Japanese small caps going cheap

Japanese small caps have dropped in price in the last two months, following an encouraging start to the year. The small-cap sector now looks cheaper in Japan than in many other markets.

Indeed, far from trading at a valuation premium to larger companies, Japanese smaller companies currently trade at around 70% of their book value. That compares to 1.2 times for the Topix index, the country's broadest equity gauge. By comparison, the Russell 2000, an American small-cap stock index, trades at nearly double the underlying stocks' book values.

After decades when Japanese stocks paid next to nothing in dividends, the yield on Japanese small caps now exceeds 2%. It's nothing to write home about, but earnings are improving and companies are starting to raise payouts. But what's the best way to get access?

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

The Japanese small-cap sector is one that many London-based active fund managers have been specialising in for decades. Fidelity's Japan Smaller Companies fund, for example, has been going since 1984. Exchange-traded funds (ETFs), on the other hand, have only been around for a few years but offer exposure to the same market at a much lower cost.

Active funds focused on the small-cap sector in Japan typically charge around 1.75% in annual expenses. By contrast, two London-listed trackers, iShares' and Credit Suisse's MSCI Japan Small Cap ETFs (LSE: ISJP and LSE: CJPS) charge only a third as much. In addition, active funds may levy an initial charge of up to 5%, however these ETFs don't.

ETFs also hold a much bigger spread of shares than their active competitors. The MSCI Japan Small Cap index contains over 800 smaller companies and the iShares and Credit Suisse ETFs hold around 80%-90% of its constituents.

By contrast, active fund managers investing in the same sector typically hold much more concentrated portfolios, containing perhaps 30-70 stocks. This allows them to move around more nimbly but also leaves room for significant tracking error against the underlying index. The divergence can approach double-digits in individual years. Most index funds, by contrast, should achieve close to the benchmark return, net of costs.

This is one of the areas of the market where it makes sense to follow an index-based approach. So I recommend picking up some Japan small-cap ETFs while prices have dipped.