The Untapped Potential of Japanese Small Caps

Japanese small cap stocks have been undervalued in recent years compared to their larger counterparts. However, current market conditions present a unique opportunity for investors. Takenari Okumura, Portfolio Manager of the Hennessy Japan Small Cap Fund, sat down with Jay Coulter on Viewpoints by Hennessy to discuss the space.?

The Landscape?

Japanese small caps are trading at very attractive prices — and the reasons to pay attention to small caps include:?

• Japan’s evolving economic landscape: The country is transitioning from deflation to inflation, evidenced by rising CPI and wage increases. The Bank of Japan’s recent interest rate hike further indicates confidence in a stable and sustainable economic cycle.
• Attractive valuations and market dynamics: Small cap stocks are trading at a significant discount compared to large caps. This disparity is largely due to the underperformance of small and mid cap companies, which have been slower to pass on costs amid rising inflation. Small-cap companies are now demonstrating a remarkable ability to pass on costs, and their projected growth is even outpacing that of large-cap stocks.

Outperformance?

The outperformance of Japanese small cap stocks can be attributed to several key factors:

• Higher profit growth rates compared to large cap counterparts: This is because small cap companies are typically in the earlier stages of the growth cycles and have more room to expand.
• Niche market or innovative ways to thrive: This combination of higher growth potential and unique growth drivers enables Japanese small cap stocks to perform well over time.
• Market inefficiencies that savvy investors can exploit: This dynamic is similar to the United States, where small cap stocks also tended to outperform due to their growth potential and market inefficiencies.

Role of Active Management?

Active management can provide a significant advantage in the Japanese small cap space, including:?

• Many small cap stocks in Japan are under-researched compared to large cap counterparts: This lack of coverage means more opportunities for active managers to discover undervalued or overlooked companies.
• Direct impact of management expertise on company performance is particularly pronounced in small cap companies: In these smaller firms, the decisions and strategic direction set by the management team can directly influence business outcomes.?
• The language barrier presents a unique challenge: Many Japanese small cap companies may not provide comprehensive information in English, which can deter international investors. However, active managers who can navigate the Japanese language and culture have an advantage in understanding variable information that may not always be available to others.?

Industrials Allocation??

Hennessy’s investment strategy has centered on the industrial sector, encompassing construction, logistics, and manufacturing. Key factors driving allocation include:

• Capital expenditures: This is particularly evident in the construction industry, where there is a strong need for infrastructure development and modernization.?
• Logistics industry: Previously under intense competition and deflationary pressures, it’s an area poised for investment. Expect profit margins to improve significantly as freight rates adjust to reflect true cost.
• Sector broad scope: This strategic positioning allows us to capitalize on the drivers and robust growth prospects within the industrial sector.

Holdings: Kyudenko

Kyudenko, a prominent electrical construction company, exemplifies the potential of Japanese small cap stocks. Despite pandemic-related challenges, we invested in Kyudenko based on its strong market positioning and growth prospects in the Kyushu region.?

The Kyushu region is expected to become a significant hub for semiconductor manufacturing, with major players like TSMC establishing factories there. Additionally, there is strong demand for large-scale urban redevelopment projects in metropolitan areas.?

Kyudenco’s strong mobilization capacity allows it to effectively meet increasing demand while improving project profitability. As the company transitions to more profitable projects, financial performance is improving, which aligns with our expectations.

LinkedIn Article Disclosures:?

These companies are all holdings within the Hennessy Japan Small Cap. Visit hennessyfunds.com to learn more.?

Current and future holdings are subject to risk. To obtain fund holdings, visit www.hennessyfunds.com.?

Learn more about Hennessy Funds at www.hennessyfunds.com.

• Follow Hennessy Funds for more insights on LinkedIn:? https://www.dhirubhai.net/company/hennessy-funds?
• Subscribe to the Hennessy Funds YouTube Channel at https://www.youtube.com/@HennessyFunds?

For Terms of Use & Disclosures, visit the following links:?

• https://www.hennessyfunds.com/social-media-terms?
• https://go.hennessyfunds.com/statutoryprospectus.pdf?

Mutual fund investing involves risk; Principal loss is possible. Small and medium-sized companies may have more limited liquidity and greater price volatility than larger companies. Investments in foreign securities may involve political, economic, and currency risk, greater volatility, and differences in accounting method. Funds concentrated in one or more industry sectors may be subject to a higher degree of market risk. The Fund’s formula-based strategy may cause the fund to buy or sell securities at times when it may not be advantageous.

Quasar Distributors, LLC, Distributor.