Japan Small Cap Investing:
Unearthing Hidden Gems
Makoto Ito, CMA
Senior Portfolio Manager
Published June 2023

Japan Small Cap Equity Strategy’s Senior Portfolio Manager
Makoto Ito shares his insight into the unique opportunities
provided by Japanese small caps, the fund’s approach toinvesting, and other key topics.

Contents:• Japan’s Resurgence: Uncovering Opportunities amid Economic Revival• A New Era of Governance: Embracing Reform• Five Good Reasons to Invest: The Case for Japan Small Caps
• Investment Strategy: The Nomura Japan Small Cap Equity Strategy• Case Studies in Improved GovernanceJapan’s Resurgence: Uncovering
Opportunities amid Economic Revival
Japan’s economy has been commanding
renewed attention from global investors as acompelling investment destination amid promising
signs of revival. Market dynamics and a series ofpivotal reforms have propelled the Nikkei 225 toreach heights not seen in over three decades,
surpassing the 30,000 yen mark, and are drawing
interest in what opportunities can be uncovered inthis transformed market.
A key driver behind Japan’s economic revival has
been its swift rebound following the gradualreopening from restrictions imposed by the global
pandemic. Despite experiencing a technicalrecession in the latter part of 2022, the country
has witnessed a firm recovery in economy activity
at the start of 2023. Inbound demand fromincreasing numbers of overseas visitors has
contributed to domestic demand recovery, and is
expected to continue moving forward. There arealso signs of change in Japan’s price and wage
norms to further support a favorable domestic
demand environment. We believe that this trend
will favor small-cap stocks, whose share ofdomestic demand stocks is high.
In terms of central bank policy, the Bank of Japan
has maintained its loose monetary stance under
the new leadership of Governor Ueda, even in theface of four-decade-high inflation rates. Governor
Ueda will wait to see how the outbreak of financial
system instability affects the real economy in thefuture, and we maintain our view that the central
bank is highly likely to make some policy
adjustments going forward. It is assumed that theyen will not depreciate as unilaterally as it did lastyear.
Valuations in Japan have also caught theattention of investors, with the TOPIX 12-monthforward price-to-earnings ratio rising as high as
13x in the first half of 2023. Notably, value stocks

have broadly outperformed growth stocks. Warren
Buffett also helped draw attention to Japaneseequities with a visit in April, his first in 12 years.
While it is hard to imagine Mr. Buffett expanding
his portfolio directly into Japanese small-cap
stocks, there are many small caps that could be
investment targets influenced by ideas like
Buffett’s if their management’s awareness ofcapital efficiency continues to shift at the currentpace.

A New Era of Governance:
Embracing Reform
It is the evolving governance landscape that has
truly captured investor interest. The newfoundresponsiveness of Japanese companies toinvestors’ interests can be attributed to the surge
in shareholder activism and notable efforts by theTokyo Stock Exchange (TSE) to push for
improved corporate value. The TSE has sent anunprecedentedly strong message to its market
constituents by requiring all listed companies onboth the Prime and Standard markets toformulate and disclose plans for realizing
management that is conscious of the cost ofcapital and share price. Among Japan’s small-capstocks, there are many value stocks that maintainhigh ROIC but lack awareness of the cost ofcapital and have accumulated an unnecessarylevel of cash and equity, resulting in low ROE andPBR below 1.0x. While we have been in periodic
dialogue with such companies for a long timeabout these topics, some companies that havebeen slow to listen to investor demands arebeginning to change their attitude at the urging ofauthorities.
The number of parent-child company pairs listedon the TSE has been declining since 2007. The
introduction of the Corporate Governance Code in2015 has accelerated this trend, and various
external factors (including the increase of activist
investors, increase in engagement activities bytraditional asset managers, and the ongoing

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reforms by Japan Exchange) could add furtherpressure to unwind parent-child listings. Our
existing Japan Small Cap strategy has benefitted
from 16 takeover bids over the past eight years.

Five Good Reasons to Invest in Japan Small Caps
1. Breadth, Resilience and Inherent Strengths
The perception of smaller Japanese companies as inward looking and exposed to a country with anaging population is, like most generalizations, not an ideal basis on which to make an investment
decision.
Many investors are unaware that Japan has over 3,000 listed companies, and is home to a huge
number of high-quality and resilient innovators that are often hidden from view amid a layer of mundaneand mediocre businesses.
Unearthing these “hidden gems” can give investors access to a trove of stable, quality companies
spanning a variety of industries, from medical equipment to kitchen appliances, that are innovative andresilient yet undervalued compared to their assets. Some of these small cap stocks will be beneficiariesof the ongoing M&A trend, as investors seek to acquire smaller, cash-rich companies.

2. An Asset Class Offering Superior Returns
TOPIX vs Russell/Nomura Small Cap Index Returns(USD, Aug 2000 = 100)
500

450
400
350
300
250
200
150
100
500
2003

2004

2006

2008

2009

2011

2013

Russell/Nomura Small Cap2014

2016

2018

2019

2021

2023

TOPIX

Gross cumulative returns from 2003 to 2023.
Source: TOPIX, Russell / Nomura Small Cap Indices. Please refer to the disclaimer at the end of this document.

History has proven that investors cannot ignore smaller companies. Small-cap equities haveoutperformed their larger peers across most timeframes and have the potential to generate higher returns
than large caps.
Returns on the Russell Nomura Japan Small Cap index have been higher than those of the TOPIX index
over the past twenty years, clearly demonstrating that this asset class offers a strong investment casethat can complement and moreover enhance returns for investors in the broader Japan equity market.
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3. Beauty in Simplicity
Compared to their large cap counterparts, small cap companies tend to have simpler business models.
It is no coincidence that strong companies have simple, basic business models that allow them to makedecisions swiftly and adapt to changes in the business environment.
Whether it is kitchen equipment producers, medical device manufacturers, or machine tool specialists,these smaller, specialized companies can respond quickly by keeping things simple.

4. Under-researched and Under-valued
Smaller companies tend to have less analyst coverage than their larger peers. This leads to greater
discrepancies between fundamentals and market valuations, providing a rich environment for active
investment.
Number of Analysts by Market Size in Japan

Source: NAM, based on Bloomberg data

Number of Analysts by Market Size, Comparison by Country

Note: Data as of April 2021
Source: NAM, based on Bloomberg data

5. Unique Diversification Benefits
Small caps are relatively insulated from geopolitical risk. They are also less vulnerable to currency
fluctuations as smaller firms tend to generate a higher proportion of revenue from within Japan. Investingin Japan small caps also provides access to the potential future drivers of innovation across a wide
variety of industry sectors.

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The Nomura Japan Small Cap Equity Strategy
This Strategy has been managed since February 2020 with the investment objective of achieving
long-term capital growth. With over 3,000 stocks in Japan, our focus is on unearthing hidden gems
among small- and medium-sized listed companies. In other words, we offer investors a broad, uniqueand under researched opportunity set.

“We like to dig for companies that are profitable,
have strong balance sheets, yet are undervalued. We actively monitor management quality
and corporate fundamentals – factors representing the heartbeat of companies that arepoorly covered by sell side analysts, and havethe most potential to be mispriced.”

Access to Companies
The Portfolio Manager conducts over 500 meetings per year with listed companies.
In total, our analysts conduct more than 5,000 meetings annually.

Investment Style
While the Japan Small Cap Equity Strategy has a slight value bias, we also lookfor elements of growth. There are mainly three types of investments that we lookfor:
1. High Quality Value Stocks: Profitable companies with strong balance sheetsthat are undervalued due to the lack of research coverage.
2. Growth Stocks: Companies with firm expectations of superior growth
opportunities offered both by cutting edge technologies and innovative businessmodels that are highly competitive and disruptive to traditional Japanesebusiness practices.
3. Opportunistic Investments: Our approach is designed to identify not onlyquality businesses, but also businesses that are deeply undervalued, despite
being well-run and able to ride the recovery wave.

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We actively monitor management quality and corporate fundamentals – factors representing theheartbeat of companies that are poorly covered by sell side analysts, and have the most potential to bemispriced. Selecting these winners requires patience and a commitment of resources to cover the vast
number of companies and diverse range of businesses.
The Strategy typically holds around 100 to 200 stocks. In the small cap markets in particular,
diversification helps to mitigate liquidity risk, and we want to achieve exposure to a breadth of investment
opportunities in order to raise risk-adjusted returns.

Unwinding of Parent-Child Listings is Accelerating
The number of parent-child pairs listed has been declining since 2007. Often, small-cap subsidiarystocks are TOBed and the share price rises. Our existing strategy has benefitted from 16 takeover bids
over the past eight years. We have been in regular dialogue not only with subsidiaries themselves, butalso with their parent companies to discuss synergies with the subsidiaries and issues with parent-childlistings.
No. of Publicly Listed Parent/Subsidiary Pairs（Companies）

4504003503002502001501001987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019 2021
(End of Fiscal Year)

Source: Prepared by Nomura Securities from data on major shareholders (Toyo Keizai Inc.) andmaterials disclosed by each company as of March 31, 2022.
Source: Nomura Asset Management
Note 1: Shinkawa changed its name to Yamaha Motor Robotics and remained listed as aconsolidated subsidiary of Yamaha.
Note 2: ZOZO is still listed as a consolidated subsidiary of Z Holdings Corp. (formerly Yahoo!)

Example of Governance Improvement: Maruzen
This company is one of the largest commercial kitchen equipment makers inJapan, supplying to restaurants and convenience stores. With a sound balance
sheet and high profitability, the company is benefitting from shifts in foodconsumption patterns.
There has been significant progress in corporate governance for larger
companies since the introduction of the Corporate Governance Code in Japan. Smaller companies stilllag behind their larger counterparts, but Maruzen is also gradually becoming more shareholder-friendly.
Until a few years ago, the company refused individual interviews, but now they accept investor meetings
on a regular basis.
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The company does not require a huge amount of capital investment, but it continues to hoard cash on its
balance sheet. However, thanks to our years of dialogue and encouragement by authorities, thecompany’s attitude is gradually changing. The payout ratio, which was in the 10% range just a few years
ago, has steadily increased to just under 30% last year and 40$ this year. In addition, an activist fund
this year made a shareholder proposal to return 100% of its profits to shareholders, putting the market
under increasing pressure. We will also continue to engage with the company for further improvements.

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About the Portfolio Manager
Makoto Ito, CMA, has more than 19 years ofinvestment and research experience.
Previously, he had experience in investment
research in emerging market equities, particularly
Chinese equities, and after joining Nomura AssetManagement in 2006, he worked as a financial
sector analyst before managing Japanese equities
in 2008. He was appointed as a Senior Portfolio
Manager in 2015.

Note: CMA is a Chartered Member of the Securities Analysts Association of Japan.

Disclaimer
This report was prepared by Nomura Asset Management Co., Ltd. (“NAM”) for information purposes
only. Although this report is based upon sources we believe to be reliable, we do not guarantee its
accuracy or completeness. Unless otherwise stated, all statements, figures, graphs and otherinformation included in this report are as of the date of this report and are subject to change without
notice. The contents of this report are not intended in any way to indicate or guarantee future investment
results. Further, this report is not intended as a solicitation or recommendation with respect to thepurchase or sale of any particular investment. This report may not be copied, re-distributed orreproduced in whole or in part without the prior written approval of Nomura Asset Management Co. Ltd.
Registration Number: Director-General of the Kanto Local Financial Bureau No.373 Membership: TheInvestment Trusts Association, Japan, Japan Investment Advisers Association, Type II Financial
Instruments Firms Association
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