A top performing Japanese fund run by investment firm Asset Management One says it is looking to build stakes in some small and midsized caps as valuations become more appealing.

The fund is also holding on to some of its artificial intelligence-related shares even after multifold gains, Tomonobu Sekiguchi, fund manager at the Asset Management One Best Selection Japan, said in an interview.

¡°The investment appeal is increasing for small and mid-cap stocks with price-to-earnings ratios below 20 times with solid growth potential,¡± Sekiguchi said. ¡°I look into companies with a high likelihood of actually growing earnings.¡±

Sekiguchi¡¯s shifting focus comes at a time when interest in Japan¡¯s small- and midsized cap companies is growing. Against the backdrop of U.S. tariffs and corporate governance reform, the Topix Small Index and Topix Mid 400 Index have both added around 18% year-to-date, edging out the 14% gain in the broader Topix.

The fund, which has returned 39% this year, was powered by the rally in its top holdings: electric wire-maker Fujikura and power facilities constructor Kandenko. The performance trounced the Topix index¡¯s 15% return, and helped it beat 99% of its competitors this year, according to data compiled by Bloomberg.

Fujikura shares surged more than 1,000% since the fund built stakes in February 2024 as capital spending in the AI sector surged. But lofty valuations and high portfolio weighting have discouraged Sekiguchi from increasing positions in the company, whose forward price earnings ratio has climbed to 28 times, the highest since 2020.

At the same time, AI stocks remain vulnerable to sudden corrections as seen in the ¡°DeepSeek Shock¡± at the start of the year. Sekiguchi, a former nonferrous metals analyst, has not completely exited his position in AI-related names even after the shock. He emphasizes sticking to his conviction with a two- to three-year outlook, while avoiding ¡°pure theme stocks¡± that lack earnings support.

Sekiguchi is also considering adding regional bank stocks, citing improved margin prospects as real wages increased for the first time this year in July, supporting the case for a rate hike.

At the same time, higher rates could pose risks to smaller companies with weaker financial foundations, underlining the importance of stock-picking.

¡°Instead, I look into companies with a high likelihood of actually growing earnings,¡± he said. ¡°In those cases, even if shares undergo a short-term correction, once people realize earnings are improving and look sustainable into next year and the year after, the stock tends to rebound and rise again, which allows for long-term investment.¡±