It is a burning question for most investors today: where can they find the more alpha and why should they keep investing in actively managed funds? In a world of scarce alpha for active management, Japanese small caps managers exhibit among the best results in outperforming their own benchmark and the Topix Index relative to other regions.
Consistent alpha
Investors looking to consistently extract excess returns from their portfolio should pay attention to Portfolio Managers who have demonstrated a consistent ability to exploit small cap stocks as a source of alpha. The Japanese small and micro caps is one of the area where it best works.
The academic research suggests that the inefficiencies in the small-cap market give rise to situation where mispricings are consistently available and managers with a disciplined and well-constructed process are able to systematically harvest the resulting alpha.
Information edge in the Japanese Small Cap universe
We met recently with a Japanese Asset Manager who launch its well-established expertise in small and micro caps under a Luxembourg-based UCITs format.
The fund is managed by a “veteran” in this area with more than 25 years of experience in managing small and mid-caps portfolios. He is highly specialised and has an extensive coverage of the opportunity set based mainly on company visits. The lead Portfolio Manager conducts on average over 900 companies’ visits per year, and he was joined in 2015 by a co-Portfolio Manager to extent the coverage. In his entire career, the Portfolio Manager met over 2.700 Japanese companies as a result of his continuous effort to conduct one to one meetings with senior management companies, often family-owned business in this asset class.
We think the fund benefit from a real information edge for idea generation given the breadth of the “on the ground” research. Being based locally also allows the investment team to better assess an inefficient investment universe with a very low analysts’ coverage in average.
Under-researched companies
Historically, fundamental analysis in under-researched businesses is key to accurately forecast earnings. Portfolio Managers with the experience and skill set are often better positioned to exploit inefficiencies and identify the cheapest companies exhibiting the higher upside potential. The investment professionals managing this fund are specialists of the asset class and the lead Portfolio Manager has dedicated his entire career to Japanese small and micro caps, which we see as a valuable insight in this asset class.
Portfolio construction
In the 1st step of the process, the Portfolio Managers spend time to understand the business company and its DNA. This is based mainly on meetings with the top management to challenge them on their strategy for growth, their vision over the medium to long term to create value for shareholders. Execution of the strategy and corporate governance is key to reach a sufficient level of confidence in earnings growth, both for certainty and sustainability of earnings. Once the company passed the qualitative filter, the Portfolio Managers then focus on valuations based on a proprietary fair price model incorporating a PER assumption and an internal EPS growth.
The portfolio construction is disciplined and address clearly the liquidity issues of such a small cap fund with a clear sizing policy for individual holdings.
The fund achieved unrivalled returns over many cycles since its launch in 2004. We like the skill set of the lead Portfolio Manager, his tenure within the Asset management company and his extensive experience in managing this strategy in the same fashion for now 13 years. This impressive track record is largely the result of having the right process to sort out the voluminous small-cap universe to identify the highest-quality, most undervalued stocks with the most attractive growth prospects and then having the discipline to wait for the mispricing to correct.
Given the fund’s current size and short track record in the UCIT format, we have added it to our Watch list with the aim to reassess it later for inclusion into our Selection Master list.
Source: WS Partners, Asset Manager as of 31.3.2017