January 2007

LONG ONLY JAPANESE EQUITIES

January represents the third anniversary of managing the long-only strategy in Japan. Over the three years our annualised return was 20.1% which represented an annualised added value versus the TOPIX of 1.8% per annum, after suffering annualised expenses of roughly 2% per annum. Over those three years our performance has been driven by a limited number of companies. The Osaka Securities Exchange was up 6x, Nintendo up 3x and Tokyo Individualised Education, Kirin Brewery, Canon and Takeda all up 2x.

As good illustration of the objectives of our strategy the dividend yield on Nintendo, Osaka Securities Exchange and Canon when they were originally purchased 3 years ago based on the dividends likely to be paid this year were 5.0%, 5.7% and 3.1% respectively. In truth we had no certainty that we were accessing such alluring yields (significantly higher than the then long term bond yield of 2.1%) but we did know that we were buying shares in exceptional business that had a better chance than most of delivering ongoing dividend growth. We hope as future years progress that these starting yields will rise further, for if they do capital values should almost certainly increase more.

It is notable that even for the two major disappointments of the last three years, Takefuji and Impact 21, both of which have fallen 20% in a market that rose 60%, dividends have risen, 130% and 60 % respectively. As a result these shares now trade on dividend yields of 4.8% and 3.0% at today's prices.

Looking at 2006 in isolation the strategy returned 15% outperforming the index by 12.9%. The main contributors were Nintendo (up 117%), Canon (up 46%) and the Osaka Securities Exchange (up 142%) and the main detractors Takefuji (down 41%), Impact 21 (down 41%) and Aderans (down 17%). It is always important to add value with the big holdings. Last year should have been even better if we had not lost out so much with Takefuji.

Nintendo began the year with a further 15% rise in value. It was better than expected 3rd quarter results that galvanised the company's continued share price ascent. We continue to reluctantly trim the position as it rises over 10% of the Fund's net assets, the maximum allowed in any one investment. Valuing a business that is changing so much is a difficulty but we still think that other investors fail to fully appreciate the dramatic effect that the strategy of attracting customers from age groups other than young males could have on the average level of future sales. Over the last 10 years sales averaged ¥500bn per annum, this year they should reach ¥900bn following the companies success with this strategy in Japan. Next year sales should be even larger especially if the success with the strategy extends to Europe and the USA, where recent indications look most encouraging. As the markets in both Europe and the USA are both typically 2x the size of that of Japan, further overall sales gains could be material. Furthermore, this surge in sales has had little effect on margins which are just above 20%. We think this may change as economies of sale improve and the one off costs of launching the recent products falls away. In the past, in good years for sales, margins have reached as high as 27%, something little discussed in the increasing volume of research written on the company. Finally, we think this year's dividend is likely to rise approximately 30% (on top of last years 44% rise) and though the yield on the shares is lower than it once was it still remains at 1.5% some 40% higher than the market yield.

Canon reported better than expected 2006 results but conservative 2007 projections that disappointed the market. We were encouraged by 2 aspects of the report. First the dividend was raised by 50% in line with the company's targeted 30% payout ratio, 10% higher than 2 years ago. Second the company curtailed its planned business expansion into the manufacture of large scale flat panel displays ('FPD'). We worried about this venture as we saw it as low return, capital intensive and highly competitive with none of the great business characteristics of the existing printer business. Clearly, following the recent declining price of FPD's, the company is concerned as to whether it can achieve an acceptable return on investment. Although it has not abandoned the venture entirely we take such an announcement with some encouragement that the understandable yearning for sales growth will be conditional on achieving an acceptable return on capital. Instead, we would be even more encouraged if the company reduced its cash pile by introducing a share repurchase programme. At the current earnings yield of 6.2% it would represent a good use of excess shareholders funds and would help bolster return on equity.



Michael Lindsell
Feb 2007

13 Feb 2007 LTL 000-043-8