Analyst: Axa Framlington

It may be small but its returns have been mighty; 88.9 per cent over 12 months to October 19 – almost double the sector average - and 12.5 per cent in the past three months.

While Chisako Hardie, its manager since launch, is forecasting more sustainable and milder-paced performance from next year, she says the market isn't overheating and believes Japan’s smaller companies offer investors a defensive refuge.

Japan is not known for its low volatility, and small companies almost by definition are considered to be riskier than large caps. So, Ms Hardie’s views are quite contrarian.

“The Japan small-cap sector is more defensive to global economy external movements and currencies. Also, a change in government will be good for the sector. I can see a big swing from the large-cap company mentality to consumer focused and entrepreneurial small businesses, which can create value,” she says.

In addition, she says lessons have been learnt, both by the companies and by their investors, from the 2005 Japanese small-cap bubble.

“I look for undervalued, structural-growth companies. I don’t look for extreme growth; if an owner says he wants to grow the business by 50 per cent per year, I avoid it. I never take a big bet, even if I’m really confident about a stock, I just can’t. I buy 1-1.5 per cent and when it gets bigger than 2 per cent, I start top-slicing.”

She adds: “If you are selective about your stocks and control your risk, I’m confident within their [an investor's] exposure to Japan, a small-cap portfolio can grow steadily, diversify their investment and by doing so they can expect a good return.”

Of the 3,500 stocks classified as Japanese small caps, 500 form Ms Hardie's personal investment universe. These include those currently in the portfolio that fell from favour previously, and stocks the manager is interested in but, for whatever reason, has not yet invested in.

Ms Hardie says she “invests in growth companies that are significantly undervalued; that’s my style”. But in a country that has been the most undervalued major stock market in the world, what metrics are used?

Under usual circumstances, Ms Hardie uses the Peg rate (price/earnings divided by expected growth rate) to discern stock value, with anything lower than 1.5 considered undervalued, depending on the market environment and peer group.

However, the market has been particularly dire during the past 12 months, she says, and therefore the manager has reverted to price/book (p/b) ratios to value companies.

“Because these are smaller companies, the distribution of information can be patchy,” Ms Hardie says. “Often there is no problem with the business but a very usual reason for the stock to be undervalued is that it’s not well known to the analysts.”