Jan 2006

LONG ONLY JAPANESE EQUITIES

The end of January is the second anniversary of the management of the long-only Japanese mandates at Lindsell Train.

Unlike the first, it is not one to celebrate. Over the last year the Close Finsbury Japan Fund returned 28.0%, substantially below the TOPIX index return of 49.3%. Indeed, as a result of last year's performance the good relative returns achieved in 2004 were not enough to offset the deterioration in 2005, resulting in the Fund's underperformance of the index over 2 years by 5.2%, a disappointing performance. Although we always acknowledged that our concentrated investment style and a stock selection process, which ignores the constituents and make up of the index, could produce markedly different returns from it, we have never before experienced a divergence of the scale witnessed in the last 5 months.

On the other hand, looking at performance from an absolute perspective the returns are more than satisfactory, 21% in 2004, 28% in 2005 and a two year annualised rate of 24.5%. As all our companies are selected on their ability to deliver absolute returns, it is reassuring that at least this objective has been achieved. However, looking forward, unlike the last 2 years, the average difference between the share prices of the stocks we own now and the intrinsic values we ascribe to them is now just 16%, well below the 2 year annualised return. Maybe this is a portent of a year of below average historical returns in the offing. Last year we attributed the good returns achieved in 2004 to the markets 'unusual' focus on dividends. Our portfolio then yielded 55% more than the market. Unfortunately it was not dividends that inspired the good performance from the market in 2005. Instead it was a broad based re-rating of financial, industrial cyclical, real estate and commodity companies in anticipation of a sustainable recovery in the economy. We owned none of these. Only one of our companies fully participated in this euphoria, the Osaka Stock Exchange, which, as well as directly benefiting from the explosion in trading volume in futures, had been fortunately acquired at an anomalously low price in late 2004.

The performance of our largest holdings, Nintendo, Takefuji and Canon were attributable for much of the disappointing relative returns in 2005. On average this triumvirate of 9% plus holdings advanced by just 22%, less than the index and the portfolio. Nintendo revised down its FY2005 performance early in the year and Takefuji's businesses only stabilised rather than recovered after three years of rising credit costs. Canon, on the other hand performed in line with expectations. All three companies have or are likely to raise dividends materially in FY 2005. Takefuji by 130%, Canon by 54% and Nintendo by c.20% we expect. All remain on reasonable if not cheap valuations and all have the potential to grow their franchises significantly. As a result we can easily envisage a situation where these companies lead the performance of the portfolio, once again, just as they did in 2004.

Other culprits contributing to poor returns in 2005 included Fuji Photo, Mandom and Taisho Pharmaceutical, all single digit risers in a year of a near 50% return for the index. All three companies were affected by poor short term results from a part of their businesses. Despite recent wobbles, We remain confident and enthusiastic on the prospects for all of them going forward especially at the current valuations.

Following the underperformance in 2005 it is not surprising that our portfolio now yields 70% more than the market at 1.6%. It is important to emphasise that the characteristic of high dividend yields that so differentiate what we do from others is secondary to our core endeavour to identify durable, cash generative businesses franchises at cheap prices. Most such businesses have few capital expenditure requirements and thus have prodigious dividend paying potential. Only from 3 years ago has that potential begun to be properly realised and although some companies, such as Kao Corporation, have returned as much to shareholders as the most hawkish investor would demand, others still have far to go. Thus the potential for the portfolio to yield even more without any change in capital value is realistic and probable.

In other markets achieving such a dividend yield premium to the market would, most likely, only be possible by investing in compromised businesses for yield alone, where the yield is more often than not a signifier of business distress rather than of true business value. It is interesting to observe that in Japan, currently, many high yield companies tend to be predicable stable businesses and low yield ones cyclical, capital intensive businesses, the opposite of other markets and something that we think will change in years to come. Accordingly we think that the potential for higher dividends, improvements in corporate governance and the improved management of retained earnings will heavily influence share price performance in the future. As these characteristics are prevalent in the companies we own we would expect to do well when these issues come into focus once again. What is abundantly clear is that domestic investors whether individuals or institutions are hungry for yield. It is notable that individuals remain more prodigious buyers and holders of foreign currencies and bonds than domestic shares (even following the recovery in the market) because of the allure of yield. Similarly, institutions, wedded to strict asset liability matching, continue to prefer domestic bonds over equities. As a result any diversification away from these favoured asset classes is likely to target equities with stable and growing yields first.

Just as such a focus on shareholder returns may be beneficial to our portfolio at the same time it could be detrimental to others as investors are forced to face up to the reality of many years of poor free cash flow generation by low quality businesses. Many such businesses, especially those that performed well in the market in the last five months, did so because of a cyclical recovery in profits that in some cases represented a greater magnitude of margin recovery than seen in previous cycles. This caused cash flows to expand temporarily and has allowed a welcome reduction in debt as well as some increase in dividends. However, unlike the businesses that dominate our portfolio once the cyclical downturn in profits arrives and cash flows dry up, we would be concerned whether debt is low enough for the business to sustain the downturn without resorting to cutting dividends once again. In many cases we suspect not. Furthermore many of these businesses have shareholder registers with a far greater percentage of portfolio investors than before who will likely agitate for higher ongoing returns in bad times, something that may be impossible to deliver without a wholesale restructuring of such businesses.

Michael Lindsell
Jan 2006