Japanese Fund Managers Look Beyond Yen-Driven Export Stocks

Japanese Fund Managers Look Beyond Yen-Driven Export Stocks

Lesser-Known Small and Midsize Companies Are Gaining Favor

YUMI OTAGAKI

Oct. 20, 2013 11:39 a.m. ET

TOKYO—Forget Toyota Motor Corp. 7203.TO -0.16% or Sony Corp. 6758.TO -0.83%When fund manager Hideo Shiozumi looks for Japanese stocks to buy these days, he shuns the big-name exporters that saw sharp gains earlier this year as the yen’s sudden drop made their goods more competitive on global markets. Instead he seeks lesser-known small and midsize companies he thinks will benefit from deeper structural changes that many economists say need to happen for Japan to enjoy a deeper recovery beyond the quick fix of a cheaper currency. Specifically, the manager of U.K.-based Legg Mason’s Japan Equity Fund is weighted toward e-commerce companies that can gain from shifts in consumer behavior, and health-care firms that can profit from the country’s aging population.After a remarkably fast and broad-based rally earlier this year, the long-dormant Japanese stock market remains an intriguing lure for global investors, but an increasingly challenging one. The revived interest in Japanese stocks was sparked late last year by new Prime Minister Shinzo Abe’s economic-recovery plan, dubbed Abenomics. Many economists remain bullish on Mr. Abe’s prospects for ending the country’s long economic slump. He aims to pull Japan out of two decades of deflation through aggressive monetary and fiscal policies, and growth strategies to spur private investment through structural reforms and deregulation.

But the opportunities for easy, quick profits—the Nikkei rose 80% from November to May—appear to have faded. After peaking at 15627.26 in late May, the Nikkei slipped 20% in less than a month, and the broad average has been trapped for the past month in a range between about 13800 and 14800. That has left those investors sticking with Japan focusing more on specific companies or sectors that might benefit from structural changes to the economy.

“While it’s true that a weak yen is good for profits at exporters, some of those exporters face some structural problems,” says Nicholas Weindling, Tokyo-based portfolio manager at J.P. Morgan Asset Management (Japan) Ltd., whose team manages $12 billion in Japanese equities. “If we believe in Abenomics, then it’s very important that we choose to bet on the domestic economy more than exports.”

Mr. Weindling likes MonotaRO Co. Ltd. 3064.TO +4.63% , an e-commerce company founded in 2000 that operates an online store for small and midsize manufacturers, specializing in tools and parts. According to his latest semiannual reports, Mr. Weindling’s $241.6 million Japan (Yen) Fund and his $86.5 million Japan Smaller Company (Yen) Fund each had 1.8% invested in the company as of March 31. MonotaRO’s stock has doubled this year. Mr. Weindling wouldn’t disclose his holdings, but he said he believes that “the growth of the company is just beginning.”

Mr. Shiozumi likes Nihon M&A Center Inc., 2127.TO +9.01% a small Tokyo-based consulting firm founded two decades ago to help the growing number of aging small-business owners find buyers—a field with potential for rapid growth as policy makers push greater consolidation in a corporate culture that has long shunned combinations.

“Many fund managers are caught up in exporters, but exporters rise only when the yen weakens,” says Mr. Shiozumi. “The concept of mergers and acquisitions is relatively new to Japan.”

He says he expects M&A activity to rise, particularly as small-business owners age and a lack of successors for their businesses becomes “a more pressing issue.” Nihon M&A is now the biggest holding in his ¥38 billion ($389 million) fund. The company’s stock price has more than doubled year to date, compared with a 39% gain for the Nikkei Stock Average.

For some investors, however, the sharp rise in some of these niche stocks has, like many blue chips, outrun their likely potential. Invesco Perpetuals’ £48.4 million ($78.2 million) Japanese Smaller Companies Fund sold its $1.3 million worth in shares of MonotaRO on March 19 when the company’s stock price hit ¥2,303, up more than four times from the ¥536 price at the time of the first purchase.

“We sold MonotaRo as the share price climbed, far exceeding our target price,” says Osamu Tokuno, chief portfolio manager for Invesco Asset Management Japan Ltd. “The possibility of a further surge in the short-term has diminished.”

Still, Mr. Tokuno, like his peers at Legg Mason LM +1.41% and J.P. Morgan, JPM +0.17%is hunting for profit opportunities among the more obscure players that stand to gain in a changing corporate Japan. Among his top holdings is Kakaku.com Inc., 2371.TO +0.90%which operates a website that offers price comparisons and other product information on everything from personal computers to pets, moving services, and funeral homes. The site’s strength lies in its user-generated content such as reviews, Mr. Tokuno says. The company also runs a popular restaurant review site called Tabelog, and draws revenue from ads and commissions from restaurants using the site to allow diners to make reservations. The firm’s share price has quadrupled year to date, amid an Abenomics-driven consumption boom.

Mr. Tokuno is also looking at companies that, among other things, can take advantage of the construction binge spurred by Mr. Abe’s big increase in public works stimulus spending, one that could be amplified in the run-up to the Tokyo 2020 Olympics. In its July statement, Mr. Tokuno’s fund showed big holdings in Sho-Bond Holdings Co.1414.TO +0.56% , which repairs, reinforces, and maintains concrete structures such as highways, railways, bridges, tunnels and buildings, and SRG Takamiya Co.2445.TO -0.12% , which leases and sells temporary machinery and materials for construction use such as scaffolding. Sho-Bond Holdings and SRG Takamiya have risen 35% and 122% year to date, respectively.

“The infrastructure sector in Japan is certainly a growing industry, as the infrastructure built around the first Tokyo Olympics is due for repair and that demand will only increase going forward,” Mr. Tokuno said.