published Mar 16th 2017, 6:00 pm, by Yuko Takeo and Nao Sano

(Bloomberg) —
Smaller Japanese companies may have more to offer investors than their big brothers, says Jesper Koll.

The Tokyo Stock Exchange Mothers Index has climbed 12 percent so far in 2017, outpacing the Topix index’s 3.6 percent rise. The small-cap gauge has produced median earnings per share growth of 31 percent over the past three years compared with the broader measure’s 18 percent increase. Analyst coverage remains low, with just a quarter of Mothers’ stocks followed by anyone at all, compared with more than half for Topix.

Japanese small caps are “undiscovered jewels,” offering better corporate governance and lower exposure to fluctuations in the yen than larger companies, says Koll, chief executive officer of WisdomTree Japan Inc. “They’re better at managing capital compared to large-cap shares,” said Koll, a perennial optimist on the Japanese stock market, in an interview in Tokyo late last month.

Return on equity is one metric that has been in the spotlight amid a growing focus on corporate governance in Japan. Topix ROE has remained little changed around 7.5 percent for the past five years. The Mothers Index’s ROE is still lower but has gradually increased since 2010 to around 5 percent in the past two years.

“The management mindset in Japan has been slowly changing,” says Max Godwin, a Singapore-based portfolio manager for the Eastspring Investments Japan Smaller Companies Fund. “There’s a rising focus on profitability, holding less cash and improving return on equity.”

Small caps are also much less vulnerable to foreign exchange rates than larger stocks, according to Koll, the former chief Japan equity strategist at JPMorgan Securities Japan Co. Domestic sales account for 75 percent of revenue for companies included in the WisdomTree Japan SmallCap Dividend Index compared with less than 45 percent for members of the large-cap-focused WisdomTree Japan Dividend Index.

But they also have more volatility. Activist short sellers have been targeting Mothers constituents since last year, questioning the businesses and valuations of companies such as robot-suit maker Cyberdyne Inc. Even without clear reasons, stocks can suddenly tumble. Earlier this week, DDS Inc., a provider of fingerprint identification systems, left analysts scratching their heads after it plunged 23 percent in one day and dragged down the entire equity gauge.

Still, Koll expects smaller firms to continue to increase sales and earnings as the country makes a long-awaited escape from deflation and household earnings climb. There are already signs Japan’s economy is shaking off its sluggish years: gross domestic product is poised for its longest run of growth in a decade. They’re also a good place for investors to escape global political uncertainties, he says.

The logic behind investing in Japanese small caps is: “I don’t care about Mr. Trump, I don’t care about President Xi, I don’t care about Europe — I care about Japan,” Koll said.
To contact the reporters on this story: Yuko Takeo in Tokyo at ytakeo2@bloomberg.net ;Nao Sano in Tokyo at nsano3@bloomberg.net To contact the editors responsible for this story: Divya Balji at dbalji1@bloomberg.net Kurt Schussler, Tom Redmond
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