October 2008

LONG ONLY JAPANESE EQUITIES

One feature of Japan over the last 15 years is the continued selling of the stockmarket by domestic investors. For the market to rise sustainably we have always believed it necessary for Japanese investors to become consistent net buyers. The market rallies in 1997, 2000 and 2005 were all driven by foreign capital inflows, to the extent that foreigners’ holdings in the market rose to ever higher levels - from 5% in 1989 to a peak of 30% recently. The market weakness today is exacerbated by a steady trickle of foreign selling as investors repatriate funds and a lack of appetite to buy on the behalf of Japanese domestic investors.

We have had the view for some time that the market would need to yield at least 4% to entice domestic investors, both institutions and individuals alike, back into the stockmarket from other less risky investments. In most other world markets equity yields trade for most of the time below bond and cash yields, reflecting the greater real growth potential from equity cash flows relative to nominal alternatives. But in Japan over the last few years, equity yields have traded for significant periods of time above bond and cash yields, reflecting deflationary forces and the country’s lower growth potential. However, at 4% yields equities would exceed the 30 year bonds yield by nearly 2% and cash yields by nearly 4%. Such a premium, we think, begins to compensate Japanese investors for the extra risk of quotational loss of value inherent from investing in equities. But today, with corporate profits falling, investors - quite rightly - should be circumspect about dividends remaining stable. Not only is the average business exposed to the potential of cash flows declining but also the average business is net indebted to the tune of around 60% of market capitalisation, which makes their dividends especially vulnerable to falling cash flows. This means that in the current circumstances dividend yields somewhat above 4% are required to give that extra cushion and comfort to potential domestic investors. At the end of October the market dividend yield was just 2.6% which implies with stable dividends the market would need to fall a further 35% to yield the required 4% and even more to provide that ‘cushion’. At its low during the month the market was 19% below the end October level, which suggests that we have not seen the worst for some companies in the market.

On the other hand the dividend yield of our portfolio was 3.4% at the end of October, much closer to the 4% level. In today’s dire economic circumstances our companies are not immune from declines in earnings. Indeed the 3.4% yield forecast incorporates a 2% expected decline in dividends for our companies in FY 2008. Aderans and Takefuji have cut forecasted dividends for this year due to poor business results, Mabuchi Motor is likely to as well if the company maintains its payout ratio target and Rohm paid an unusually large memorial dividend last year, which will not be repeated this year. For most other companies we own we think dividends are secure and, for some, dividends may rise. After all, many of our companies have relatively stable cash flows and huge stores of excess cash on their balance sheets, allowing for higher payout ratios in difficult times. We hope that when FY2008 dividends are confirmed mid next year, our companies will at least have stable dividends. If we are right perhaps there is no need for a premium yield over 4% today to account for dividends falling. What is clear is that if the 4% yield target has any validity the downside for our portfolio is limited to around 15%, a good deal less than for the market as a whole and frankly near enough over the long term to reinforce our increasing enthusiasm for the value of the businesses we focus upon. This is buttressed by the potential upside from our portfolio holdings, simply the difference between the current market price and our view of intrinsic value, which today is 128%, the highest since the strategy began.

One of the companies illustrative of such value, yielding over 4%, is Meiko Network which announced satisfactory annual results to August 2008, with sales and profits up 4% and 3% respectfully. More pleasing was the increase in the dividend, up 21.4%, and a forecasted increase for FY 2008 as well, one obvious reason for today’s 4.2% dividend yield. Meiko operates a franchise business model, has minimal capital inputs and thus generates prodigious excess cash that has fuelled dividend payments that have increased at an annualised rate of 35% over the last ten years. In 2006, Tokyo Individualised Education (‘TIE’) a competing extra-curricular educational specialist that operates directly run schools mainly based in Tokyo, bought a 14% stake in Meiko Network. At the time we thought this might presage a combination of these businesses. Then in 2007 Benesse, a company that provides a wide range of educational correspondence courses, bought a majority holding in TIE. With that transaction Benesse inherited the 14% stake in Meiko, the ownership of which was then transferred to Benesse. For some time it appears that the management of Meiko have been worried about Benesse’s intentions but, following recent discussions, Meiko claim that Benesse will keep the stake of 14% ‘for investment purposes only’, a statement which neatly encompasses a wide range of intentions without committing to any. More recently another company in the educational industry has appeared on Meiko’s register - Gakken, a company that predominantly publishes educational books and magazines, has taken a shareholding in the company and committed to an agreement that we think will be potentially value enhancing for Meiko. In addition to its publishing interests, Gakken operates schools around Japan for elementary school pupils with ages ranging from 7 to 12. Meiko schools educate pupils from 13 onwards. Gakken plans to refer these elementary school students to Meiko schools and develop educational materials that are compatible. Meiko thinks that once this referral process is in place it could significantly boost pupil numbers. So that Gakken can share in any future value creation Meiko has sold its treasury shares (4.2% of the company) to Gakken for Y697m, a knockdown price even if it is 15% above the very depressed current price, and Meiko will buy 2.3% of Gakken, costing at today’s price Y435m. Subsequently, Meiko has bought back an equal percentage of the company from the market (exactly the same amount as treasury shares sold) for Y610m. It is typically Japanese for this commercial agreement to be formalised by a cross shareholding rather than, for instance, a commission or referral payment but at least there is strong business logic in the business relationship. Meiko’s shares remain extremely cheap, trading at a 12% free cash flow yield (P/E ratio of 8x) with 60% cash backing.

Michael Lindsell
Oct 2008

12 November 2008 LTL 000-070-9