Oct 2006

LONG ONLY JAPANESE EQUITIES

Takefuji experienced another weak month of performance.

The shares fell by 22% in October in response to news that the new laws introduced to reduce the maximum interest rates charged by consumer finance companies, such as Takefuji, proposed a lower rate than previously indicated and that Takefuji and other consumer finance companies were required to make higher than anticipated provisions against the 'excess interest' on existing higher rate loans, causing interim losses and a fall in book value. We had thought that proposed changes would be less draconian as politicians would recognize that consumers' demand for such loans was as much a basis for growth in the industry as the promotional effort by the companies to advance their business. Also, restricting interest rates and the size of loans by statute not only withdraws credit but may encourage borrowers to seek the funds elsewhere from far less reputable sources, thereby negating the moral purpose of the change in legislation in the first place. Despite such obvious woes and our misjudgement of the political agenda, we remain attracted by the value of the shares for a number of reasons. First, the company is currently valued at a discount to book value of almost 30%. Next, it has ample capital, with loans backed 60% by equity, to cope with the increased provisions that should accompany the contraction of its existing business. Also, with the announcement of its interim results the company maintained its dividend, currently 5.4%, (we thought it might be cut), a sign, we think, of the true capital strength of the company in such torrid times. Finally, despite the industry inheriting, though its past practices, a certain distasteful notoriety, Takefuji, for good or for ill, operates one of the most widespread and recognised consumer franchises in Japan. Still the proposed changes will doubtless impact both the extent and likely profitably of its future business but we think future cash flow returns should remain better than most other businesses in Japan even if they may be lower than they once were.

Another poor performer was Aderans which fell 11% after disappointing interim results. The company makes bespoke wigs for both men and women. Originally men formed the largest customer base as loss of hair in Japan had a social stigma which Aderans cleverly exploited. However such concerns are less today than before so the company has relied increasingly on the thinning pate of older women to grow its business. New customers almost always become repeat customers, for obvious reasons, giving the company a particularly durable business dynamic. However, growth is dependant on new customers that have been difficult to attract because of competition in the women's market, where their virtual monopoly has fallen to an 80% market share, and the difficulty of persuading men of the necessity of wearing wigs in the modern age. Offsetting this, the company's overseas business that concentrates on hair transplant and hair care clinics has moved into profits. While the company addresses the problems in the women's market it has at least committed to return 100% of free cash flow to shareholders in dividends and/or share buybacks, making the shares on a dividend yield of 2.0% and an enterprise value to sales ratio of just 1x good value with little potential downside risk in our judgement. On a brighter note Meiko Network announced results in line with expectations but increased its dividend by 20%, the 8th consecutive year of increase, a 40% annualised rate over that period. The shares responded with a 12% monthly increase. Also, Astellas, following on from the significant changes to its capital allocation policy last month, rose a further 11% in October.




Michael Lindsell
Nov 2006

15 Nov 2006 LTL 000-041-1