Fund managers are talking up small-cap stocks in Japan as an opportunity to extract value amid questions over the economic fundamentals underlying a resurgence in the nation’s equity market.

The Nikkei 225 Index has rallied 42% since November 12 on a wave of optimism, with Shinzo Abe of the Liberal Democratic Party re-elected president in December on the back of his “three arrows” policy of aggressive monetary easing, fiscal stimulus and support measures to boost economic growth. The strategy has been called Abenomics.

Japan’s Cabinet approved Abe’s ¥92.6 trillion ($996 billion) budget for fiscal 2013 commencing April 1, with Abe targeting 2.5% annual economic growth, from 1%. Earlier this year SBI Japannext reported record equity trading volume, as reported.

Just yesterday, the Bank of Japan (BoJ) surprised markets with its pledge to increase its purchase of government bonds by ¥50 trillion per year to achieve a 2% inflation target. That's equivalent to almost 10% of Japan's GDP.

Moreover, Abe has pushed through a ¥10.3 trillion public spending programme designed to end nearly two decades of deflation.

But Kwok Chern-Yeh, manager of Aberdeen’s $290 million Global Japanese Smaller Companies fund, dismisses the effectiveness of Abenomics, noting that public works only provide a temporary economic boost and can, in fact, add to the country’s structural problems, most notably its level of debt.

He also questioned the likelihood that the new government could hit its 2% inflation target, given that the country has yet to achieve its 1% goal. However, he was speaking before yesterday's aggressive move by the BoJ.

Kwok urges investors to look beyond macroeconomic headlines to find value in Japanese small-caps, with the Russell/Nomura Small Cap Index up 36% since November 12.

His fund, which invests in companies with a market cap of ¥250 billion and below, returned 28.8% in 2012, beating the Russell/Nomura index by five percentage points, although at the time of interview the fund was lagging the benchmark.

Kwok notes that the only stock holding it has added to its 50-strong portfolio is a real estate company. He says he is bullish on companies with strong brands abroad that are less susceptible to sluggishness in the Japanese economy, which grew an annualised 0.2% in the fourth quarter.

He points to Japanese firms that have set up factories overseas, benefiting from their domestic growth while avoiding high labour costs and a dwindling workforce in Japan.

Kwok says the advent of Abenomics has seen interest in the fund pick up among European institutions, but that this has only translated into “some inflow”.

“It is important to keep in mind that some investors have been burnt by Japan in the past,” adds Kwok, noting that the only real differences this time around are a falling yen and a central bank governor, Haruhiko Kuroda, who is willing to print money.

The yen has sunk nearly 17% against the US dollar from October to April. “I suspect investors are looking for a few more concrete steps that changes are coming,” he says.

Another firm targeting European and Asian appetite for Japanese small-caps is Sumitomo Mitsui Trust Group, which manages around $500 billion largely for Japanese pension funds.

The head of investment management at its Hong Kong subsidiary, Kota Murakami, tells AsianInvestor the firm has just launched a Japanese small-cap Ucits fund, with between 50 and 90 securities.

The company has provided this underlying strategy to Japanese pension funds since 2005 and manages about $160 million. It returned 41.23% in 2012. Now its Hong Kong office is among the distributors for this Ucits version.

“We are looking for money from overseas institutional clients,” says Murakami. “Normally the names that attract attention in Japan are the big exporters such as Toyota and Panasonic. But there is plenty of opportunity in small caps, which are not so well covered by the sell-side analysts. Many of these companies will benefit from Abe’s domestic growth plans.”

The fund’s chief portfolio manager, Satoshi Marui, notes that the small-cap sector has been supported by the easing of regulation against margin trades, which encourages individual investors to trade frequently among different stocks. He points to daily trading volume of ¥150 billion in emerging stocks – almost seven times higher than six months ago.

In addition, the announcement by Japan’s Financial Services Agency of a review on regulations for short-selling is expected to provide more liquidity in the market and support for the small-cap sector in the near future.