Apr 2006

LONG ONLY JAPANESE EQUITIES

Following our visit to Japan at the end of March we began to establish a small holding in Sansei Food, a recently listed business we first came across in June 2005.

Following our visit to Japan at the end of March we began to establish a small holding in Sansei Food, a recently listed business we first came across in June 2005. At the time we were undecided about its prospects but the recent visit allowed us to firm up our views. Sansei is a small and simple business generating annual sales of ¥7bn. It manufactures and sells sugar-free confectionary, most boiled sweets, distributed under the 'Teicalo' brand name. Three years ago it developed a new product that has 'cool', minty flavoured layer sandwiched between two half-sized boiled sweets, a combination that the company subsequently patented. This proved an instant success because even though the sweet has no medicinal qualities, the taste has that effect. As a result it became especially popular in winter for soothing sore throats and colds. Over a period of three years the product 'Xyliccrystal' became the best selling sugar-free sweet in Japan and the second best selling individual confectionary product, with sales of ¥5.5bn versus ¥10bn for top selling 'Hi-chew', produced by Japan's largest confectionary company, Morinaga. The success of the product was such that, in the last 2 years, the company was unable to fully satisfy peak demand. Part of the listing proceeds were used to invest in a second production facility completed early this year. Sales next year (beginning from October 2006) should expand 10% as supply increases, allowing margins to rise from 17% to 21% and cash flows to more than double without the burden of new investment. On this basis we think we have accessed the businesses on a free cash flow yield of 8% and a dividend yield of 2.5% so long as the company holds to its stated dividend payout policy of 30%. This is admittedly a small businesses centred around the success of one product. However the economics of making and selling sweets worldwide are well renowned, not least because the ingredients are so cheap, and the company with its patent protection has time to its build its brand recognition and cement its market share. Observing how the company invests its cash flows will be most important as many other companies in this industry have a plethora of unsuccessful products, which is one reason why such companies generate low returns from what is inherently a highly profitable business.

Since January and especially since the Bank of Japan began reducing commercial banks excess deposits, long-term bonds yield have risen. Generic 10 year bond yields are up from 1.5% to 2.0%. Although one interpretation of this change is that it is a confirmation of the sustainability of the economic recovery and indicative of just how far businesses have come as compared to 2 years ago, it nonetheless represents a tightening in monetary policy and a more hostile investment environment for assets with little yield support. Unfortunately, it is also likely to affect the most vulnerable businesses the most. Included in these are the vast array of small unlisted enterprises, which employ over 70% of Japanese workers. Such enterprises, with paid in capital of ¥100m or less, have an average equity ratio of 24%, implying significant debt finance. As long-term loan rates rise, following changes in the 10 year bond yield, these businesses face an imminent rise in financing costs. This is particularly unwelcome because these companies have not experience anything like the recovery in fortunes as compared to their larger listed brethren. This is party because so many of the businesses are orientated to the domestic economy, which has not improved to anything like the same extent of the export economy, and also because many are part of a subcontracting chain extending down from larger companies, which have squeezed pricing for their benefit and smaller companies' detriment.

Traditionally the lenders to all businesses were major banks, regional banks and insurance companies. With the increased availability of securitised lending from the market and the improvement in cash flows and credit quality, large companies have been paying off traditional loan debt altogether leaving financial institutions loan books more exposed than before to the small companies. The main recent opportunity for loan growth for financial institutions has been personal mortgages and non-recourse loans to the property industry. Lending here may not be without its risks as rising capital values and recent rises in interest rates lessens the allure of property as an investment. In early 2003 Japan Real Estate Investment Trusts ('JREITs'), exclusively investing in prime commercial properties without any leverage yielded 5.5%-6.0%, while 10 year bond yields were 1%. Now average JREIT yields, which now include lesser quality commercial, retail and residential, with average debt to equity of 70% are now yielding just under 3% with 10 year bonds yielding 2%. The margin of safety (i.e. the simple difference between the yields) has fallen from 4.5% to 1%.

The rise in interest rates will effect small businesses most, will in turn restrain improvements in wages and employment for the vast majority of Japanese workers and will lessen credit quality of a major part of loan portfolios at financial institutions. Maybe financial institutions can offset some this increased risk with higher loan spreads. But overall, for the economy, rising long-term interest rates risks putting even more reliance on exports to support overall demand in Japan.


Michael Lindsell
May 2006