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Jan 2008 LONG ONLY JAPANESE EQUITIES The unpropitious start to the year, with major Japanese stock market indices down by approximately 10%, suggests that a significant profits recession is in the offing. Hints have already appeared in the few announcements of third quarter fiscal year profits we have seen. A margin squeeze induced by rising costs is the primary cause but more worryingly there are also signs of disappointing sales growth as well. As almost all growth in the last five years has emanated from overseas, a stalling or reversal of this vital source of growth would indeed weigh heavily on risk premia. It has been notable how much the market has punished individual shares whose profits projections have in any way been below scratch. One day falls of 10-20% are not unusual, even for shares that have fallen in value materially prior to such an announcement. Our strategy has not been immune: Canon, one of our largest holdings, was down following a fourth quarter result that failed to match expectations, and this month Namco Bandai fell sharply following poor quarter results and revisions down to future expectations. For us, such extreme reactions serve to reinforce our conviction of how important stable streams of long-term cash flow are to maintain current values and how such cash flows are important in underpinning shareholder returns in difficult times, whether through stable or rising dividends or through accretive share repurchases. If the market’s sharp fall is correctly prescient of a major profits recession (as we suspect it is) some of our companies will inevitably be affected - even if they have not been to any significant extent as yet. In this environment we take comfort from the strength of the business franchises we own, their solid balance sheets and the flexibility that affords them in difficult times. As prices fall some business franchises that we have been monitoring closely are becoming so undervalued that we have begun to accumulate nascent positions. In all probability it will take time to build them up as we like to accumulate on weakness rather than try and pinpoint the bottom and buy in one go. One such franchise is Hogy Medical, a supplier of medical equipment to hospitals. Its future is dependent on the success of ‘Opera Master’, a service designed to provide a hospital with all surgical equipment required to perform operations, from gowns to swabs to scalpels. The equipment is assembled off site in Hogy’s facilities and delivered in time for the operations, allowing the hospital to cut out the cost of sterilising equipment, storage and the administrative burden of organising its distribution. It allows cash strapped hospitals to cut costs, both labour and inventory. For Hogy a contract is necessarily a long-term commitment as once the hospital has slimmed down its procurement and related staff, it becomes reliant on Hogy’s services. It has taken time for Hogy to establish contracts with hospitals whose reluctance to commit was as much associated with such reliance as with the need to determine the cost benefits of the service. Such stalling has in turn bred scepticism from investors as to whether the service would prove successful. Now, three years into the project with 87 hospitals signed up, the signs of a virtuous cycle are appearing as an increasing number of referrals from satisfied hospitals act to embolden others to take the plunge. We have high hopes for Hogy’s growth from here.Another new position is SFCG, a specialist provider of finance to small companies through loans supported by third party guarantors. This business has been on freeze since the late 1990’s on account of questionable business practices (perpetrated by a major competitor) and a surge in bad loans for the struggling small company sector. SFCG has spent these years cleaning up its balance sheet and concentrating loans to only the best borrowers. In the last three years the company has expanded its balance sheet by growing a new business of real estate backed loans. We think some of these will inevitably require provisions, which could be why the share price has been so weak in the last six months as investors question the inevitability of ever rising property prices. Despite this threat we think the balance sheet remains rock solid with equity at 48% of loans, whereas in more normal circumstances it could be nearer 25%. Also the company is in an unusual position following more than five years of torpor in the core business for it effectively has no competitors and thus operates virtual monopoly in this specialised segment of the loan market. In addition the severity of the environment has raised the barriers to entry for others. Value is compelling. The free cash flow yield is 12%, price is only 65% of book and dividend yield is 2.1%. We hope to buy more at lower prices and for those to materialise we think it will need bad news concerning the property loans to induce further weakness in share prices. We have also added to positions in Shinwa Art Auction, Canon, following the recent share price weakness after the results, and Kao Corporation. These new purchases and the new positions have been funded by incoming dividends and further sales of Fuji Photo (see August 2006 monthly report) and may soon be funded by a further reduction in the position in Kansai Electric Power Company (‘KEPCO’). It is clear that what we believed to be a temporary increase in capital expenditure from the low levels of 2001-2006, will last much longer than two years (see December 2006 and March 2007 monthly reports). Not only is the company likely to reconfigure more old style coal power stations to improve energy efficiency and address environmental concerns but it is clear that more nuclear power stations will require ongoing repair following the rupturing of pipes at two power stations in recent months. As the investment case for KEPCO was predicated on stable operating cash flows and low capital expenditure this materially worsens the prospects for share price appreciation. It also reinforces how sure we must be before digressing from our slavish concentration on companies with durable business models, which generally exhibit characteristics of a low capital intensity and high return on capital. There is no doubt that KEPCO is a durable business, after all it has an effective monopoly in supply power in the Kansai area in Japan, but the capital intensity of power business is particularly high and the return on capital is low, two characteristics that normally put us off owning such shares. Our ownership of KEPCO was dependent on an unusually low capital intensity for a significant period of time (say ten years), partly in reaction to years of excessive expenditure when the company was a government controlled utility and to some extent in recognition of the demographic reality that fewer Japanese would require power in years to come. Not only have KEPCO’s fundamentals changed for the worse but also its allure from a valuation perspective has deteriorated. It used to be the case that the power companies in Japan were the sole high yielding shares in the market, but today KEPCO’s yield at 2.2%, and for that matter yields on other power company shares, are strikingly less than the average yield of the portfolio as a whole at 2.6%. We began reducing our 7-8% position in KEPCO earlier last year and now are faced with reducing it further for no incremental capital return, which is disappointing. Reflecting on the investment it is a ready reminder that adapting our investment principles to temporarily changed circumstances may prove a false opportunity in the long run. Nevertheless, the shares have held up well versus a difficult market and overall have contributed to the long-term return on the portfolio. Michael Lindsell Jan 2008 10 Jan 2007 LTL 000-059-3 |
This document is produced solely for information purposes only. It is not intended for use by private individuals. Opinions expressed whether in general or both on the performance of individual securities or funds and in a wider economic context represents the view of the fund manager at the time of preparation and may be subject to change without notice. It should not be interpreted as giving investment advice or an investment recommendation. This document is produced solely for information purposes only and may not be copied or distributed without expressed permission. Past performance is not a guide or guarantee to future performance. Investments are subject to risks and their value and income from them may go up as well as down. Investors may not get back the amount they originally invested. Issued by Lindsell Train Limited Authorised and regulated by the Financial Services Authority |
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| Dec | I Wished A Client... | Japan Eq | |
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| Sept | Do Dividends Really Matter? | Japan Eq | |
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| May | Reflections on Markets in 2009 | ||
| May | You Will Come | Japan Eq | |
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| Jan | I Forgot More Than You'll Ever Know | Japan Eq | |
| Feb | Cash Hoarders & Debt Dependants | ||
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| Feb | What's up in 2007 | Japan Eq | |
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| May | Various thoughts on Japan | Japan Eq | |
| Jun | Idea Updates | Japan Eq | |
| Jul | The Bids | Japan Eq | |
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| Nov | On the Failure... | Japan Eq | |
| Nov | Is Japan a 'Buy'? | Japan Eq | |
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