Funds: Why you should buy Japanese small caps

Last year Japanese small caps took a terrific drubbing. But this year, as hopes for economic recovery boost markets worldwide, fund managers such as Edwin C Merner of the $2.5bn Atlantis group of companies, and Curtis Freeze, who founded the $600m Prospect Co in the mid-1990s, have clawed their way back.

Japan isn't the only market to have rebounded this year. But there's a reason why now could be a good time to invest in Japan, and small firms particularly. On 30 August, voters ejected the conservative establishment from power, after a 50-year run during which the government had been closely tied to big business and to a vast bureaucracy. This 'iron triangle' of bureaucrats, business and politicians worked wonders for Japan in a distant high-growth era, but then acted as a severe economic drag.

The new government is a reformist bunch, far more allied to small- and medium-sized businesses, of which there are millions scattered over what is still Asia's largest economy. These firms are a feisty lot they've had to survive nearly two decades of economic stagnation, with far less official support than the big firms routinely got from government. Now looks like their time to shine.

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Hank Morris, a north Asia adviser to Hong Kong-based investment advisory Triple A Partners, says: "Japanese small caps ought to be in the driver's seat again for the first time in a long time because the new government will most probably want to show that it is dedicated to doing its best to raising the living standards of ordinary Japanese." The absolute key, says Atlantis's Merner, is that the economy starts growing again, and corporate earnings start to rise.

That growth is, in fact, already happening. Kosai Yutaka of Japan Economic Research (JER) reckons that real GDP growth should be 1.4% in the year to March 2010, from a 3% fall last year. As for profits, it seems they are on the rise again. The JER reports that current profits, which shrunk by 57.8% in the year to last March, are set to rise by 33.8% in 2009/2010.

That process of recovery is being reflected in the performance of small-cap funds. Merner reports that his London-listed investment trust, the Atlantis Japan Growth Fund, rose by 16.3% this year in dollar terms to the end of August, compared with a gain of 9.2% for the Topix. Freeze reports that the Prospect Japan Fund was up a healthy 26% this year, by the end of July. And Tetsuo ('Ted') Tanimura, president and CEO of Tokyo-based Tower Investment Management, says that the group's flagship Tower K1 Hedge Fund, which suffered a loss of 48.3% in 2008, had shot up 82.1% by August this year.

Investors are putting money into Japan again too. The $5bn-plus SPARX group of firms, which has been losing assets month by month, started to see things pick up again in the summer, confirms Masaki Taniguchi, president of SPARX Asset Management.

But all of this happened before the August elections. So will the change of leadership make a difference to the economy? It all boils down to the moodo (a Japanese term for the public mood). Japanese politics may just bumble along with the new prime minister, Yoshio Hatoyama, in charge. But if moodo returns, the markets will capture it. Gerald L Curtis, professor of political science at Columbia University, says the new administration could take up to a year to introduce specific measures to benefit businesses. "There's not going to be a rush to implement overnight." But the mere hope things will get better makes people feel better, and markets duly respond.

That's good news for small companies in particular, reckons Merner. "Japan is now a low-growth economy," he explains. "Most of the big companies are not going to grow very much unless they have most of their sales overseas, [and] most of their production overseas." But "small companies are mostly niche companies and can grow quickly... if properly managed and in the right business, they can do very well indeed". This is what they're saying at SPARX too, a group that has nurtured small caps since its inception by Shuhei Abe in 1989. The small caps research whizz there, Tadahiro Fujimura, presents visitors to the Tokyo head office with a multi-coloured chart. It shows that there are 3,283 small-cap companies in Japan, with a market value of 48trn ($521bn) as of 30 June 2009. That space contains countless "hidden investment opportunities", says the chart.

Many of these companies are too small for institutions to buy. But there's money to be had, if an investor or fund manager is willing to scale down their expectations. Many of the small-cap firms, observes Freeze, are run by men in their 70s and 80s. "Every business day of the week a company president dies at a listed firm," he notes. So mergers and acquisitions (M&A) opportunities abound. Japan just has "too many companies", says Ted Tanimura. And despite deal volumes falling year on year so far in 2009, Japan was the leader in M&A within the Asia region during the first quarter, according to The Wall Street Journal. With all this in mind, both the Atlantis (LSE: AJG) and Prospect (LSE: PJF) funds look good, particularly as they trade on hefty discounts to net asset value of 18% and 27% respectively.