* Investors favor small-cap shares with strong fundamentals
* Nikkei/Topix ratio drops to lowest since Feb 2016
* Nikkei undermined by heavyweights Fast Retailing, SoftBank
By Ayai Tomisawa
TOKYO, Aug 21 (Reuters) - Japan’s small-cap shares have outshone the overall market as investors saw them as better placed to dodge the geopolitical concerns and the stronger yen that have plagued the Nikkei share average, now languishing at more than three-month lows.
The Nikkei has fallen 1.4 percent since the beginning of June, but the broader Topix index has risen 1.6 percent, led by gains of around 5 percent in the Topix Small Stock index, which excludes the 500 biggest companies on the main board.
“There is uncertainty over global risks and geopolitical concerns, so there is a growing interest for ‘quality stocks’ such as small- to mid-cap stocks with higher returns on equity,” said Takuya Takahashi, a strategist at Daiwa Securities.
He said such examples include Start Today Co, an e-commerce company that has risen 23 percent, and Nihon M&A Center, that has gained 13 percent over the three-month period.
S-Science Co, whose business ranges from nickel processing to real estate management, has jumped 160 percent during the term.
The outperformance of Japanese small-caps is in sharp contrast to Wall Street, where large-cap multinational shares have led the rally and small-caps have underperformed.
The divergence of performance between the Nikkei and the Topix brought the Nikkei/Topix ratio, or N/T ratio, to a 1-1/2-year low.
The Nikkei’s underperformance also stems from big falls in its two biggest heavyweights, Fast Retailing Co and SoftBank Group Corp.
Unlike Topix and other major market-cap-weighted indexes, the Nikkei share average is a price-weighted index and offers outsized weightings to those two companies.
Fast Retailing has fallen 16 percent while SoftBank has dropped around 4 percent since the beginning of June, when the N/T ratio started to decline.
“The Nikkei has a higher correlation with dollar-yen levels because many blue-chip exporters are in there. Since the dollar’s rises are seen capped, the Nikkei’s upside is probably limited,” said Takatoshi Itoshima, chief portfolio manager at Commons Asset Management. The auto sector, with its global heavyweights such as Toyota Motor Corp and Honda Motor Co, had been one of the worst performers of 2017, but it gained 2.6 percent during the past three months on bargain-hunting.
Still, traders say the auto sector is likely to remain one of foreign investors’ least favorite segments this year because of the strong yen and weak U.S. car sales.
The outlook for the dollar remains clouded by political turmoil in the United States and lingering doubts about whether the U.S. Federal Reserve will hike interest rates again in 2017. There are also concerns that geopolitical tensions between the United States and North Korea could flare up at any time.
Reporting by Ayai Tomisawa; Editing by Eric Meijer