Where obsession meets opportunity: Japan’s ‘overlooked’ small caps

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As with any investment, your capital is at risk.

True obsession often only reveals itself in person. That was the case in July, when Brian Lum travelled to the Japanese city of Ogaki. It’s the headquarters of Seria, a chain of about 2,000 shops where everything costs 100 yen (50p).

“The meeting was on a rather dreary Monday morning, and the president was giving very polite and precise answers – then I mentioned that I’d been to one of its stores in Asakusa, Tokyo,” Lum tells the Short Briefings on Long Term Thinking podcast.

“Eiji Kawai’s eyes lit up. He took his laptop out, and before he even opened it, he knew that particular store was doing well. He started clicking on all these metrics to show me why its layout works and how the store had decided to place certain product categories here and there.

“For a business where success or failure depend on whether you make an extra penny on an item, that obsessiveness about detail was interesting, and I don’t think I could have got that via a Zoom call.”

Japan’s Galápagos syndrome

Seria was one of 49 companies Lum met over three weeks. It marked his first trip to the country since becoming lead manager of Baillie Gifford Shin Nippon investment trust and joint manager of our Japanese Smaller Companies Fund in May.

Lum previously focused on ‘small caps’ across the globe but relishes this opportunity to specialise in a market with unique characteristics. And he draws an analogy between the sector and the wildlife of the Galápagos Islands.

“In the Galápagos, you find a lot of unique animals because the islands are isolated, and a certain set of environmental conditions shaped their evolution.” Likewise, he explains, Japan’s smaller-sized companies are relatively protected from global competition thanks to high barriers to entry from culture, regulation and language. Moreover, many of the country’s large domestic incumbents are slow-moving and inefficient, creating the potential for nimble small innovators to be highly disruptive.

“You’re still talking about 120 million people and one of the top five economies in the world – in some ways, this is the sweet spot for small cap investing.”

Lum gives LITALICO as an example of this dynamic at play. The firm trains adults with disabilities for the workforce and provides related recruitment agency services for companies looking to hire. Japan’s economy suffers from chronic labour shortages. The government increased private companies’ legally required quota of employees with disabilities to at least 2.5 per cent in 2024, and plans a further raise next summer.

“LITALICO works with the government and local authorities, and it’s not something that a foreign company could come in and try to take over,” he explains. “It currently runs 160 vocational training centres and hopes to get to 1,000 in the next 15 years. And it’s also adding new services. For example, there might be an opportunity to offer specialised insurance.”

AI-accelerated growth

Artificial intelligence’s rise also plays to the strengths of these smaller, agile companies. “Pretty much every company I met had some sort of AI angle,” he recalls, highlighting two.

The first, Weathernews, is already one of the world’s largest private weather services providers, helping ships, airlines and road hauliers avoid storms, and Japanese convenience stores to predict demand for ramen, ice-cream and other stock.

Last year, it partnered with Google to use AI to predict rainfall in five-minute increments up to 12 hours in advance. The two have since extended the tie-up to develop more accurate flood and cyclone forecasts.

“The chief executive discussed a case in Thailand a few years ago when hundreds of cars were washed away from a car park and lost,” Lum says. “If you know torrential rain is coming, you could park them elsewhere. And Weathernews is just beginning to explore such opportunities to add value.”

The second example is Soracom, a specialist in making objects ‘smart’ by connecting them to the internet. This ranges from adding matchbox-sized trackers to shipping pallets to developing a connected light switch that tells families if older relatives are going to bed at a sensible time.

Recently, the firm has started using generative-AI analysis of security camera footage and data from other sensors so that users can receive automated alerts or ask questions.

“You can find out if workers are wearing safety helmets in a factory or be told if someone has fallen down the stairs and needs checking out,” Lum says. “All that means more things to connect, which is where Soracom makes money.”

Niche and unnoticed – but for how long?

Lum will return to Japan in November alongside his Japanese Smaller Companies Fund joint manager Jared Anderson. As long-term investors, he explains, it often takes two or three interactions to commit to a new investment, although he adds exits can happen faster.

“We tend to make quick decisions where things have changed,” he says.

Regarding the category’s broader appeal, Lum acknowledges that Japan’s smaller-sized growth companies represent “a niche asset class” that has underperformed in recent years, with valuations “that make very little sense” compared with higher-rated counterparts in other markets.

But, on the basis that share price performance follows earnings growth over the long term, he asserts there is a great opportunity for intrepid clients today.

“Most of the public focuses on the FTSE, the Nasdaq, even Bitcoin. Japan’s small caps are overlooked – and that’s precisely the opportunity.”

Words by Leo Kelion

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