February 2007

LONG ONLY JAPANESE EQUITIES

We are pleased with the drip feed of good news that emanates from Canon. Following a reassessment of its diversification into the production of large flat panel display screens (see January 2007 monthly), a poor and highly competitive business we think, the company has initiated its first ever share repurchase programme. Canon plans to buy back 1.3% of its equity over the next month at a current earnings yield of 6.2% which is highly accretive for long term investors, such as us.

Late in the month we visited Japan to amongst other things update ourselves with the progress of some of our smaller company positions. Earth Chemical’s business is performing in line with expectations. As it specialises in selling home use insecticides and has high and stable market shares, the business is predicable except when affected by unseasonable weather. Apart from the stable cash flows there are two potential sources of upside surprise for the company. First is the prospect of transferring production capacity overseas to take advance of lower labour, capital inputs and raw material costs. The company think that overall production would be halved in China. However, due to delays in acquiring the revelant permits, the management signalled that the pace of expansion overseas would be slower than suggested in July last year. Second, is the prospect of consolidation in the industry. There are 3 competitors in this Y100bn industry and the president of the company believes ultimately there should be just 2. In December Earth bought more shares in Fumakilla, the third largest company with a 10% market share, raising its stake to 5%. Despite the belief and actions, the management play down expectations of any consolidation in the near term. Currently, we only have a 1% weighting in the strategy and would like to increase the exposure but only at lower prices.

We are intrigued by the 13% stake Tokyo Individualised Education (‘TIE’) owns in Meiko Network. We used to own TIE but sold it when it reached elevated prices and instead concentrated our investment in this industry on the company with the better business model, Meiko Network. Both businesses generate lots of free cash and TIE has, interestingly, decided to invest theirs into Meiko shares instead of buying back there own or paying higher dividends. The management of TIE is coy about their intentions and claim the holding is just a long term investment. Whatever it is, I feel encouraged about it. If it is just an investment it provides and independent endorsement of the value we see in Meiko’s business by someone who is much more knowledgeable about the extra-curricular educational business than us. On the other hand if there is a hidden agenda to promote consolidation the industry that would be good as well, both commercially and because Mieko’s share price would more likely reflect its true intrinsic value, which we judge is at a level much higher than the price today. We watch events with interest.

We met with Medikit for the second time. The company makes medical equipment, such as intravenous needles and angiography catheters. Its bread and butter business, where it has a dominant market share is supplying intravenous needles for use in dialysis. Dialysis use growing a reliable rate of 5% per annum. The only negative is needles, like most other medical products and equipment, are subject to mandated price reviews every two year from the health and welfare ministry. Growth will be driven by overseas sales of intravenous indwelling needless, which have a patented valve to prevent reverse flow of fluids that in turn helps to prevent infection. This year sales are up approximately 20%, driven by demand from the big overseas medically products distributors such as Boston Scientific. Next year the company expects overseas sales of angiography catheters, catheters inserted up veins, to grow in the same way. The company is increasing production capacity by as much as 30% to satisfy this new demand. The shares remain cheap, trading on a free cash flow yield of 7%, dividend yield of 2% with 50% of the market capitalisation backed by cash alone. The strategy now has a 2% exposure to this £100m company.

Our other relatively recent purchase, Sansei Food, has been disappointing. Confectionary sales were weaker than expected in late 2006 and are also behind budget in the beginning of this year. Fixed costs should begin to decline as the new factory was completed but the company has been plagued with higher input costs, mainly of raw materials. There is no doubt that the unseasonable weather has not helped. The sweets sell disproportionately well in winter to help to soothe cold and sore throats, even though they have medicinal function. The shares have fallen and now yield 2.5%, and generate a cash flow yield of 8.5%, assuming normalised depreciation and capital expenditure. The shares are cheap but will probably not rise until current poor sales trends stabilise.

We confirmed that the prospects for Obic Business Consultants (‘OBC’) remain good. As the main provider of packaged business software to small Japanese businesses sales were boosted by the update to company law during 2006. In 2007 we expect a similar benefit from the introduction of the Japanese equivalent of the USA’s Sarbanes-Oxley compliance and then in 2008 we anticipate companies will begin to upgrade to the new Microsoft vista operating system. All this helps spur new or repeat revenues over and about the ongoing 6% growth in new companies annually. This revenue is highly accretive at 40% operating margins. My gripe with the company has been the use of the cash flow. Although this year’s dividend was raised 17%, the payout is still low at 25% and there is no history of share repurchases. What is worse is that a proportion of historical and we presume future cash flows are invested in a burgeoning portfolio of unrelated business and funds. With the stock market at its highs these investments have done well, but that might not always be the case in the future, introducing unwelcome risks. We have made allowances in our estimate of intrinsic value to account for these risks, but in our view OBC would be a far better and more valuable business where they not around in the first place.


Michael Lindsell
Mar 2007

08 Mar 2007 LTL 000-044-7