Aug 2007

LONG ONLY JAPANESE EQUITIES

Months like October, when the market declined by 5.7%, remind us just how indiscriminate selling of shares can become in a down market. This of course presents us, as long-term investors in a concentrated portfolio of durable businesses, with buying opportunities and we continue to add enthusiastically to our positions in Medikit, Takefuji, Credit Saison and Aderans at lower prices than we might have anticipated.

In all cases the fundamental attractions of the businesses remain as they were when we began to buy them, even if in some cases the market has revalued them downwards by an amount disproportionate to the short-term impacts of profit disappointments.

Takefuji's decline is worse both in its scale and in its influence on the portfolio. For many investors the uncertainty of not knowing how the new regulatory environment for the consumer finance industry will impinge on the company is too much to bear. We, on the other hand, are reassured by a number of aspects of the business: first, the amount of excess capital the company had accumulated prior to the change in regulations, which has allowed the company to weather the provisions and write-offs incurred thus far; next, the franchise built up over decades of successful operation; then there is the growing market share, as others pull out of the business; and finally the compelling economics of a business that has the potential to earn high returns on capital.

At the same time it is reassuring to own companies generating stable or growing free cash flows and high returns on capital, as it allows business value to build faster than might be the case otherwise. Part of the value of the companies we own is the excess capital accumulated over many years of successful operations. Recently Canon, Astellas, Medikit, Rohm, Mabuchi, Meiko Network, Takeda Pharmaceutical and Shinwa Art Auction have all announced share repurchases to deploy such excess capital at relatively attractive free cash flow yields that in time we think will also act to boost return on equity ('ROE'). This year Canon has bought back ¥400bn worth of shares and in doing so reduced its estimated year end excess cash by 40%. With Yen deposit rates lower than 0.5%, and the free cash flow yield at 5%, the economics of such an investment are easy to comprehend. Astellas continues the policy announced last year to boost ROE through share buybacks. We think its ROE will rise from last year's 8% to 11% this year, following a recovery in margins and a more efficient deployment of excess capital, a significant step towards its target of 18% in 2011.

Mabuchi Motor released encouraging half year results, raised the dividend and bought back 3% of its equity in a tender offer. The business had been suffering from a sharp contraction in demand for micro-motors from the audio visual industry (especially compact discs) following the digitisation of music and popularity of MP3 players (see September 2005 monthly). As we suspected, there were many other potential alternative applications for micro-motors, especially in the automobile industry, and we anticipated that once Mabuchi exploited these its business would stabilise and margins recover (see February 2006 monthly). To some extent this has now occurred. It is now important to assess how much more of a recovery we should expect from this one product business selling components to large scale customers that, on account of their size, tend to have the whip hand in any pricing negotiations. Achieving the margins of 25% attained five years ago looks unlikely but further improvement from the 11% expected this year is probable. Mabuchi is a cash generative well run business and, although it has some vulnerabilities that are absent from many of our other investments, when we bought the shares in 2005 we took great comfort from its reserves of excess cash that represented 60% of the market capitalisation. With market capitalisation having risen, cash is now down to 50% which, although it may not be as compelling as before, is still a significant comfort and one of the key reasons that we continue to maintain our position.


Michael Lindsell
Aug 2007

15 Sep 2007 LTL 000-052-3