May 2007

LONG ONLY JAPANESE EQUITIES

Now that most of our companies have reported FY 2006 results it is worth taking stock of some of the salient characteristics of the portfolio.

Of course, one of the most important, given the emphasis we place in predictable cash generative businesses, is its dividend paying potential. Our companies have chalked up another year of high and stable returns on capital of 20%. Over the last five years this figure has averaged exactly the same level fluctuating between 19% and 21%. These returns were generated with a low capital intensity giving each company free cash flow to disperse to shareholders as dividends or to fund share buybacks. Last year 55% of these free cash flows were dispersed in such ways, up from 34% three years earlier. Tangible returns for shareholders in the form of dividends grew impressively last year by 27%, coincidentally the same rate of growth on average over the last five years. Interestingly, dividend growth projections for FY 2007 are 6%, almost the same as what they were for FY 2006 at this time last year. We think dividends this year could rise more as the year progresses, not so much driven by the performance of profits, which we expect to grow adequately but not spectacularly, but more by the pressure on companies to raise payout ratios and tangible shareholder returns in particular.

The earnings yield1 (taking the denominator as enterprise value not market capitalisation) of the portfolio for FY 2006 was 5.6% and, assuming some growth in profits, 6.9% for FY 2007. As long-term bond2 yields in Japan are trading at 2.5%, the 3.1% yield pick up in equities we think adequately compensates for the risks associated with any variable equity income stream. The dividend yield is 1.9%, again highly attractive versus bonds and cash, especially as payouts are likely to rise as more pressure is brought to bear on companies to achieve higher returns on retained earnings. The good value of the portfolio is persuasive enough from an absolute perspective but from a relative one is even more compelling. The return on capital3 of the market4 at 7.7% is less than half that of the portfolio. The average business is much more capital intensive, relies on debt to finance its business and thus has less capacity to fund dividend increases and share repurchases. As a result the dividend yield of the market at 1.1% is 40% lower than the dividend of the portfolio and, unsurprisingly, the payout ratio (including share buybacks) is much lower at 30%. The market's3 earnings yield1 is 3.6%, lower than our portfolios at 5.6%, despite the worse fundamental characteristics of the average business within the index. In our mind, this remains the big anomaly of the Japanese market. Good businesses continue to be priced very cheaply compared to average ones. This, more than anything else, gives us confidence that our strategy has the capacity to generate significant returns relative to the market over the long-term.

After holding its dividend in the face of the regulatory onslaught last year, Takefuji announced that the company plans to reduce it by 22% in FY 2007. The reduction is already incorporated in the 6% dividend growth forecast for the portfolio as a whole mentioned above. In justification, following the huge provisions the company made last year, not only has the company's excess capital been depleted but also such action appears contrite in the face of such regulatory zeal.

Following the loss of our holding in Impact 21 to Polo Ralph Lauren's tender offer we initiated a new position in Credit Saison. The company is Japan's second largest issuer of credit cards, both in its own name and in affiliation with other businesses especially retail store chains and banking groups. Like Takefuji, it has been hit by the new regulations on unsecured consumer lending and has been forced to reduce its maximum interest rates on current loans to 18% as well as make some provisions for past over-charged interest expense. Although the lending part of the business earns attractive returns, even if those margins have recently been constrained by regulation, the processing of credit card transactions and the business flow brought in from its affiliations are the most attractive characteristics of credit card companies and Credit Saison in particular. Recently, the company has made acquisitions and established affiliations to boost scale. Japan's credit card market is much less mature as compared to other western countries both with regard to credit card usage and with the fragmentation of the industry. We think Credit Saison will benefit from growth in the future as credit card usage increases nearer to western norms and a consolidation of the industry.

Michael Lindsell
May 2007

18 May 2007 LTL 000-049-3