Japan's small caps emerge from AI's shadow as investors eye value

By Junko Fujita

TOKYO, July 23 (Reuters) - Japan's deep bench of small- and mid-cap stocks has been largely overlooked amid AI euphoria and may stand to benefit as investors rotate into value shares.

The benchmark Nikkei gauge marked a record high close on June 25, riding a tide of AI optimism that has boosted global shares and as foreign investors boosted weightings in Japan.

But the Nikkei has slid 8% since then, and its heavy weighting in tech has made it vulnerable to whipsaw swings and moves by its South Korean counterpart, which is dominated by a few AI-related names. The Topix index, which has more than 1,600 names to the Nikkei's 225, is up about 1% over the same period.

"Foreigners who do not know Japan well have grabbed heavyweight, chip-related stocks as an entry to the market," said Hiroki Iura, chief fund manager at Resona Asset Management, who manages the small-cap fund. "If they become more serious about Japan, they will buy the broader Topix. As a result, discounted small- and mid-caps will likely become more attractive."

Japan's economy and stock market were moribund for decades, with the Nikkei finally exceeding its bubble-era 1989 high in February 2024. Part of the breakthrough for the market was a governance push by the Tokyo exchange that pressured companies to improve profitability and shareholder returns.

GOVERNANCE REFORMS

Those reforms convinced many foreign investors it was time to buy. Their net purchases of stocks amounted to 10.1 trillion yen ($61.95 billion) this year through the beginning of July, according to Japan Exchange Group data, nearly double the amount from all of last year.

The exchange's next reform phase, due to commence in October, will tighten liquidity standards for Topix companies and press them to improve efficiency of cash usage.

"Many of the small and mid caps are cash rich, so the new reform may add further pressure on those companies," said Kazunori Tatebe, chief strategist at Daiwa Asset Management.

Those two forces — index-level distortion from the AI boom and a fresh regulatory push — are converging to put a spotlight on Japan's smaller, cash-rich companies that have largely traded under the radar.

DEEP DISCOUNTS

Many smaller Japanese companies continue to trade at deep discounts because their value is unnoticed, and some do not have any analyst coverage, according to Tatebe.

Nippon Kodoshi 3891.T, another lesser-known name, makes specialised paper known as separators used in components of AI servers, smartphones and home appliances. It controls about 60% of the global market for the product.

The company trades at 24.4 times earnings compared with 88 times for Taiyo Yuden, a darling of the AI sector. Taiyo Yuden, a leading maker of capacitors used to regulate power in AI servers, has risen 240% this year to become a key component of the Nikkei's surge.

"We don't have a company like Nvidia NVDA.O in Japan, but we have many companies that are skilled at manufacturing equipment and materials," said Hiroki Takayama, director at BlackRock who manages its Japan Small & MidCap Opportunities Fund.

Takayama's fund has grown 16-fold since its start in 1998, compared with nearly threefold growth for BlackRock's Japan Equity Fund, which focuses on large caps, over the same period. One of the constituents of his fund, Kioxia 285A.T, is a prime example of a smaller company turning into a giant.

The chipmaker's market value has jumped as much as 50-fold since its market debut in 2024, briefly exceeding Toyota Motor's value last month.

($1 = 163.0400 yen)

(Reporting by Junko Fujita, Editing by Rocky Swift and Sam Holmes)

((junko.fujita@thomsonreuters.com;))