JAPAN IS THE RIGHT PLACE TO LOOK FOR TURNAROUND IN SMALL-CAPS

This year’s rally in Japanese small-cap stocks has sneaked up on some international money managers and left others pleasantly surprised.

The roaring over-the-counter exchange, the Jasdaq, was up more than 22% for the year, at the start of last week. Japan’s large-cap Nikkei 225 was also cooking, with a recent one-day rise of 5%. For the year, it’s up more than 9%.

While experts say it’s too soon to call this a bona fide recovery, the good news is long overdue. Investors who bought into Japanese small caps late last year are profiting handsomely. But many U.S. value managers who increased their positions last fall did so with big companies like Nissan Motor Co. Ltd. and Canon Inc., whose gains have been more subdued.

The biggest gains were in companies with market capitalizations ranging from $500 million to $5 billion.

“I’m surprised at how well international small-caps have done, and Japanese ones have done the best,” says Matthew Peterson, vice president of investment management for CMS Financial Services, a Rockville, Md., consultant with about 100 rich clients and $900 million in assets.

Japan funds buying

Buyers outnumber sellers on the Jasdaq and Japan-dedicated mutual funds also are buying Jasdaq stocks because of single-digit price-earnings ratios of potential growth stocks, says Andrew Reitenbach, a small-cap portfolio manager with Pinnacle International Management LLC in New York. It has $5.5 million in individually managed international small-cap accounts.

Pinnacle has Fancl Corp., a leading mail-order cosmetics company, in its portfolio. It’s up more than 50% for the year.

Fancl is one of a handful of IPOs — including Yahoo Japan Corp. — that came to the market last year and helped propel the Jasdaq, Mr. Reitenbach adds.

Japan-dedicated mutual funds saw a net gain in sales of $2.1 million in January, according to Financial Research Corp. in Boston, coming after December’s loss of $64.1 million. The big month for Japan funds, however, was last November when they gained $113.3 million.

The smaller companies clearly have some international managers interested, although firms like J.P. Morgan Investment Management Inc. are too big to make a splash in that market.

Investors say small and midsize companies in Japan aren’t as burdened with debt as larger companies and they tend to have managers who aren’t afraid to shake things up.

Over the past months Brandywine Asset Management Inc. in Wilmington, Del., has seen its basket of 10 Japanese small-caps increase to 20% of its exposure there, from 15%.

Since November Putnam Investments in Boston, which holds $225 million in mutual funds assets in international small companies portfolios, has increased its weighting of Japanese stocks to more than 8% from 5%. And Lloyd George Management in London, which manages $1.2 billion in U.S. assets, is increasing its Pan Asian allocation to Japan to 40% from 25%, focusing on small companies.

Some managers and analysts say the domestic economy could grow this year, benefiting smaller companies that sell to consumers at home.

They are looking at companies with a stake in the Internet or computer software.

Brandywine owns Taiyo Ink Manufacturing Co. Ltd., which makes inks for electronic materials like wiring boards.

Investors also are looking for companies that are laying off workers and closing old factories. One such company in Brandywine’s portfolio is Japan Foundation Engineering Co. Ltd., which is listed on the Tokyo Stock Exchange.

That’s a big change from the old days, when “management was treated like royalty,” says Paul Ehrlichman, a managing director at Brandywine.

“Ten percent to 20% of the labor force was women who took care of men,” with serving tea a big part of their job, he adds.

Other small- and mid-cap stocks Brandywine owns include Japan Airport Terminal Co. and Ralse Co. Ltd., a supermarket chain that specializes in inexpensive produce.

Still, says Henrik Strabo, chief investment officer for international equity at American Century Investment Management Inc. in Greenwich, Conn.: “Small-caps are more sensitive to economic development. With Japan’s economy, the perception is that it’s going to recover. But, there’s been eight years of promise.”