Feb 2008

LONG ONLY JAPANESE EQUITIES

‘I’ve been investing in tech stocks for the better part of three decades (I first started buying techs in 1979). Almost all of the tech stocks that I followed in the late-70’s and early 80’s don’t exist today. I was just looking at a list of the 53 tech stocks that I was most closely tracking in 1982 – 25 years ago - and noted that only three of the stocks exist today. Most of the other 50 were the victims of obsolescence.’ This quote is taken from the January issue of the ‘High Tech Strategist’, a monthly publication edited by Fred Hickey, which focuses on US stocks and tech companies in particular. The reason I quote it is that it illustrates a central tenet of a Lindsell Train belief that businesses are much more vulnerable than people think when viewed over long time periods such as 20 years. Tech businesses of the type that Hickey follows are perhaps more vulnerable than the average but it is quite usual for only 20% or so of the constituents of a major stock market index to survive in the index over an equivalent period in time. Oddly enough, for a country in almost permanent recession since 1992, Japanese companies exhibit more survivability than most because of the historical reluctance to merge or acquire, supported by interlocking business relationships and financial support from corporate cross shareholdings. However, with cross shareholdings having fallen, that blanket of support has diminished which is why activist shareholders have been able to accumulate large stakes in Japanese companies in recent years. The Japanese establishment has responded with protectionist measures which we view as regressive and regrettable but recognise it to be an understandable reaction to change. These measures range from government imposed limits on investment in ‘strategic’ industries to the imposition of poison pills and other dilutive shareholder defences. Some companies have even responded with a re-establishment of some cross shareholdings. These defences are easy to implement in good times, when cash flows and share price levels are high, but less easy to action when times get tougher. With the market now down 25% from its peak in June last year and profits declining, times are indeed becoming tougher. We expect that activist investors may well have more success in the future than they did in the past and that their increased presence may prove to be a catalyst for a surge in the number of rational business consolidations in Japan.

Two of our companies, Aderans and Nissin Food, are more than 25% owned by the same US based activist investor. We think that the franchise value of both businesses is substantially under-appreciated by the market. Clearly the activist investor has a similar view and in the case of Aderans has lost patience with the management and their policies, which have failed to realise full value. In February the investor called for the resignation of the entire management team, an unusually aggressive move in Japan, at the same time as further increasing their stake in the company. As Aderans has enacted dilutive takeover protection measures it will be difficult for the activist investor to impose its will on the company, so view this action as sabre rattling. Following a particularly difficult year, some of which could be blamed on management policies but most on the appalling consumer environment, there is an urgent need for the business to reclaim market share. We hope such public pressure will strengthen that resolve and will not divert management attention away from the task in hand.

Our companies continue to acquire, merge and invest - which makes rational sense for businesses that collectively have 24% of their combined market capitalisation sitting as idle low yielding cash on their balance sheets. We comment in particular on:

- The Osaka Securities Exchange (‘OSE’) has innovated on a number of fronts. First, its launch of a new index futures contract, the ‘Nikkei 225 mini’ (with a trading value of one tenth that of the existing Nikkei futures to specifically appeal to individual investors) has proved highly successful. So much so that trading volume (crucial for OSE’s fees) in the new contract in the December quarter reached more than two times the existing contract. Also in January the company announced a planned merger with the Jasdaq exchange, which it clearly plans to merge with OSE’s Hercules exchange. This will create Japan’s largest small company exchange, thus sowing the seed of another significant liquidity pool for the OSE. Finally in February the company announced plans to open a new stock options market in conjunction with International Securities Exchange, the largest US exchange for stock options by traded value.

- Taisho Pharmaceutical made a tender offer for a majority of the shares of Biofermin Pharmaceutical, having bought a 40% stake in the company from TZCS - a subsidiary of SFCG, our recent new holding (see January 2008 monthly). Biofermin’s main product is a branded over the counter (‘OTC’) drug which aids digestion and prevents gastric illnesses. This adds to Taisho’s already dominant OTC portfolio. Interestingly the company was bought for a price equivalent to 4 times sales, equal to the multiple of sales for which the OTC businesses of Boots and Pfizer were sold two years ago. Taisho’s enterprise value equates to less than one times its sales, too cheap in our view, even despite the management making an irrational decision to establish a distribution joint venture with Toyama Pharmaceutical three years ago. Recently Fuji Film, another one of our holdings, bought a majority stake in Toyama at the same time as Taisho increased their minority stake from 22% to 34%. All very incestuous. The logic behind the change in Toyama ownership and the intentions of Takeda Pharmaceutical, a company with a professed focus on prescription drugs but also with a 10% shareholding in Biofermin and a legacy Y60bn OTC drug business of its own, needs exploring in more detail, something I plan to undertake on my next visit to Japan.

- Nissin Food has pulled out of its deal with Japan Tobacco to buy 49% of Katokichi (see November 2007 monthly) ostensibly in protest to Japan Tobacco selling pesticide coated dumplings sourced from China that have caused a widespread food scare in Japan. I think it is more likely an excuse to pull out of a deal that left Nissin in a minority position.

- Kirin’s acquisition spree looks like continuing, according to comments made by a director of the company. He reconfirmed continued ambitions to expand internationally into beverages and food, financed by liquidating idle securities and fixed assets. Currently, the company is rumoured to be interested in buying Dairy Foods in Australia to complement its recent purchase of National Foods.



Michael Lindsell
Feb 2008

10 March 2008 LTL 000-060-5