Chinese demand stokes Japan's fires as small caps lead the pack

Japan is set to be one of the hedge fund industry's big themes, according to many practitioners, as individual companies restructure and Chinese demand grows..

There have been many 'false dawns' of recovery in Japan across as many bear market years, but this time recovery is likely to be sustained, believes Omar Kodmani, senior executive officer at Permal Investments.

Japan is an attractive market for hedge funds compared to Europe and the US simply because it is less crowded, he says. There has been a lack of investor interest in the country because people have been disillusioned with its market.

"Crowding is a fairly long way off," he adds, "the market is big and mature enough that if there is a surge in investment, it can accommodate it. In Japan, there are 20 to 30 funds, which seems a good working number for regional funds. We have large positions with established managers and smaller with newer managers." There also exist many inefficiencies for hedge funds to exploit.

The structure of Japan has been attractive to hedge funds for a while, according to Kodmani. Of around 5,000 companies, about 1,000 have an improving market position, with a focus on cost cutting and growing profits. The remainder are making no changes, creating an interesting long/short environment.

Every few years, small-cap companies rise in value rapidly in a cycle that can offer "phenomenal upside," according to Kodmani. This happened in 1999 and is happening again now, he says.

The reason is Japan's macro-economic environment. "It is a good market through which to capture global economic growth and we are currently seeing synchronised global economic growth," Kodmani says.

Japanese companies, many of which are exporters and supply key products to growth, are real beneficiaries of that synchronised growth.

Small-cap valuations have also been the hardest hit in Japan's sustained bear market, and so have further to bounce back, says Kodmani.

In the long term, there is no doubt that Japan is enjoying a classic export-led recovery driven by economic growth in China, the US and the West, and foreigners have responded by buying and pushing up Japanese equities, according to Michelle Sanders, co manager of New Star's Japan hedge fund.

The differences between this recovery and others that proved short-lived are that there is now a genuine story of micro restructuring that is coming through and the influence of China, she adds.

In the past, classic exporters led recovery in Japan and were its main beneficiaries. "Global exporters had decoupled from Japan's problems and were basically US stocks, correlated with the US," she says.

These stocks dominated Japanese indices and were massively over-owned by foreign investors, but have now started to underperform the market.

The reason is that the main driver for exports this time is China, which accounted for more than 70% of export growth in Japan last year.

The demand coming from China is for products of a very different set of companies to the big blue chips. China does not require Toyotas and Sony Playstations, it wants heavy machinery, industrial plant and raw materials - products that have traditionally been the domain of domestic companies in Japan.

While many traditional domestic firms are benefiting from China's growth and restructuring, many others, however, have failed to restructure and remain fundamentally poor, providing shorting opportunities.

Another strategic long-term shorting opportunity is that blue-chip exporters are over-held by foreign investors and are likely to experience a multi-year down trend relative to domestic stocks, according to Sanders.

Ed Morse, director of sales at Thames River Capital, is also positive about Japan. "We have said for some time that we felt there was an ever-increasing chance that the cyclical rally that began in March 2003 might well be the early stage of a bull market in Japan," he says.

There is a 70% chance that economic recovery will be sustained, according to Morse, driven by demand from China and micro-level restructuring.

The next few months are critical in determining whether recovery will last, and the Japanese government is capable of putting an end to it, Morse believes.

"I would never underestimate the ability of the Japanese authorities to snatch defeat from the jaws of victory," he says.

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