Japan and Small Companies Prove a Surprising Combination

Though volatile, Japan small-company funds are putting up good numbers this year.
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Japan and Small Companies Prove a Surprising Combination Though volatile, Japan small-company funds are putting up good numbers this year.

You can make money in surprising places sometimes.

It has been a long time since either Japan or small-company funds have been those places. But virtually below the radar screen in this roaring bull market, the combination of Japan and small companies has become one of the most unexpected places to profit this year.

Although highly volatile, Japan small-company funds have been putting up numbers this year to rival those of the

S&P 500

index.

Fidelity Investment's

(FJSCX) - Get Report

Japan Small Companies fund is the No. 1 performing Japan fund tracked by

Lipper Inc.

, up 24.6% through Dec. 17.

Scudder's

(SJPNX)

Japan Fund, which is focused on small- and mid-sized companies, is ranked second, up 19.5%.

DFA's

(DFJSX) - Get Report

Japanese Small Company Portfolio, an index fund, is the third-ranked Japan fund, up 16.7%.

By way of comparison, the S&P 500 index was up 23.4% percent through Dec. 17, a performance exceeded by only 11% of actively managed equity funds this year, says Lipper. The small- and mid-cap funds are far outpacing the average Japan fund, which is up just 4.6%.

To be sure, Japan remains a risky place for investors for all the usual reasons: too much debt, too little commitment to deregulation, an economy racked by deflation. Private-sector demand continues to fall and the government budget is widening. The

Nikkei

index is down again this year.

Over the years, Japanese small-caps have hardly been a rewarding place to be. The country's structural problems have hurt the small-caps far more than the large export-oriented giants, and investors have sought safety in brand-name companies. The DFA small-company index fund is a pretty good proxy for just how bad it has been: The fund is down 52% over the last five years, more than twice the 21% decline for all Japanese funds in the Lipper universe. Don't even bother to think how any of these funds fared compared with their U.S. counterparts.

The years of bad news have taken a heavy toll. In all, there is but $1.5 billion in money in the 40 Japan funds tracked by Lipper, less money than you would find in some Fidelity select funds. The biggest of the Japan funds that emphasize small- and mid-cap stocks, Scudder's Japan Fund, has only $270 million.

"If you read the headlines, you have missed a very solid opportunity," says James Lowell, editor of

Fidelity Investor

, a newsletter.

Gregg Wolper,

Morningstar's

international funds editor, says Japan's small companies have rebounded because they have been more aggressive in adopting Western-style cost cutting and other shareholder-friendly practices. Lowell adds the small companies have less of the leverage that has been disastrous for the bigger companies.

Then, too, the small companies are simply so far behind. "The small-caps have underperformed for years before this year," says Wolper.

At Fidelity's Japan Small Companies fund, manager Kenichi Mizushita has prospered by emphasizing export-oriented technology and manufacturing companies. For instance, his top holding,

Union Tool

, which produces drills for printed circuit boards, is up 80% this year, in large part due to demand from customers outside Japan.

Morningstar notes that Mizushita remains pessimistic about Japan's domestic economy and is sticking with the companies that have healthy foreign revenues. Mizushita, for example, added

Uyemura & Co.

to his top holdings because the company supplies chemicals for coating hard drives to a growing list of international customers, Morningstar says.

The Scudder Japan Fund, one of only three Japan funds with a 10-year record, also has gained because it has two-thirds of its assets in small- and mid-cap stocks. That emphasis on smaller stocks hurt the fund last year; over the last five years the fund is down about 14%, which still puts it in the top half of its peers.

Portfolio manager Seung Kwak, who has run the fund since 1994, does no currency hedging because he wants his stock picking to drive performance. His big winner:

Nidec

, a maker of motors for hard disk drives, which is up 156% this year. The fact that he owns no banks hasn't hurt.

These funds have had a surprising run this year, and they may not be done yet. But be careful: This is probably not where you want to put your kids' college money.

Mutual Fund Tax Chat

Still have questions about the taxes and your mutual funds? Then join

TSC

Tax Forum columnist Tracy Byrnes for a mutual fund tax chat presented by

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Monday night at 9 p.m. EST (Keyword: Sage). She'll hash out those nasty capital gains distributions, discuss tax-loss selling and make sure that the wash sale rule doesn't get in your way.