Dec 2006

LONG ONLY JAPANESE EQUITIES

An update on Nissin Food's tender offer for a stake in Myojo Foods, discussed in last months review: 86% of the company's shareholders accepted Nissin's terms which means that Nissin takes over the business and consolidates it with its own, raising its share of the instant noodle market in Japan by 10% to 55%, all for an enterprise value of just ¥19bn.

This compares to the ¥55bn each that 10% of Nissin's market share was valued at by the market prior to the announcement of the transaction. It points to an excellent deal on the part of Nissin and helps to justify the recent rise in the share price. Normally it is just the aquiree's price that rises following an acquisition, not the acquirer's. However, for companies in Japan with excess cash resources, such as Nissin, we think it is logical that corporate activity that deploys such low yielding cash to better use is welcomed and celebrated with higher share prices.

Kirin Brewery's price performed well last month in reaction to explicit measures in the recently announced 3 year plan to target higher shareholder returns. It has long been a gripe of ours that Kirin's return on capital has been less than half that of the major overseas brewers we follow such as Anhauser Busch and Heineken. Anhauser Busch operates 12 breweries in the whole of the USA generating approximately double the sales Kirin's 11 domestic breweries. Then Kirin carries cash and investments of approximately ¥500bn, almost as much as the value of its tangible assets. Many of these investments are in cross shareholdings that we think, these days, are obsolete. Kirin made explicit reference to improving shareholder returns in the future especially in 'reviewing its asset holdings to make more aggressive use of the balance sheet'. We would certainly welcome this as well as the explicit commitment to assess the payment of the dividend from consolidated earnings as opposed to parent earnings. As consolidated earnings are typically 20% higher we should expect the dividend to grow more than the pace of profits in the next 3 years. Time will tell whether these statements signify a material change in approach. Certainly the market took in that way marking the shares up 15% in short order.

Our investment in Kansai Electric Power ('KEPCO') has been more successful than we anticipated. Since late 2004 the shares have risen by 65%, which for a utility with returns on capital as low as 3% is not bad. We had expected that excessive debt would be reduced: it has, with more to go. We had hoped dividends would be increased: they have, by 20%, probably earlier than we expected. We had expected costs to be cut: they have, but price cuts enforced by the regulatory regime have come earlier than anticipated as well. In summary with the price up so much from where we first bought it there is, now, not so much to go for. Unlike other business we have bought on the expectation of no growth that have subsequently grown (i.e. Nintendo) allowing an upward revision to our initial share price target, we see no opportunity for any growth from KEPCO. As a result we reduced the weighting marginally from 6.5% to 5.5%. The dividend yield remains alluring at 1.9% and should dividend growth progress as we think it might future gains are possible from here but not at the rate we have experienced in the last 2 years.

Taisho Pharmaceutical has been a lousy investment since we established it in 2004. Its ethical pharmaceutical business (one third of the business) lacks critical mass especially in its investment in research and development to develop really effective new products and its over the counter ('OTC') drugs business is dominated by sales of tonic drinks that are falling. Profits have deteriorated steadily over the last 3 years. The management is resting on the laurels of past successes and in our view needs to conduct a root and branch reform of both businesses to put them back on track. The only action of management that is creditable is their use of recent cash flows to buyback shares. Over the last 5 years 1 1/2 times the value of dividends paid was spent retiring 10% of the equity at what we think are rock bottom prices for the shares. Today's downside risk is protected by the value of cash and investments, which equate to 65% of market capitalisation. The upside is even more alluring. We know from recent transactions abroad: Boots selling its OTC drugs business to Reckitt Benckiser and Pfizer selling its to Johnson & Johnson, that these transactions took place at approximately 4x annual sales. Were Taisho's enterprise value to rise to that level the share price could rise 4 times from here. This explains our continued interest in the business, one we would like to add to if the management could ever get their act together.



Michael Lindsell
Jan 2007

16 Jan 2007 LTL 000-042-4