The Prudential Japan Smaller Companies Fund is a new feeder fund that invests in small capitalization stocks in the Japanese equity market (click here to read the factsheet). The lead manager is Kenichi Ura, whose been running the mother fund, the M&G Japan Smaller Companies Fund, since January 2000. He has 17 years of investment experience and has been with Prudential Fund Management since 1999. As a rule, small cap funds tend to outperform large cap stocks during a market rally, which has been the case for the past year in Japan. The mother fund has been a prime beneficiary and in the 1-year period ending 31 August 2004, the fund returned 60.7% against a benchmark performance of 58.2% (see table below).

Despite this run-up, the fund house believes that the growth cycle for small cap stocks in Japan is not over. In an interview, Kevin Gibson, Chief Investment Officer (Japan) for Prudential Fund Management talks more about the fund.

Q: What is the rationale behind investing in small-to-mid cap companies as opposed to larger companies?

A: Smaller companies stocks can be more attractive as they have higher growth potential. This can be a decided benefit during a market upturn when investors' risk appetites increase. In the 1999/2000 rally for example, Tokyo's smaller company second board rose 193% whereas the main board rose "only" 76%. In the 2003/2004 rally, the same pattern was evident with the smaller board rising 109% against the main board's 34%. Smaller companies stocks are also often under-researched, so pricing anomalies abound. These anomalies present opportunities to the disciplined and valuation focused investor.

Q: The Japanese equity market did undergo a strong rally this year. Will that fizzle out, or do you think there is real strength in this rebound? Why?

A: We remain confident about the long-term prospects for the stock market which should be supported by continued low interest rates and easy money. What is exciting this time is that many economic indicators are pointing to the return of structural growth in Japan. Corporations have increasingly restructured, and that is boosting profitability. That, in turn, is providing the working capital companies need to grow. For the past decade, economic upturns were being snuffed out as neither the banks nor the companies themselves could provide the working capital needed for expansion. That companies now have access to this money is a major step forward in our view.

While the market has paused recently as economic growth is consolidating, the outlook is encouraging. An additional support will likely be found in the changing dynamics of share transactions - changes that are for the better. In recent years, for example, banks and corporations have been net sellers as they unwound their cross shareholdings. This selling will virtually come to an end this fiscal year. Indeed, corporations are now actively buying back their shares.

In our view, the market could well move in a similar fashion to both 1971-72 and 1986-87. During these periods, the market more than doubled despite weakness in the underlying economy. We would not be surprised to see the TOPIX move significantly higher over the next few years.

The issue for investors is, of course, timing. Investors remain swayed by trends in the domestic and US economies. Both economies have hit "soft spots" to quote Federal Reserve Board Chairman Greenspan. The fundamental economic drivers suggest that both economies will transverse these "soft spots". When they do, there is ample excess liquidity to drive the market higher. In our view, though, this will take at least six months. With recent market setbacks due mainly to profit-taking by hedge funds, our view is that "buy on the decline" is the best advice.

Q: What are the main criteria for companies in the fund? Are many of the companies geared towards local demand, or are they export oriented?

A: We look for companies that exhibit qualities such as growth potential (illustrated by innovative products, high market share and natural barriers to entry); strong cash flows and under-valuation (price to earnings ratio, price to book, the return to equity, yield and enterprise value).

Some of the themes we consider are:

• Merger & Acquisition Opportunities
• China related stories
• Revival of International Competitiveness

For example, there are several small companies in Japan whose net cash holdings are higher than their respective market capitalizations. Such companies are attractive M&A targets. We hold, for example, management consultants, Tanabe Management. The company has ¥4.3 billion of cash with no debt. In contrast, its market capitalisation is a much lower ¥3.2 billion. The dividend yield is 3.8% against a background of virtually zero interest rates. Whilst we do not expect the company to grow in the manner of Honda or Sony, there is almost no possibility of bankruptcy. In our view, this company's fair value is around 2.5 times the current price.

Q: How will movements in the Yen affect the fund?

A: A stronger yen makes Japan's exports more expensive. Japanese companies understand this risk well and are gearing themselves not only by setting up manufacturing activities outside Japan but also by moving into higher technology, higher margin products. For example, Toyota and Honda supply the Singapore market from their Thailand based manufacturing plants.

Q: Going forward, what are some of the factors that will drive the equity market? (i.e corporate restructuring etc). Companies in Japan have been undergoing restructuring and cleaning up their balance sheets for some time. Has this news been completely factored in, or will it still be a growth driver for the market going forward?

A: Valuations as at September are up with events. There is tremendous longer term valuation upside however. Even though the economy has hit a "soft spot", various economic indicators are pointing to an economic "breakthrough". New orders are rising, the yen is extremely cheap on a trade weighted basis (and thus unlikely to stymie growth this time around) and machine tool investment is rising. Furthermore, both corporate net and operating profits are rising.

The picture that is emerging is one in which the market has paused to take breath while awaiting the benefits of the slowly emerging underlying structural recovery.

Corporate restructuring is continuing. This is being felt in the banks with the recent takeover of UFJ by the Mitsubishi Tokyo Group. The underlying dynamics affecting individual shareholders referred to above has also to fully run its course.

Q: What are some of the main risks for the Japanese equity market?

A: Clearly, deflationary forces are difficult to squeeze out - this was evident in the second quarter economic growth data. The risk that China miscalculates and slows its economy by more than it intends (thus slowing Japan's exports) is a risk. Sustained higher oil prices would also restrain growth. The biggest risk, however, is probably that today's export and investment led recovery does not feed through into domestic demand. The transition is occurring, but it is much slower than many would like.