Three unloved small-caps

Each week, a professional investor tells us where he’d put his money. This week: Nicholas Price, Fidelity Japanese Values.

A rigorous, bottom-up approach can consistently identify companies where the market is underestimating or mispricing future growth potential, or there is a clear disconnect between short-term sentiment and mid-to-long-term fundamentals.

I tend to invest in mid-to-small-cap growth companies, where I can find better business models and returns on equity, and management has greater incentives in terms of shareholder returns. Smaller firms – being relatively young and dynamic – are often able to create their own niche markets and so may be capable of growing their business regardless of the economic backdrop.

Unsurprisingly, the number of sell-side analysts who cover mid-to-small-cap stocks regularly is limited. This means that active managers have the opportunity to unearth under-covered and under-researched companies at an early stage of their development. As a result, the potential for generating outsize returns (“alpha”, in the City jargon) from smaller companies can be much greater than for large caps.

Here’s an example of the type of companies I look for. The fund owns Kotobuki Spirits (Tokyo: 2222), an under-researched confectionery firm that blends regional cultures and traditions into high-quality Japanese sweets and cakes that are distributed across the country for sale as souvenirs.

The firm is making brisk earnings, supported by its strong product-development capability and price increases, as well as the widening of its sales network to include Tokyo central station and international airports. The growth of Japan’s souvenir market, driven by rising numbers of foreign visitors, will support growth over the mid-to-long term.

Another example is Ryohin Keikaku (Tokyo: 7453), which operates the Muji brand of general merchandise stores and is one of Japan’s fastest-growing speciality retailers. Strong brand positioning underpins the stability of its domestic business, which has delivered eight consecutive quarters of double-digit profit growth.

Its overseas operations are centred in east Asia (particularly China), where its product lineup has strong brand appeal among the growing middle-class population. Ryohin Keikaku also delivers relatively high shareholder returns, targeting a payout ratio of 30% and returns on equity in excess of 15%.

I will invest further up the market-cap scale when I find an attractive growth opportunity. One example is Keyence
(Tokyo: 6861)
, a leading producer of sensors and measuring instruments used in factory automation globally.

As increasingly data-intensive manufacturing processes drive demand for sensors and vision systems, Keyence’s highly profitable business model is well placed to deliver sustainable earnings growth. The need for labour-intensive industries to introduce robots and automation is a long-term driver for the company.