The long bear market in Japan has taken its toll on trading volumes in Japanese small caps and sell-side research coverage. Consequently, overseas investors have trouble finding research or company disclosures in English for these companies and moreover, can get caught in individual names because of thin liquidity.
For example, foreign hedge funds in 2006 were shorting larger-cap Japanese stocks and going long smaller-cap Japanese stocks. However, the Livedoor scandal sent individual investors fleeing from small caps, while the larger cap stocks actually outperformed—leaving the foreign hedge funds high-and-dry trying to liquidate individual positions in illiquid small cap stocks. Unlike the first section of the Tokyo Stock Exchange where foreign investors dominate trading, individual investors dominate the small caps, recently accounting for as much as 80% of trading value on JASDAQ, Japan's NASDAQ, and well over 60% for small caps listed on the Tokyo Stock Exchange second section and the TSE Mothers market.
Historically, Japanese small caps have been capable of powerful rallies, such as the two-fold surge in the JASDAQ during the IT bubble between 1998 and 2000, and the nearly three-fold surge in the Tokyo Stock Exchange’s second section index between Japan’s financial crisis low in 2003 to 2006.
Source: Tokyo Stock Exchange
But Japanese small caps have been largely ignored in the Japanese market recovery since March 2009 lows, as global and Japanese investors chased performance in the emerging markets, particularly in Asia, where markets like Indonesia and India surged six-fold from spectacular crash and burns during the 2008 financial crisis.
Source: Yahoo Finance
As we entered 2011, however, hot emerging markets like China, Brazil and India are consolidating because of central bank monetary tightening to get ahead of growing inflationary pressures, and these markets are now testing medium-term downside resistance. The consolidation in these emerging markets could be the canaries in the coal mine warning of the next correction in developed markets, but foreign investors as well as Japanese individual investors are now looking to Japan as the contrarian call (dark horse) for 2011.
In fact, the performance of USD-denominated Japanese small cap ETFs like the JSC SPDR Russell/Nomura Japan Small Caps (JSC), the Wisdom Tree Japan Small Cap Dividend (DFJ) or the iShares MSCI Japan Small Cap Index (SCJ) has not been that bad, outperforming both the NASDAQ and the S&P 500 during 2009 and the S&P 500 during 2010. These funds also solve the problem of thin liquidity in individual Japanese small cap names as well as the dearth of information on these companies in English.
Source: BigCharts.com
Further, these ETFs compare very well versus the domestic Japanese small cap benchmark indices like the TSE 2, JASDAQ, the Nikkei Small Cap Growth, Nikkei Small Cap Value and especially the Tokyo Mothers. Unlike these static indices which include a lot of chafe with the wheat, the constituents of these funds are regularly reviewed to weed out the weaker factors and of course have gotten a boost from the strong yen. The SCJ ETF, for example, tracks the MSCI Japan Small Cap Index, which has been the second best-performing of the Japan small cap indices.
Source: Nikkei Astra
As with U.S. small caps, the caveat of course is that Japan small-cap outperformance is strongly tied to market direction, i.e., small caps go up faster in rising markets but also go down faster in falling markets. The reason that small caps outperform large caps over time is that stock prices are rising most of the time, not falling. Thus for our money, we would prefer to take new positions in U.S. and Japanese small caps as the benchmark indices like the S&P 500 are confirming downside support from the next interim correction.
Source: Marketsci Blog
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
