MW-30 -- Go Small Cap, Young Man

J@pan Inc Magazine Presents:
Weekly Financial Commentary from Tokyo

Issue No. 30
Tuesday, June 3, 2003

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Tel: +81 3 4560 9610,
Contact - Ayumi Gonno,

Viewpoint: Go Small Cap, Young Man

The Bottom Line:

o While central bankers and economic policy makers fret about
that 500-pound gorilla called "deflation," the world's equity
markets, in keeping with a time-honored tradition, have
rallied; the rally began literally as soon as the shooting
started in the Iraq War.

o As measured by the MSCI indexes, euro markets are up a solid
21.7 percent, while Eastern European emerging markets have
surged 30.5 percent. Small caps have led the rebound, with
European small caps rebounding 24.1 percent and their North
American counterparts gaining 21.3 percent. In contrast,
Nasdaq's 16.6-percent recovery looks more mundane and was even
surpassed by a solid 17.1-percent rebound on Jasdaq. Indeed,
Jasdaq has staged a nearly 40-percent rebound from early March
lows, after closely tracking the benchmark Topix for most of
last year.

o For Japan, one can only hope that the entrepreneurial "animal
spirits" of the smaller cap companies and risk-taking foreign
capital eventually lead to Japan's revival, just as the
resurgence of entrepreneurial activity in the late 1980s and
early 1990s was the engine of the US IT "miracle" and the
"new" economy. There may even be Japan's next Sony somewhere
in Jasdaq's growing ranks.

o Consequently, while the rally in small-cap stocks in Japan has
so far largely been a "stealth rally," even the fund managers
of larger domestic funds are now beginning to take notice. If
there is a playable rally in the cards for Japan's stock
market, small-cap stocks (and high-beta stocks like Nomura
Securities and the other broker stocks) will very likely lead
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Go Small Cap, Young Man
Global Equity Markets Claw Their Way Back from Secular Lows

Equity indexes around the world are slowly climbing back from: a) the
bursting of the tech-media-telecom (TMT) bubble in 2000; b) the 9/11
terrorist attacks in 2001; c) the corporate governance crisis of
2001-2002 that was instigated by the spectacular failures of Enron and
Worldcom and stricter regulations as exemplified by the Sarbanes-Oxley
Act in the US; and d) the Iraq War. Yet central bankers and
governments around the world are still fretting about the 500-pound
gorilla called deflation. Trading volumes and fund flows are but mere
shadows of the funds flowing into global equity markets (centering on
the US) during the TMT bubble, but markets are coming back from the
lows seen at the onset of the Iraq War.

As Money Watch pointed out as the Iraq War was just beginning, "the
time to buy is when there is blood running in the streets," as Baron
Nathan Rothschild so bluntly put it back in 1815 or so. Meanwhile, as
governments around the world have moved to ease monetary policy to
support the negative impact of shrinking capital values on
their respective economies (led by Alan Greenspan at the Federal
Reserve), there is lots of liquidity sloshing around.

Some of this liquidity stampeded into gold stocks as geopolitical
tensions were peaking, and some of it "hid" in bonds and other
defensive investments. But recently there has been a different trend
developing, one that is potentially more equity-market friendly -- and
that is price gains in small cap stocks and emerging markets.

In the developed markets, the euro markets (as measured by MSCI
indexes) are up a solid 21.7 percent quarter-to-date, aided in large
part by continued new highs in the euro against a failing US dollar.
Eastern European emerging markets have surged 30.5 percent, while
small cap markets in Europe have rebounded 24.1 percent and in North
America by 21.3 percent. In contrast, Nasdaq's 16.6-percent recovery
looks more mundane and was even surpassed by a solid 17.1-percent
rebound in Japan's Jasdaq. Indeed Jasdaq has staged a nearly
40-percent rebound from early March lows, after closely tracking the
benchmark Topix for most of last year.

Singing the Praises of Small Caps
The global small-cap rally has a lot to do with liquidity. In the US,
the Fed has kept the money supply perking along at 8 percent or so
yearly for years now. There is also plenty of hedge-fund money that is
still itching to participate in the small-stock rally. Besides the
cheap borrowing costs, America's freshly scrubbed small-caps are
enjoying a junk bond rally given record-low interest rates.The biggest
encouragement from this is the promise of what it could bring.
Small-cap stocks are often the first to rally after a bear market.
Small-cap companies, often perform quite well after a war or
recession. Indeed, since 1946, smaller-cap stocks in the US had an
average one-year return after recessions of 37.8 percent, compared
with a return of 23 percent for large caps, according to Ryan Beck &
Co. So far in 2003, the US Russell 2000 small-cap benchmark index has
outpaced the gains for the Standard & Poor's 500 index and the Dow
Jones industrials, although it trails the Nasdaq composite. As the
economy recovers, smaller companies often see more explosive growth
than bloated, large companies with more complicated businesses.

In the US, small-cap firms are also less prone to accounting scandals
that have wreaked havoc on large companies such as Enron and, more
recently, HealthSouth in the US. In Japan, small caps are less
susceptible to the tsunami of cross-holding unwinding and "daiko
henjo" (return of the Welfare Pension portion of corporate pension
funds). Economically smaller companies have less diversified
businesses, and those that manage to survive a downturn (or a
long-term malaise in Japan's case) actually benefit from the
structural changes taking place in the economy and a pickup in mergers
and acquisitions in the months ahead as interest rates remain low and
investors go bargain hunting.

Globally, small companies are rebounding because the economic picture
(or at least perceptions thereof) has brightened and investors are
taking a new look at stocks that were battered severely in the market
downturn. Finally, since small companies are typically domestic and
don't have as many "moving parts," investors in the main do not have
to be too concerned with the geopolitical issues that investors have
been faced with essentially since Sept. 11, 2001. Instead, they can
focus on the basic business of each company.

Jasdaq Doesn't Necessarily Mean Small Cap
Jasdaq is increasingly beginning to resemble Nasdaq in the US in terms
of company attitudes toward listing, and in terms of the market
capitalization of companies listed on Jasdaq, i.e., they are no longer
all micro-cap companies with extremely thin liquidity, and some of
them actually like being on Jasdaq rather than using the bourse as a
springboard to the "big board" Tokyo Stock Exchange.

For example, Yahoo Japan has a whopping 1.4 trillion yen in market
capitalization, and has become an example of a successful "new
economy" model for Yahoo around the world. The other original "new
economy" stock is Rakuten, which is up a whopping 67.8 percent since
the end of March, 2003. Moreover, foreign capital business models are
well represented, including Yahoo Japan, McDonald's Japan, UMC Japan
and Toys R Us Japan. From looking at Yahoo Japan and Rakuten -- two
pioneers of Japan's "e-economy" dream -- Japan's "diginet" was not a
total boondoggle. While the bulk of Japan's new diginet company
business models failed, those who assumed first mover advantage long
before the boom hit appear to have done much better than the legions
of "me too" diginet companies that subsequently emerged.

Thus while the world's central banker's fret about a global contagion
of Japan's deflation, and geopolitical concerns about things like Sars
and terrorism linger, investors are beginning to rummage around in the
post-TMT bubble and corporate governance-scandal debris for stocks in
which they can obtain at least a medium-term capital gain. Though
current fund flows are nowhere near what they were at the peak of the
TMT bubble, there is, nevertheless, enough money left to fuel a good
rally in the smaller capital markets and companies. Global equity
markets are thus at a crossroads. Historically, small-cap stocks have
performed well during the initial stages of an economic recovery. Thus
the current small-cap rally, from a historical perspective, is the
first sign that the global bear market in equities may be turning the

More Than a False Dawn?
The bears will tell you this is a false dawn, just as the rally in
Japanese stocks in 1993 was a "sucker's rally" that merely drew a
large number of still-surviving investors into the vortex of Japan's
decade-long bear market. A look at the long-term Dow Jones industrial
average in the US shows an ugly-looking head-and-shoulders waiting to
happen. In addition, the recent rallies in the US market are starting
to look over-extended, at least short term. But Money Watch believes
that the global economy and global equity markets (beginning with the
US market) are still structurally much more healthy than Japan. During
the US Great Depression in the 1930s, a "comedy of errors" actually
produced a four-stage depression. In fact, given the litany of
government errors (i.e., in terms of both monetary policy and fiscal
policy), it's a wonder the US economy recovered at all in the 1930s.
The "too little, too late" policies of the Japanese government in the
1990s look very similar to the follies of the US government in the

But the situation for the global economies, particularly the US,
appears to be much different than that of the 1930s. Unlike Japan, the
US banking system still works; it continues to fulfill its role as a
money multiplier through which the Fed can exert influence on the real
economy with monetary policy. In addition, while the US stock markets
have crashed, there has not been a corresponding crash in property
prices. Thus, while there is a small possibility (as admitted by Alan
Greenspan) that the US may merely be where Japan was in 1993, their
recognition of the problem and willingness to do whatever it takes in
terms of Fed and fiscal policy to prevent deflation is a world of
difference from Japan's awareness of its problem in the early years of
the Heisei Malaise. As most economists who have studied the problem in
depth observe, an ounce of anti-deflation prevention is worth a pound
of cure.

In Japan, Small Caps Have the Cards Stacked Against Them
One can only hope that the entrepreneurial "animal spirits" of the
smaller-cap companies in Japan and risk-taking foreign capital
eventually lead to the economy's revival, just as the resurgence of
entrepreneurial activity in the late 1980s and early 1990s was the
engine of the US IT "miracle" and the "new" economy. There may even be
Japan's next Sony somewhere in Jasdaq's growing ranks.

In terms of stock prices, however, investors still have to keep a few
caveats in mind. Essentially, the second section of the Tokyo Stock
Exchange (TSE 2) and Jasdaq stocks have fallen between the cracks
during Japan's long-term bull market. Here are the reasons why:

1. The "flight to quality" in Japan has meant fixed income and
highly liquid, large-cap stocks; the funds invested in
smaller-cap stocks have until fairly recently been shrinking.

2. The stock market malaise has meant shrinking research
departments on the sell side, and a focus on those companies
where the brokers have a hope of providing investment banking
services. In addition, it takes a lot of orders in the stock
of small-cap companies to equal one order from a big-cap
company. Consequently, there is structural prejudice against
covering small caps on the sell side, meaning that there is
little, if any, coverage of vast swaths of listed TSE 2 and
Jasdaq companies.

3. The majority of these companies have taken a very passive
attitude toward investors, and in some cases don't even hold
analyst meetings! This has prompted Jasdaq officials to
actually require that Jasdaq-listed companies initiate
investor-relations programs. There is a dearth of information
about these companies.

4. The majority of the trillions of yen that the corporate
pension funds are liquidating to turn over the cash in Welfare
Pension funds to the Government Pension Investment Fund will
end up in indexed funds or in the stocks of those companies in
the major benchmark indexes, i.e., Topix, not TSE 2 or Jasdaq.

5. The pool of mutual funds that manages equity funds remains
depressed, as individual investors flee overseas or simply
keep their savings parked in the post office. Consequently,
the rally in small-cap stocks has so far largely been a
"stealth rally." But even the fund managers of larger domestic
funds are now beginning to take notice. If there is a playable
rally in the cards for Japan's stock market, small-cap stocks
(and high-beta stocks like Nomura Securities and the other
broker stocks) will very likely lead the way.

-- Darrel Whitten

============================= EVENT ==================================
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Written by Darrel Whitten

Edited by J@pan Inc staff (


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