an e-commerce site operator that accounts for 16 percent of the Jasdaq, jumped 97 percent this year through yesterday. GungHo Online Entertainment Inc., a gamemaker that accounts for 6 percent of the gauge, surged 553 percent.

GungHo and other online-game companies don’t appeal to Nigauri.

“It looks like the pie for this market is still getting bigger, but the way it’s expanding isn’t stable,” he said.

Bigger gains on smaller Japanese stocks come with wilder share swings. The 100-day historic volatility for TSE Mothers stood at 48.38 yesterday, more than twice the 21.79 level of the Topix.

Nigauri worked as an analyst at Daiwa Institute of Research Ltd. before joining Daiwa SB in 2002. He started managing the small-cap fund in 2003.

“Finding good small-cap stocks is a process of elimination,” he said. “You have to start by picking the ones nobody is excited about, the ones that haven’t risen. That’s the logic of this type of investment.”

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