TOKYO Long-term foreign investors are looking into small cap Japanese shares as the Tokyo market's bellwethers such as Toyota Motor Corp (7203.T) and Sony Corp (6758.T) no longer look cheap even after considering the effect of the weak yen.
Some fund managers have been dabbling in subcontractors of big Japanese exporters while others look at companies whose coverage by analysts is low and have been neglected by international investors.
"Many export-oriented companies have become a little expensive to us," said Drew Edwards, portfolio manager at Advisory Research Investment Management based in Chicago, who has $800 million under management.
Edwards, who has more than 40 Japanese stocks in his fund, mainly ones with market capitalization of less than 200 billion yen, instead picks up Daiseki Co (9793.T), a Nagoya-based company specialized in industrial waste disposal, as one example.
The sales of the company, which recycles disposal oil from manufacturers' factories, are 100 percent generated in Japan.
"It's selling into Toyota and other manufacturers, so the weakening of the yen absolutely impacts its customers which in turn impacts them, and you've been seeing that flow through in its earnings and revenue," Edwards said. "Daiseki is a very good indicator in what's going on in the market."
Driven by Prime Minister Shinzo Abe's aggressive reflationary policies, the benchmark Nikkei .N225 has risen 41 percent so far this year, the best performer among developed countries.
The gains were mostly led by exporters on the back of the weakening yen, which lifts their competitiveness abroad as well as their profits overseas when repatriated. Toyota has risen 61 percent while and Sony has gained 118 percent so far this year, respectively.
After a big rally, foreign investors' interest in Japanese shares remained high.
The number of overseas money managers at recent conferences in Tokyo organised by Mizuho Securities doubled to 320 from its previous conference in February. Some 500 attended a Bank Of America Merrill Lynch event this month, about twice the number at its previous event a year ago.
"I am looking for stocks where something is changing and the market is failing to fully appreciate the value of future cash flows, and where capital is allocated in an efficient manner," said Nick Anderson, head of equity research at Henderson Global Investors Limited based in London.
Local fund managers say that the key to investing in small caps is whether portfolio managers can take advantage of their untapped potential.
"If you look at the Japanese market overall, half of the companies have zero or one analyst covering, so we think that there is big opportunity in them," said Nicholas Weindling, portfolio manager at JPMorgan Asset Management based in Tokyo.
He owns internet-related stocks such as MonotaRO Co (3064.T), M3 Inc (2413.T) and Kakaku.com Inc (2371.T), whose stocks prices soared 94-216 percent this year.
Even after these surges, Weindling intends to hold the shares for now.
"We think that these companies have multi-year growth ahead of them. It's not a one- or two-quarter story, it's not a two- to three-year story. It's a ten-year-plus story," he said.
(Editing by Simon Cameron-Moore)