September 2008

LONG ONLY JAPANESE EQUITIES

One of the features of the last twenty years in the Japanese market has been the continuous rise in non-Japanese (foreign) ownership of the market. At the market's peak in 1989 foreign ownership was under 5%, now it is just down from its peak of 30%. This relentless rise helped fuel the considerable bear market rallies in 1997, 2000 and then in 2005. The problem today is that, with more pressing need for the money at home, foreigners are now selling and in so doing are helping to drive the market down. Domestic investors are reluctant buyers because the market, even with the dividend yield having risen from less than 1% to more than 2% in the last three years, does not offer enough yield to compensate for the potential of quotational loss of value investing in volatile equities and does not satisfy the income needs of a nation increasingly made up of pensioners. We have always held the view that the dividend yield on the market would have to rise to at least 4% before domestic investors would buy again and we still hold to that forecast today. What we have been unsure about was how the 4% yield would transpire: through price deterioration or dividend growth. We think the companies in which we invest have the potential to raise payouts and grow earnings but that much of the market can do neither, either because the businesses have little revenue and profits predictability or because debt repayment takes precedence over dividend payouts. With the economy as weak as it is today and with earnings falling precipitously it is clear that dividend growth is now off the agenda for most companies (rather, dividend cuts may become more prevalent), making market price the main mechanism for the necessary increase in the yield.

It is encouraging to note that even in current circumstances a number of our businesses continue to enhance shareholder returns through share repurchases in difficult times. Canon, Takeda Pharmaceutical, Obic Business Consultants and Shinwa Art Auction have all initiated programmes in the last month.

Another market flooded with foreign capital was the property market. It was a surge of foreign money that started the recovery in central city property from 2002-2007. Yields of medium grade office properties fell from 8-10% to 4% or below resulting in substantial gains for investors. New capital flooded the Real Estate Investment Trust ('REIT') market, with the number of funds increasing from two to forty one. Bankers opened the spigots offering non-recourse loans. Now, however, following on from a surge in supply - mainly of condominiums - and from the withdrawal of foreign capital, the market is weak and frozen, like interbank markets, with few transactions. The situation was exacerbated by the authorities, who clamped down on bank lending to property companies late last year. The combination of these factors has led to a swathe of bankruptcies of property developers and weakness in market prices. Late last week the first REIT filed for bankruptcy having failed to rollover its financing. We have a minor exposure to the problem through holdings in Credit Saison and SFCG. Credit Saison is Japan's second biggest credit card company but it has a 40% owned subsidiary called Atrium that mainly specialises in liquidating property collateral on behalf of lenders. Last year and early this, it greatly expanded its inventory of property which it now cannot sell. Credit Saison will be obliged to support Atrium while it eliminates this inventory overhang, which will affect consolidated earnings and may require new capital to support the balance sheet next year. In the context of the whole business of Credit Saison it is not significant but nonetheless is an unwelcome distraction and a contributor to recent share price weakness. SFCG may have a bigger proportionate exposure to property through its secured lending but we are comfortable that it can manage this with a containable impact to profits and capital. Indeed we originally made the investment in the company earlier this year in the expectation that some provisions against the property lending would at some point be necessary. The appeal of the company was its strong capital base and its extensive network and franchise in small company lending, a market it dominates with only a few competitors, all of which are capital constrained. Our investment is small, currently amounting to between 1 and 2% of the strategy, having fallen from 2.5%. Once we have more visibility of the extent of the downturn in the industry we are keen to increase the position once again.

We have been accumulating a new holding in a small fresh food retailer that operates in a relatively wealthy district of central Tokyo. The company has been going for 50 years, is family owned and managed, and operates a relatively profitable cash generative business model. Operating margins average 8% - well above other retailers owing to the efficiency of the operation, especially the control of waste. Ozeki specialises in a high quality convenient service matching the discerning tastes of their customers and differentiated from the main competition, the national supermarkets, whose only advantage is price. Having successfully invested four years ago in a very similar business in another part of Tokyo, C2 Network, that was eventually bought by Tesco, we know well the characteristics of such businesses. Recently the deceased founder's daughter was appointed President, taking over from a cousin, and she has indicated that the company will expand the store network from 50 sites by 2-4 openings per year. This should underpin growth that is today slow and dependent on existing store sales. Expansion costs should fall well within cash flow. The company has ample excess funds, currently equivalent to 54% of market capitalisation. We expect some improvement in shareholder returns in the future from utilising this cash and also anticipate an increase in the payout ratio from the current low level of 17%.

Michael Lindsell
Sept 2008

13 October 2008 LTL 000-069-5