July 2008

LONG ONLY JAPANESE EQUITIES

One of the recurring features of the last year has been the unremitting weakness in the price of small company shares. Small company indices have performed notably worse compared to larger ones. The Hercules and Mothers markets have fallen 83% from their peaks, Jasdaq 60% the TSE second index 52% and Topix (larger companies) 31%. Part of this is attributable to the excessive rises in small stocks seen in late 2005 but it also results from extraordinarily prices today. The smallest companies we invest in are undeniably cheap and provided we are correct about the strength of their business franchises should generate exceptional returns for the strategy from these depressed levels. Our holdings in small companies (we define them a those with market capitalisations below $1bn) have steadily risen from 15% of the strategy in late 2005 to 25% today. We have suffered some losses in individual companies as we accumulate bigger positions into falling share prices but by no means as much as the market moves imply.

We are indifferent to the size of a company we invest in and have no need to own small companies. Indeed, longevity of existence is a key characteristic that we seek in companies which biases us away from smaller or newer businesses. Such companies have not spent decades establishing leading market positions, in all types of economic environments and have not had the time or exposure to such a wide range of customers fostering a high brand recognition which is the case for some of our favoured bigger companies. Hence we consider most small companies to be riskier investments because they usually have a shorter trading history, less established market shares and often operate in growing markets where the threat of competition is greater. Of course, we hope and believe the small companies we select will succeed in establishing such unassailable market positions, which is why we are prepared to take on the risk of owning them at such a relatively early stage in their existence expecting that the reward, if we prove right, should be commensurately greater. But in deference to this heightened risk we tend to initiate only small position sizes in small companies, at 1% or 2% of NAV. As a result the number of companies we own in the portfolio tends to rise when our exposure to small companies increases. Today we own 27 companies compared to the 22 we had in late 2005. This is not to say that our small company position sizes necessarily remain small. Indeed, we hope the small company positions will grow through market performance. As an illustration, before we reduced our holding in the Osaka Securities Exchange in 2006 it rose to more than 5% of NAV, Tokyo Individualised Education rose to 6% prior to its sale and today Meiko Network is 4% of the strategy.

The positions we have added to of late include Obic Business consultants, Medikit, Morningstar Japan, Osaka Securities Exchange and Shinwa Art Auction. In all cases a good part of the margin of safety is provided by net cash and investments on the balance sheet which is 91%,83%,68%, 27% and 98% respectively. At current prices one is being asked to pay little or nothing for the operating business. Dividend yields also provide support especially in the case of Shinwa Art Auction at 7% but also with Medici at 2.5% and the OSE at 2%. Operating margins for these companies average 30% or above in all cases which leaves plenty of cushion for some contraction should economic circumstances cause a temporary margin squeeze. Often there is little or no brokerage research on these businesses, which maybe is one reason why the market pricing is so anomalous - a factor that often favours investment in small companies generally. Accumulating positions is slow as volume is thin in declining markets. We are happy to take on liquidity risk in building such positions because in our experience this often pays huge dividends once investors return to buy small stocks when economic conditions improve and investor interest percolates down the market capitalisation range.

And buy with a vengeance we think investors will because the establishment of small service orientated businesses represent the future growth potential of the economy as it relies less on manufacturing and more on domestic services. We note with interest the joint initiatives from the Tokyo and London stock exchanges to establish a new small stock market similar to the AIM market in London and also the merger discussions between Jasdaq and Hercules exchange run by the OSE. Should both projects succeed it would provide the foundation for any resurgence of interest in small companies. What would help as well would be government incentives for small businesses to encourage the formation of small companies and to promote a restructuring of domestic industry which is often sheltered from competition by stifling regulation and archaic business relationships and practices. There is no sigh of this yet but declining markets and weak economic growth is already increasing the pressure on politicians to become more assertive on the policy front in the months ahead.

Michael Lindsell
July 2008

15 August 2008 LTL 000-067-9