August 2008

LONG ONLY JAPANESE EQUITIES

Over the last few months we have seen some of our companies raise dividends and initiate share repurchases even though the general environment for corporate earnings is worsening. This is an encouraging sign. However, as these companies in aggregate (ex-financials) have 30% of their current market capitalisation sitting in cash earning next to nothing on deposit, not only do they have plenty of cushion to guard against difficult times but they have far more scope to reward shareholders than they are currently exercising. Some examples follow:

· One of the most shareholder responsive companies is Astellas, which so far this fiscal year has repurchased 3.8% of its equity. Although impressive, the company, with this repurchase and the forecasted annual dividend, has spent no more than the equivalent of the whole of this year's cash flow. More repurchases will be needed in the second half of the year to draw down on excess cash, which still amounts to over 20% of market capitalisation.

· Takeda, its pharmaceutical colleague, bought back 3.4% of its equity earlier in the year, again within the scope of its annual cash flow.

· Mabuchi Motor announced a buyback of 1.6% of existing equity. If executed at around current prices it would take place at a price only 23% higher than the value of liquid investments in the balance sheet and at an earnings yield on enterprise value of 19%. It will cost just more than this year's current cash flow and thus deplete cash balances, but only marginally. The company could do a lot more.

· Obic Business Consultants have announced a buyback of just under 1% of existing equity. As this will cost only 25% of this year's cash flow, cash balances this year should continue to rise. Like Mabuchi cash and liquid investments already represent 73% of market capitalisation, making the return on enterprise value of any purchase today mouth-wateringly high. Again we wish the company would buyback more.

· Taisho Pharmaceutical is midway through a repurchase of 1.7% of existing equity which, together with dividends, should account for just 70% of this year's cash flow. All other things being equal balance sheet cash should rise. Again we look for more.

· Takefuji is in the middle of a buyback amounting to 2.2% of existing equity at a highly accretive price to book of less than 0.5x. In effect it is buying back 10% of the potential dilution from the convertible bond issued earlier this year at a 35% discount.

These are the few companies that have taken action. Many others have done nothing, even if they have the scope to do a lot. It may yet be early in the fiscal year, with companies keen not to commit to shareholder rewards until most of the year’s trading is complete, especially in a year when profits are weak, but on the other hand share repurchases at current levels, as demonstrated above, can be hugely accretive to remaining shareholders. We expect more activity as the year progresses and will encourage managements when we meet them to think in the same way.

A notable exception to the declining trend in profits is Nintendo, which has just revised its annual operating profits up to a 33% gain for the year. Reflecting Nintendo's policy of directly linking profits to dividends, the dividend is expected to rise by the same amount, making the company for the third year in a row the largest dividend contributor to the portfolio. Despite this, Nintendo has been a poor performer year to date, falling in value by 23%. Such weakness is perhaps not surprising in light of the tremendous out-performance of the company over the last two years. Other investors wonder how long it can be sustained. We are more sanguine. The company's products continue to sell exceptionally well at a seasonally low point in the year for video game sales and both the Nintendo DS and Wii continue to well outstrip the run rate of sales of the previously best selling video game console, Playstation 2. We continue to believe that the eventual sales of both products will exceed Playstation 2's current total of 120m units and may even approach 150m. From this perspective the DS is halfway there, with 70m of sales, and the Wii has plenty of room for growth, with 30m of sales to date. We continue to think that Nintendo's strong growth in free cash flow, that directly fuels high and rising dividends, might prove just what investors in Japan need in the face of the general decline of corporate earnings.

The credit crunch has extended to Japan over the summer with most stress felt by the property sector, especially condominium developers. There are now four listed companies that have sought bankruptcy protection in the last three months, after failing to secure roll-over financing from banks, and 60 property related bankruptcies in July alone, more than double the amount in the same month a year ago. Unsurprisingly, Real Estate Investment Trusts ('REITs') performed particularly badly, with the REIT index down 33% this year, almost as bad as the small company indices. Now that economic weakness is percolating through the service economy Tokyo's central city office vacancies are rising from a low level and, with a lag, rents will probably soon decline as well. To compound the oversupply we think that foreign investors that bought property in the last five years may now, through force of changed circumstance, have to sell - creating an unhealthy overhang for the market. It is understandable why bank shares have been weak in response to these trends as almost all their lending is based on the security of property collateral. The strategy has some indirect exposure through an affiliate of our holding Credit Saison, Atrium, and through some short-term property backed lending undertaken by SFCG. Both shares have been weak in response, even if Credit Saison did well in mid month on rumours it may merge with ORIX, a larger non-bank with an unrivalled network of connections with small and medium sized companies in Japan.

Kirin Holdings continues with its Australian acquisitions. Last week it made an agreed bid to acquire Dairy Farmers, a farmer's co-operative, for Y84bn including assumed debt. Dairy Farm's operating profits were Y4.1bn but with synergies could more than double over the next three years, which if achieved and sustained would make the deal accretive. It neatly blends with last year's acquisition of National Foods and gives Kirin more than 50% of the milk and yoghurt markets in Australia, forcing the company to divest certain brands to allay competition concerns. These recent acquisitions have been financed by debt and some selling of investments including cross shareholdings. The net effect, excluding goodwill, should be a small gain in ROE. We would prefer to see more aggressive sales of cross shareholdings. Although the long-term return on investment from these two acquisitions is better than cash and cross shareholdings, milk and dairy is by no means as good a business as beer and the acquisitions come with some implementation risk. Kirin has to prove its ability to extract the synergies and margin improvements it has forecasted from the acquisition for the price to look good value.

Michael Lindsell
Aug 2008

23 September 2008 LTL 000-068-9