Is Yen Depreciation a Headwind or Tailwind for Japanese Small Stocks?

Key Takeaways

» A weak yen typically affects retail-related companies that import and sell goods from overseas.
» Inbound tourism and foreign investment in Japan are not only considered pure beneficiaries of the yen depreciation but also drive a shift in corporate management mindset.
» We believe bottom-up stock picking and fundamental research strategies can capitalize on these tailwinds.

The Japanese yen continues to decline against major currencies.

In 2024, the Japanese yen has significantly weakened, especially against major currencies such as the U.S. dollar, euro, and British pound. This trend is primarily due to the Bank of Japan’s (BoJ) dovish monetary policy, which stands in stark contrast to the aggressive rate hikes by other central banks over the last two years. This situation is likely to persist, raising important questions about how the continued depreciation of the yen affects Japan’s small and mid-cap stocks. 

Small and mid-cap stocks generally have a higher proportion of domestic demand companies compared to large-cap stocks. As a result, they are likely to be negatively impacted by the weak yen, particularly retail-related companies that import and sell goods from overseas. The rising costs of imported raw materials and fuel, exacerbated by the yen’s depreciation, pose significant challenges to their operations. 

Challenges and Opportunities for Japan’s Small and Mid-Cap Stocks

Looking at the example of TOPIX Small, 78.8% of its sales are domestic and 22.2% are overseas. Considering that TOPIX is 50.5% domestic and 49.5% overseas, Japanese small-cap stocks can be considered negatively affected by the weak yen, simply because TOPIX, with its high ratio of overseas sales, has a stronger ability to earn foreign currency, resulting in higher revenue in Japanese yen terms. The depreciation of the yen is expected to exacerbate the rising costs of imported raw materials and fuel, adversely affecting the operations of small and medium-sized enterprises in sectors with high import dependency, such as construction and retail.

However, we believe there are also positive factors that could benefit small and mid-cap stocks. Inbound tourism and foreign investment in Japan are not only considered pure beneficiaries of the yen depreciation, but also drive a shift in corporate management mindset towards proactive price pass-through strategies, which were unthinkable under deflation.

1) Pure Beneficiaries of the Yen Depreciation

Inbound Tourism: ‘Land of the Plunging Yen’ is a bargain-basement tourist destination.

Inbound tourism is a bright spot. Japan, having opened up to tourism only about 15 years ago, saw a peak in 2019 with each tourist spending approximately $1,200 to $1,500, contributing $40-45 billion to GDP. This sector, which suffered during the pandemic, is now rebounding strongly, aided by the depreciated yen which increases tourists’ purchasing power. In March 2024, the number of inbound tourists to Japan surpassed 3 million in a single month for the first time in history. This trend continued for three consecutive months, with over 3 million tourists each month as of May. The numbers are on track to exceed the pre-COVID peak of 31.88 million annual visitors.

J. Front Retailing Co., Ltd., a major Japanese retail company best known for operating the department store chains Daimaru, is a pure beneficiary of inbound tourism. The company’s store network is primarily centered in Osaka, Kyoto, and Tokyo, making it well-positioned to cater to the needs of inbound tourists. As inbound tourists spread from Tokyo to regional areas, inbound consumption is also expanding to major regional cities. The firm is preparing for the redevelopment project in Nagoya, a Japan’s fourth most populous city and is a major economic and cultural hub, set to open in 2026. Despite having conservative business plans for the next three years, the strong inbound demand is driving performance at a pace that suggests the mid-term management plan will be achieved ahead of schedule. With its ability to capture inbound demand, including in regional areas, we believe the company continues to have significant upside potential

Foreign Investments: Leveraging the yen depreciation for strategic investments.

As Warren Buffett noted, Japan is seen as geopolitically safe. This perception is reinforced by significant investments from companies like TSMC and Micron Technology in Japan. These investments are drawn by several factors, including lower capital expenditure burdens and the availability of skilled engineers at reasonable costs. Additionally, Japan’s stable political environment, advanced infrastructure, and supportive government policies make it an attractive destination for high-tech manufacturing and research and development. The depreciation of the yen further enhances Japan’s appeal as a cost-effective location for international businesses looking to expand their operations.

Kyudenko Corporation, a construction company based in western Japan, is well-positioned to capitalize on the current economic trends. Our initial investment in Kyudenko was made in 2019, based on the expectation that its temporarily decreased profit margins would recover. Despite experiencing high growth and increasing its workforce, Kyudenko’s stock price had stagnated due to unprofitable projects. We believed this decline in profitability to be temporary. With steady improvements in profitability and strong domestic demand for capital investments in semiconductor factories and data centers, the company’s performance is being further boosted. While the market is focused on the increasing demand for capital investments in semiconductor factories, such as JASM (Japan Advanced Semiconductor Manufacturing, Inc.), a joint venture sponsored by TSMC along with other Japanese companies, we believe that the business environment surrounding Kyudenko is even more robust than anticipated. The demand for capital investments extends broadly to peripheral industries, and large-scale redevelopment projects, such as the “Tenjin Big Bang”, are on the horizon. Kyudenko’s strong presence in its home base of Kyushu gives it a significant advantage in securing partnerships and talent. 

2) Hidden Benefits of Yen Depreciation

A Shift in Corporate Management Mindset.

Today, moderate inflation has become more prevalent, initially driven by rising commodity prices and now further influenced by the depreciation of the yen. As the burden of rising procurement costs for raw materials increases, it becomes necessary to pass these additional costs onto sales and order prices to sufficiently secure profits. In Japan, where deflation has persisted for a long time, consumers have become accustomed to a deflationary mindset. Additionally, Japanese companies have been forced to adopt conservative management practices in this extremely deflationary environment, leading to a tendency to refrain from raising prices and making future investments. Now, Japanese companies need to shift away from their previously conservative stance and actively pursue sustainable growth.

Take MaedaKosen Co., LTD. a company specializing in the production of industrial and construction materials, as an example. Through its subsidiary BBS Japan, MaedaKosen is also known for manufacturing high-quality wheels, particularly forged wheels. BBS’s forged wheels, which achieve unparalleled lightness and strength through their unique manufacturing process, are used in motorsports including F1, as well as in luxury car brands. This has established BBS as a dominant force in the industry. In Japan, where a prolonged deflationary environment has persisted, implementing price increases is challenging. Despite this, the company’s high-quality, unmatched product capabilities ensure that price increases do not lead to customer attrition. The management is actively implementing price adjustments to improve profit margins. Furthermore, the company’s production of large wheels is seeing growing demand led by the trend towards larger wheels, which are aimed at improving driving performance and achieving a more refined appearance. This trend is expected to continue driving the company’s performance growth in the future.

In Japan, where a prolonged deflationary environment has made it difficult for price increases to be accepted by all consumers, companies that offer high value-added products, like MaedaKosen, tend to have their price increases accepted. The management of these companies is steadily working on improving profit margins through price adjustments. We believe that investing in companies that can adapt to these changes and see them as business opportunities is becoming increasingly important.

An Opportunity to Benefit

While the depreciation of the Japanese yen presents challenges such as increased costs for imported raw materials and fuel, it also offers opportunities for growth. Inbound tourism and foreign investments are driving demand, benefiting companies like J. Front Retailing and Kyudenko. Additionally, the shift towards more proactive pricing strategies exemplified by companies like MaedaKosen, indicates a positive transformation in the corporate mindset. 

One way to potentially benefit from this trend is with the Hennessy Japan Small Cap Fund. The Fund is sub-advised by Tokyo-based SPARX Asset Management Co., one of the largest and most experienced independent Asia-based asset management specialists. SPARX employs a bottom-up fundamental approach with a deep understanding of the situation to construct a portfolio focused on small domestic Japanese companies likely to benefit from the depreciation of the yen.