Small but mighty: Japan’s small caps poised to roar in 2026

• Resilient domestic focus: Small caps are primarily domestically oriented, benefitting from local consumption growth while being less exposed to trade volatility compared with large caps.

• Strategic growth industries: These companies possess specialised skills and are deeply integrated into high-growth, strategically important sectors. They stand to benefit from Japan’s AI ambitions, reindustrialisation efforts, and policies aimed at strengthening domestic supply chains.

• Currency risk is limited: A weaker yen is unlikely to significantly impact earnings. Domestic demand, pricing power, and policy support remain the primary drivers of growth and valuation re-rating.

• Attractive upside potential: Japanese small- and mid-cap companies trade at an approximate 33% discount versus large caps, offering meaningful re-rating potential. This segment could deliver around 14.3% growth by FY2028. Investors can gain targeted exposure through the Janus Henderson Horizon Japanese Smaller Companies A2 USD and the iShares MSCI Japan Small Cap ETF (NYSE: SCJ).

Japan’s equity rally has largely been framed around the strength of large-cap exporters, yet a quieter and increasingly compelling trend has been taking shape beneath the surface. While the Nikkei 225 Index surged roughly 35% in 2025, smaller companies also posted an impressive 26% gain, despite remaining significantly under-recognised by global investors.

In 2026, as the market narrative pivots toward domestically driven growth, we believe Japan’s smaller companies are well positioned to move from the sidelines to the forefront of the next phase of market expansion.

Dual growth engines: Consumption upside and trade resilience

Japan’s first female Prime Minister Sanae Takaichi secured a landslide victory in the 8 February 2026 snap election, placing her in a strong position to advance an aggressive stimulus agenda with minimal political resistance. From the JPY11.7 trillion consumption package to her proposal to reduce food consumption tax to zero, consumption-led growth is emerging as a defining theme for Japan’s economic direction in 2026.

Alongside direct fiscal support that boosts household disposable income, Rengo, Japan’s largest labour union, is advocating wage increases of 5% or more this year, reinforcing momentum toward stronger domestic demand. This intensified focus on household purchasing power is likely to provide meaningful tailwinds for companies primarily serving the domestic market.

In contrast to large-cap corporates that typically depend on global brand recognition and international trade, Japan’s smaller companies derive nearly 90% of their revenue from domestic sources, significantly higher than the roughly 55% generated by larger peers. This domestic orientation makes them more sensitive to improving local consumption trends and wage-driven demand.

A domestically focused business model also reduces small-cap companies’ exposure to external trade volatility. Japanese exports to the US continue to face tariffs of around 15%, with the automotive and materials sectors remaining particularly vulnerable. The US still represents Japan’s largest automotive export market, accounting for roughly one-third of total shipments. Meanwhile, major steel producers such as Nippon Steel, Kobe Steel, and JFE Holdings face tariffs of up to 50% under Section 232 national security provisions. Against this backdrop, the domestically oriented revenue base of smaller companies has enabled them to deliver more resilient earnings growth in financial year 2026 (Figure 1).

Figure 1: Small cap companies in the consumer discretionary and materials sectors are performing better than large cap companies

Under Trump’s policy framework, trade protectionism is expected to remain a structural feature. As such, a meaningful rollback of tariffs on Japanese exports appears unlikely in the near term. This persistent trade friction reinforces the relative appeal of domestically oriented companies, whose earnings are less exposed to external policy shocks and better positioned to benefit from Japan’s internally driven growth cycle.

“Strong Japan’” agenda gives small caps room to shine

Sanae Takaichi has placed renewed emphasis on building a “strong Japan” capable of navigating intensifying US–China strategic rivalry while cultivating “new industries” to drive long-term prosperity. Her growth strategy prioritises 17 strategic sectors, including semiconductors, AI, defence, and critical resources, to strengthen domestic supply chains and technological self-sufficiency. While large-cap corporates remain the primary beneficiaries of the JPY7.2 trillion investment fund, smaller niche champions are also well positioned to thrive, given their deep integration into industrial supply chains and highly specialized technological expertise.

A central pillar of her strategy is to position Japan as Asia’s leading AI hub while accelerating the industrialisation of its semiconductor ecosystem. Japan’s small- and mid-cap companies play a critical role across advanced packaging, specialty materials, and testing, areas that are essential to building a competitive domestic chip supply chain. Companies such as Ibiden, renowned for its high-end semiconductor substrates, and Resonac, a global leader in specialised semiconductor slurries, exemplify this technological edge. Their strong global market positions and highly specialised product portfolios make them indispensable partners not only within Japan’s domestic ecosystem but also for leading international chipmakers and foundries. As Japan steps up investment in advanced chip development and promotes domestic semiconductor manufacturing, demand for these specialised local players is likely to rise in tandem.

Table 1: Some of the key SMIDs critical to semiconductor supply chain

Industries	Key SMID companies	Strategic value
Packaging & Substrates	Ibiden	Global leader in high-end IC substrates; critical for TSMC’s Chip-on-Wafer-on-Substrate (CoWoS) technology and a key factor in attracting TSMC to Japan.
Slurries & Chemical mechanical polishing	Resonac	Holds the No. 1 global market share in some of the critical materials, including CMP slurries (for wafer surface planarisation) and thermal interface materials (essential for cooling AI chips).
Back-end tools	Tokyo Seimitsu	A unique integrator of semiconductor manufacturing equipment and precision metrology, with a clear edge in advanced multi-axis dicing solutions.
Specialised materials	Tokyo Ohka Kogyo	Major supplier of EUV resists for 2nm and 3nm logic chips used by TSMC, Intel, and Rapidus in Japan.

Despite their specialist strengths, smaller companies often face structural disadvantages due to limited scale and capital resources in an industry increasingly defined by rising capex and R&D demands. To address this gap, the government has allocated JPY150 billion to strengthen domestic supply chain resilience and foster technological collaboration through new “back-end R&D centres.” These include advanced 3DIC initiatives led by TSMC in Ibaraki, an advanced packaging lab by Samsung Electronics in Yokohama, and a chiplet-focused facility developed by Rapidus in Hokkaido. Through these platforms, specialised suppliers such as Resonac and Ibiden are embedded in next-generation semiconductor development, with the government acting as a coordinator to integrate small cap companies into Japan’s evolving innovation ecosystem.

Beyond semiconductors, the policy agenda also focuses on national resilience, modernising infrastructure and addressing labour shortages through automation and robotics. Large construction firms secure major contracts but often outsource specialised projects to small- and mid-cap players. For example, Shimizu Corporation leads in seismic retrofitting and digital civil engineering projects under the 2026 National Resilience budget, while Yaskawa Electric benefits from “Physical AI” and factory automation initiatives. As government subsidies encourage small and mid caps to automate operations and enhance productivity, domestically produced robotics solutions are likely to see accelerating demand, further reinforcing the growth outlook for Japan’s specialised industrial champions.

As a result, sectors such as information technology, materials, and industrials are poised to deliver double-digit growth in FY2027 (1 April 2026 to 31 March 2027) (Figure 2). Meanwhile, a reflationary environment driven by higher interest rates is likely to continue benefiting the financial sector, and ongoing consumption stimulus measures are expected to support robust growth in both consumer discretionary and staples.

Figure 2: Most sectors are projected to achieve double-digit growth in FY2027

Corporate reforms filtering through small-cap universe

Since the Tokyo Stock Exchange (TSE) launched reforms in March 2023 to address Japan’s persistently low price-to-book (P/B) ratios, large-cap companies have begun unlocking significant value. Supported by share buybacks and greater market recognition, large caps are increasingly valued for operational efficiency. In contrast, small caps still hold excess cash and maintain limited investor communication. As of the end of January 2026, large caps trade at roughly 2.6X P/B, compared with 1.4X for smaller companies, highlighting a significant 46% valuation gap (Figure 3).

Figure 3: Small caps lag large peers in P/B growth

We believe 2026 presents a compelling opportunity, as small caps remain the “low-hanging fruit” for governance-driven gains. Additional measures have been introduced to help small caps improve operational and capital efficiency. In September 2025, the TSE tightened the continued listing criteria for the Growth Market to JPY10 billion market cap, effective 1 March 2030. This has triggered a wave of “defensive governance,” as companies actively engage investors to boost share prices and avoid the risk of delisting.

The government has also launched the Small and Medium Enterprise Growth Acceleration Subsidy, providing funding for machinery or AI software that reduces labour, increases productivity, and enhances business efficiency for growth-oriented small caps. Complementing this is the “10 Billion Declaration,” a public pledge to reach JPY10 billion in sales, serving as a government-backed “seal of quality” to help investors identify truly growth-focused small companies. Together, these initiatives are pushing small caps to deploy idle cash to accelerate business expansion and strengthen governance - setting the stage for higher returns.

A weak yen concern is temporary

Small- and mid-cap companies are more domestically oriented, meaning they derive limited benefit from foreign currency translation. Instead, many rely on imported materials, energy, and intermediate goods, which can leave them more exposed to cost pressures when the yen weakens. Under the Takaichi era, expansionary fiscal policy and relatively accommodative interest rates could exert some depreciation pressure on yen, raising concerns for these firms.

However, we see limited downside risk. Takaichi’s overwhelming election mandate enhances policy predictability, potentially attracting foreign capital inflows and providing a stabilising effect on the yen. Her emphasis on “responsible active fiscal policy” suggests measured, rather than reckless, fiscal expansion. Additionally, should USD/JPY approach 160 in a disorderly fashion, authorities may consider intervene.

Despite near-term pressures, we believe the yen is likely to maintain a slight upward bias this year, supported by potential Bank of Japan rate hikes and narrowing US–Japan interest rate differentials later in 2026. More importantly, currency movements are not the primary driver for small-cap performance; domestic demand, pricing power, and policy support remain the key catalysts for growth and valuation re-rating.

Japan small caps offer bigger opportunities than large peers

Japan’s small-cap universe represents a unique convergence of opportunity and resilience. Structural reforms and targeted policy support are driving better governance and operational efficiency, while domestic demand, pricing power, and strategic sector positioning provide robust growth drivers. Small-cap companies are prime candidates for re-rating in 2026 and beyond. Investors seeking both quality and upside are likely to find the most compelling opportunities in this often-overlooked segment of the market, positioning Japanese small caps as a central theme for the next phase of equity growth.

With the recent broad-based rally following Sanae Takaichi’s landslide election victory, small-cap valuations have begun to recover. Yet, relative to large caps, small caps continue to trade at an approximate 33% discount (Figure 4). While Japanese large caps continue to offer growth potential, many have already reached elevated valuations, leaving smaller caps with comparatively greater upside and more attractive entry opportunities.

Figure 4: Japanese small caps continue to trade at a significant discount to large peers

After a strong rally following Takaichi’s election victory, the Nikkei 225 has climbed to elevated levels, showing limited upside of 2.4% to our FY2028 target (year ending 31 March 2028). In comparison, small-cap stocks still appear to have more attractive potential. Based on a fair P/E multiple of 17X, the MSCI Japan Small Cap Index is projected to reach around USD 230 by FY2028 (year ending 31 March 2028), representing a 13.6% upside. If small-cap companies continue to demonstrate stronger governance, along with improving P/B ratios and ROE, this segment has significant potential for further valuation re-rating, which could translate into stronger returns for investors.

Japan remains one of our top market picks for 2026, and investors can target small-cap names to capture outsized growth opportunities. For focused exposure, we recommend the Janus Henderson Horizon Japanese Smaller Companies A2 USD and iShares MSCI Japan Small Cap ETF (NYSE: SCJ).

Table 2: Projections for the MSCI Japan Small Cap Index

	FY2025	FY2026	FY2027	FY2028
PE Ratio	21.2	19.7	16.9	14.9
Earnings Growth	23.4%	7.4%	16.5%	13.7%
EPS	9.5	10.2	11.9	13.5
Projected Fair Price (USD)				230
Upside (Based on fair PE ratio of 17X)				14.3%
*Each fiscal year ends 31 March. FY26 refers to the 12-month period ended 31 March 2026. Source: Bloomberg Finance L.P., iFAST Compilations. Data as of 17 Feb 2026.

Figure 5: Share price vs. EPS chart for the MSCI Japan Small Cap Index

Declaration:

For specific disclosure, at the time of publication of this report, the analyst who produced this report and IFPL (via its connected and associated entities) holds a NIL position in the abovementioned securities.