July 2006

LONG ONLY JAPANESE EQUITIES

One reason for the long-only strategy's positive performance in the first half of 2006 was the good performance of companies such as Nintendo, Canon and Kirin Brewery all of which advanced more than 20% in a falling market.

Another was that we had limited exposure to investments in poor performing shares such as highly valued small companies and companies that led the rise in the market late last year but have fallen subsequently. Unfortunately, the second half of the year has begun with one of our large holdings, Takefuji, falling 18% and one of our smaller ones, Impact 21, falling 13% in the month.

Takefuji's weakness stems form the threat of regulatory change. As a lender of short term unsecured funds to individuals with annual income averaging ¥5m (£23,000) the company charged an average annual interest rate on such loans of 23% (on average over the last 10 years). This was necessary to cover the cost of finance, the cost of default, which was high compared to secured bank lending, the cost of administering over 2 million customers with outstanding loans averaging ¥650,000 (£3,000) per customer. Having accounted for all these costs, 11%, just under half of the original 23%, remained as profit of which 4.5% was retained, 5.5% paid as tax and 1% paid as dividends to shareholders. Consumer lending may have a poor reputation yet these economics make for a good business and one that has generated great returns for shareholders historically. While debate and discussions are ongoing, the uncertainty makes it difficult for the company to pursue existing business and, in addition, there is a risk of increasing provisions against existing loans until such a time as the law is clarified. As a result this year's earnings will be worse than anticipated and the business scale may shrink in the future if regulations are changed placing restrictions on the company's lending rates. We have had such large position in Takefuji because it has been valued by the market for some time at prices well below our estimate of intrinsic value. Although regulatory change could lower that intrinsic value, it is unlikely to do so enough to alter the relative attractiveness of the investment. Before the threat of change materialised, the company was valued at just over book and following the recent fall is now at 75% of book. Book value includes no accounting for the value of the Takefuji franchise, one of the most widespread in Japan, and is assessed after 5 years of consumer recession where provisioning policies have been especially conservative compared to past history. The company raised its dividend by 130% last year in recognition of the degree to which it was overcapitalised with the loan book financed as much as 68% by shareholder's equity (as a comparison a typical city bank would finance only 6% of its loans with equity). Clearly with earnings as weak as they may be this year, the company could cut the dividend, yet if the end result is that the scale of the business is to decline, the capital needed to support it will as well, arguing for its maintenance. For what it is worth, we think a such a wholesale change in the regulatory framework is unlikely because excluded borrowers would be forced to defer spending or, more likely, source funds from less transparent and less reputable lenders who may flout these new regulations, delivering exactly the opposite response to that intended by the proposed change in law. Even assuming a worst case scenario of maximum interest rates capped at 20% we plan to hold shares in Takefuji and take advantage of the recently depressed prices to add to our holdings.

Impact 21 has performed poorly all year but its decline in price intensified this month following a downward revision to its 2006 business results. The company is suffering from a decline in profits caused by poor fashion merchandising of the Polo Ralph Lauren label, which it has exclusive rights to in Japan. Inventories have accumulated following slow sales and now need to be sold at lower prices. This is a temporary situation, which may take 2 years to mend. Polo Ralph Lauren is a well known and sought after brand with a reputable market position which in due course should grow supported by better merchandising and stronger consumption. While we wait for the combination of those two important dynamics we invest in a company backed 65% by net cash on the balance sheet, a 2.9% dividend yield and a free cash flow on depressed earnings of 7.5%. We have a relatively small position of just over 2% in the company which we aim to maintain.


Michael Lindsell
Aug 2006

LTL 000-038-9