After a decade of consistent outperformance, Japanese small caps began underperforming their large cap peers in 2018, a trend that has accelerated since 2023. In fact, Japanese small caps have underperformed the broad Japanese market by 38% since 2018, 1 including 18.5% of underperformance since the beginning of 2023 (Exhibit 1).
We have spent considerable time trying to understand the reasons for this marked shift in relative performance. We have also worked to determine how likely it is for Japanese small caps to revert to their long-term outperforming trend. While small cap fundamentals will play a central role in developments from here, several other factors – mentioned below – will also be important. In combination, we see many reasons to expect they may ignite a new period of outperformance for small caps.
- Forex: Rapid yen depreciation since 2021 boosted overseas income in yen terms significantly, favoring large cap EPS growth over this period. However, the yen is as undervalued as it has been in decades and the widening interest rate differential that has caused it to weaken seems likely to narrow.
- Real wage growth: In 2018, real wages hit a peak of 1.1% and have fallen into negative territory ever since. Because small caps derive 80% of sales domestically versus large caps at less than 50%, they suffer when domestic buying power declines. However, labor and management agreed to 5.1% wage hikes in April, the highest since 1991, and real wages turned positive on a monthly basis in June for the first time in over two years. We believe real wages are likely to continue to rise.
- Fund flows: The BOJ began buying ETFs in 2010. It started slowly and reached a peak in 2018, when it purchased ¥6.3 trillion in total. These purchases were focused on indices such as Nikkei 225 and TOPIX 400, giving larger stocks the advantage. However, fund flows have changed drastically: the BOJ has stopped its ETF purchases. Moreover, individuals, long sellers of Japanese stocks, have stepped in as new buyers since January 2024 thanks to tax incentives to invest in NISA retirement accounts. Individuals, known for their affinity for small caps, are on track to buy ¥6.4 trillion of domestic stocks in 2024, which is similar to the annual level of BOJ purchases during Abenomics.
- Corporate governance: Large caps have improved their corporate governance faster than small caps, taking measures like bringing on independent directors. However, regulators have turned their attention to the small caps, urging them to manage toward higher returns and valuations.
Digging into the Variables
Fundamentals
Because the intrinsic value of stocks represents the discounted value of future cash flows, a weakening in the relative fundamental earnings power of small versus large caps would warrant their underperformance. Analysis shows, however, that fundamentals provide minimal explanation for small cap underperformance after 2018, with multiple compression playing the bigger role. The key fundamental divergence was in EPS growth from 2023, and it seems the weak yen — which favored large caps with higher levels of overseas sales — was the cause.
Since 2018, small caps showed marginally higher ROE and margin growth, however EPS growth began trailing large caps in May of 2023 (Exhibit 2). 2 Until then, small cap fundamentals had kept pace with large caps, suggesting that fundamentals were not behind the underperformance of small caps from 2018 to 2023.
Sales growth, not margin expansion, drove the outperformance of large cap EPS growth after 2023. Actually, small cap sales growth had begun to flag in 2022, but small cap relative margins increased at the same time, helping small cap EPS keep pace with large caps. However, the continued decline in sales caused EPS to begin underperforming from 2023. A closer look at this suggests that yen weakness was behind sales weakness from 2022. Exhibit 3 shows the yen (on an inverse scale) against the spread in sales growth between small caps and large caps. Relative small cap sales growth suffered in lockstep with the depreciating yen after 2021.
Large caps outperform during times of yen weakness because they have more international sales, which grow in yen terms when the yen weakens. The TOPIX index has an overseas sales ratio of 41%. While 52% of sales of the TOPIX 100 is from overseas, only 34% of the TOPIX mid-400 and 20% of TOPIX small cap sales come from overseas. 3 Companies with localized cost bases benefit from the currency translation of profits. Companies exporting goods from Japan benefit from additional margin expansion because some inputs, such as labor and capital, are denominated in yen. In this way, the yen is linked with the fundamental performance of Japanese companies.
Looking forward, we wouldn't extrapolate continued yen weakening into the future. We don't have a strong view on the currency, but we note that from a purchasing power parity perspective the yen is as weak as it has ever been, at least since 1970. 4 In addition, with domestic inflation in Japan pushing up and inflation in the U.S. plateauing, one can imagine a scenario where the interest rate differential begins to tighten, creating some respite for the yen. Additionally, political pressure for a stronger yen is building in Japan and the United States. We would expect a plateauing of the yen to ease small cap headwinds and strengthening to create a tailwind.
Relative Valuations
Although inferior EPS growth from 2022 was a drag on small cap performance, multiple compression is apparent from the time small caps began underperforming in 2018. As a result, Japanese small caps are trading at the largest discounts to their large cap peers over the past decade (Exhibit 4). The MSCI Japan Small Cap Index is trading on a P/E of 13.5x compared to the MSCI Japan Index P/E of 15.4x. The spread of -1.9x is the largest since 2010. Small caps are trading at a P/B of 1.1x compared to large caps at 1.6x. The -0.5x spread is the largest going back to 2007. Small cap dividend yields exceed those of large caps by 0.5%, a level unseen since 2001. From a relative and absolute value perspective, small caps are looking extremely attractive. (At some point, valuation matters!)
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