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Small-Cap Japan

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Kenichi Mizushita has managed Fidelity Japan Smaller Companies (FJSCX) since December of 1996. Mizushita joined Fidelity as a research analyst in 1985, covering a variety of mostly cyclical industries. While Mizushita might not be a household name, those who invested in his fund back in 1999-2000 have likely never forgotten his significant (240%-plus) contribution to their portfolio’s performance. Since we’re wading back into Japan in this month’s issue, and since many of you are in some cases weighting international markets more heavily in client portfolios, Mizushita’s experience as a long-standing analyst and top-ranking manager will provide some unique perspective.

What is your investment style and the fund’s objective? My fund’s investment objective is defined by the small-cap market in Japan, which has been expanding over the last decade; and I expect it to continue expanding, backed by new companies’ listings. Last year there were 150 new companies listed in the stock market, and for 2002 I expect more than 100 new companies to come into the market, even if the large-cap stock market situation remains negative. My investment style is basic. I focus on individual companies’ fundamentals. I focus on the earnings and then growth potential for each company.

Do you also focus on the management? And, would you say there is a different kind of management in the small companies in Japan today than, say, five or ten years ago? Yes, to both questions. Ten to 15 years ago most new companies were not as aggressive or driven as they are now, because the top management just wanted to get money from the market through their listing. However, nowadays, a new kind of management has been coming to the companies, and to the market, and they understand the key role they play in growing the company well. The small-cap market is also totally different compared to before the bubble economy of the Japanese stock market.

Can you give us a sense of the capitalization range of the companies you invest in? Right now the average market cap in my portfolio is around $790 million U.S. dollars, but I have been searching for very tiny companies, like $5 million U.S. market-cap companies. Also, within Japan’s small-cap market there are some comparatively large-cap names, so I have to analyze their potential role, too.

The majority of names in your top 10 holdings (which represent over 30% of your fund’s net assets) are consumer discretionary and consumer staples names. What does that tell us about your investment style and where you are finding opportunities in Japan today? If you look at the industry structure in Japan, in particular the small-cap market, there are many service industry companies coming to the market. I think Japan is changing from a manufacturing economy to a service-oriented one, and in this regard is catching up to the “industry” structure in the U.S. For example, last year, of the 150 names that came to the market, more than 60% were from the service industry. I believe the service industry will continue to grow and expand in Japan. That translates into many more companies in the market from which I can pick and choose.

Describe the type of technology names an investor would find in your portfolio. Are any companies that export technology, or are they more related to, say, cellular phones within Japan? The latter. For example, there is a company that is making camera lenses for mobile phones. If you look at the mobile market in Japan, mobile with video, that type of mobile phone has been expanding. I expect within a few years, almost all mobile phones will be equipped with cameras that let the end user do much more than simply access the Internet, view movie clips, etc. This company owns the technology to transform the phone into a camera. I do not currently own any company in the export market, or the Internet, or semiconductor-related equipment companies. While I think we’re becoming a service-oriented economy, I also believe that Japan is still a manufacturing country. In some areas, Japan continues to lead technology. For example, take the mobile phone: In that area there should be some small companies that will have a huge upside potential.

Pharmaceutical manufacturers and biotechs are a significant part of the U.S. growth stock story. Is that going to be a growing area in Japan, or will it remain a fairly small percentage of the economy? Unfortunately the number of biotechnology companies in Japan is small. It is difficult for me to find out about biotechnology-related companies in the small-cap market. My guess is, it’s too early in Japan. Maybe three or five years in the future we will see them.

Characterize the singular strength of the types of companies you invest in. The companies I invest in have a very strong competitive edge in each market.

Fair enough. What role would you see Japan Smaller Companies playing in the overall portfolio of an advisor, who will typically be heavily weighted in large- and mid-cap U.S. companies–with a slight emphasis in European and Japanese large-caps? I don’t know the U.S. market, but we have only 3,600 listed companies in Japan, from big to small. The Japanese economy consists of many small companies, and more are on the way. One of the Japanese government’s policies is to introduce new companies into the market in order to stimulate the Japanese economy. The Japanese small-cap market continues to expand for this reason. I believe it is one of the most exciting stock markets in the world.

Does the government play a dramatically different role when it comes to supporting the stock market in Japan, than our government does over here? Today the government announced some market stimulation policy. So the government is also worried about the weak stock market in Japan. I don’t expect drastic policy changes in Japan.

You run a concentrated portfolio, around 150 names, with about 33% of the fund’s assets in your top 10 holdings. Is that by design or just a function of not finding as many names as you would like to find?

And would an advisor looking at your current and past number of holdings and percentage of assets in your top 10 stocks be able to expect that going forward, or will it become more diversified? I don’t know. It depends on the companies and the stock market. I don’t have any strict numbers, such as stating that the top 10 holdings will account for more than 30% of my portfolio. I am just looking for the companies that will grow reasonably fast and with generally attractive valuations.

Let’s talk about valuations. Do you find that smaller companies have greater transparency in their accounting than the large-cap side, so that their numbers are more transparent, more trustworthy? Yes, I think so. Because the small companies are usually very simple businesses, so it is relatively easy to understand their balance sheet and profit/loss statements, compared to large-cap names. On the other hand it is difficult for us to find out, because we are just investors, not bankers. So disclosure material is limited.

But I believe the Japanese accounting system is okay, and I never met a company that had bad reporting.

Is there anything that we have not asked that you think an advisor or their client should know about you or your fund, or small companies in Japan? If investors in the U.S. look at the Japanese stock market–if they look at what’s going to happen in the large- and the small-cap market–they should know that we still have a bad debt problem in the banking sector that affects large-cap stocks here. We still have the big problem with cross-shareholdings between the banking sector and the large-cap names. And we still have the problem in the large-cap name companies in that they are losing competitiveness. For example, large semiconductor companies; many strong companies are coming into the market from Asia. The large-cap companies are in the middle of restructuring their businesses right now. So you should separate the Japanese stock market between the large- and small-cap markets. It is a good time to buy cheap small-cap names in Japan, I think.