"All eyes have been on the mega-cap stocks as familiar themes such as AI continue to dominate. But beyond the headlines, the latest quarterly earnings show that companies lower down the market cap spectrum are quietly making progress. The continued focus on corporate governance and the prospect of a settled currency suggests there is more to come." 

Bittersweet moments

Over the past year, there has been a growing dislocation in performance in large cap companies versus small cap companies, with a spread of 1100 basis points in favour of large caps. Looking at this year to date, some familiar themes stand out, notably technology, and of course AI.  Screen Holdings and Socionext are both up over 40%. Softbank, a company that we have never liked, has risen 25% over the past few days.

The rush to allocate to Japan and take advantage of the corporate governance story that we have been highlighting since the launch of Zennor three years ago this month is a bittersweet event for us. As mid-cap specialists who buy large caps but have greater exposure to mid and smaller companies, we have been fighting an uphill battle against the mega-cap stocks.

Despite Japan’s large stock market, liquidity is a problem. Only 200 stocks out of 3,200 trades more than $20m per day. My colleague, David Mitchinson mentioned to me last week that results were “generally quite soft”. He has a point. Positive surprises outweighed negative surprises by only 10% (46%/37%).

For every company like Toyota or NGK Spark Plug that are doing well, there were reciprocal poor results. Omron revised down full-year operating profit from ¥100bn to ¥24bn, citing a weak industrial automation business, and continued problems in China. Yasakawa, saw servo motor weakness, particularly in China. Toray, a carbon fibre play disappointed as did Fuji Photo Film. We had warnings about the bio-CDMO market at Asahi Glass when James saw them in Japan and these seem to have affected Fuji Photo as well.

A reverse indicator moment

Factor styles this year include large cap, high volatility, ROE, and sensitivity to US stock prices. When foreign investors say on the newswires, “We have no choice but to buy Toyota Motor”, which is up 30% year to date, we are happy. It is a classic reverse indicator moment. Not our market but here is the good news. Results have been pretty good at most of the companies we hold. Looking at the top 10 holdings, seven have beaten estimates, two are in line, and one is in the process of selling a valuable subsidiary that will leave it with a cash pile equal to its market capitalisation.

Our largest position, Toyota Industries announced a good set of numbers, with strength seen in both forklifts and logistics solutions. It made its full-year numbers at the nine-month stage. Price rises are taking hold and the core automobile business stayed at a high level.

Genda*, an amusement arcade consolidator, is making good progress with M&A. Recent M&A deals will add ¥30bn to sales and ¥2.7bn to EBITDA. We would suggest that sales and profits will continue to be revised up as investors don’t really understand the accretive nature of most of the deals which are being carried out at EV/EBITDA multiples less than 2x. 2x sales could still see the shares rise over 50%.

Fuji Media announced a decent set of numbers, but activism from several key investors has encouraged management to begin buying back shares and seeking a higher ROE. Dai-Nippon is one of our corporate governance flag-bearers. It will buy back 25% of the company over three years and its recent results suggest that the electronics business is doing very well. From EV battery pouches to metal masks and OLED materials, the company is positioning itself away from the legacy business.

Panasonic delivered better results than expected. Despite issues in the Lifestyle division (air conditioners etc), avionics and batteries were good, and a sum of the parts calculation leaves a lot of upsides if it delivers on withdrawal from loss-making businesses.

Daiei Kankyo*, the waste company again revised up (the second time in six months) and continues to consolidate a fragmented sector. Trading on 17x with 23% operating margins this is a solid business with a 15% return on equity.

Skymark Airlines* has caused us a few sleepless nights. The company, which is a dominant domestic airline has seen its share price fall sharply because of the strong yen and oil prices. It has beaten its nine-month target by a fair distance which means an overshoot to 3/24 is likely. What encouraged us also was a large dividend hike. Companies like this should bounce sharply when the currency begins to settle.

And finally, T. Hasegawa, our favourite flavouring company. Inventory issues in the US are now ancient history and the first quarter was a very positive one. Trading on 12x ex-cash and a free cash flow yield to enterprise value of 8%, there is lots of intrinsic upside here.

Corporate governance to be the driver

What has heartened us has been the corporate activity in our portfolio. Nittetsu Mining* has moved to a 3% dividend on equity. Kurimoto, now taking our proposals very seriously regarding a 3% DOE. Even, Sintokogio, now announcing Tokyo Stock Exchange proposals in May 2024. We think there is much more to go for.

So far, the big announcements have come from Ricoh and Mitsubishi Corp (10% share buyback). As I have found in 35 years in Japan, this eventually filters down to the smaller cap brethren. Small looks very good value. 13x forward earnings and just 1x book value compares to 16.2x PER and 1.7x price to book for large-cap stocks.

As ever, the fund has a broad representation across large, mid, and small. With the portfolio trading on 14x PER and less than the break-up value, there is more to go for, but the message is that corporate governance will be the driver. A sharp move upward in the yen would help our portfolio as we remain underweight yen weakness beneficiaries.