November 2008

LONG ONLY JAPANESE EQUITIES

The strategy’s long association with the Osaka Securities Exchange (‘OSE’) became notably more significant during the summer and autumn of this year. Having maintained a minimal holding of just over 1% for two years, we tripled the size of the holding into sharply falling prices. We accessed the business on an 8% free cash flow yield, 3 times enterprise value to sales, a 2.7% dividend yield and with 37% of market capitalisation backed by cash. This is a business that generates average operating margins of 30% and a return on equity of 14% (lower than it would otherwise be because of the need to retain capital to guard against the risk of counterparty failure). We were presented with such an opportunity because investors anticipate that the company’s revenues and profits will decline as market volumes fall – more likely a 2009 event rather than one this year. We agree, but even at lower levels of volume significant revenues and profits will still be generated as the OSE remains the largest liquidity pool for investing in the Nikkei options and futures, a not inconsiderable quasi-monopoly in our view. For some time the company has been in discussions with the JASDAQ small companies exchange about a combination with its Hercules small companies market. Last month a price was agreed at ¥7bn, using up 25% of its balance sheet cash. The combined exchange could become the largest dedicated small companies market, a franchise that would become strategically valuable if small companies are at the centre of a future bull market as we suspect they will be. There is a chance that, if the market remains weak, the company will trade at a lower price next year but given the strategic importance of its businesses we would not be surprised if it outperformed as it seems to have been doing since we bought it.

For some time we have been keen to access important financial franchises for the strategy. Not only is this a potential area of growth, especially in the area of securitised savings products as bank deposits migrate in search of yield, but also most of the businesses we are keen to buy are leaders in their respective fields. The OSE is one example of such a business. Others include Morningstar Japan, Takefuji, Credit Saison and SFCG. Generating positive returns from such investments in recent market conditions has not surprisingly been challenging and we do not expect any improvement in the immediate future. Nevertheless the current prices of these franchises have never been lower, which reinforces our determination to continue to take advantage of such opportunities.

In light of this we have been monitoring the business and valuation of Nomura, Japan’s largest securities broker, for some time and last month began to start a position in the company for the strategy. Nomura’s best business is its domestic retail distribution, which is unrivalled in the Japanese securities industry. The company’s custody of ¥70t of assets earns them on average an annual transaction fee of approximately 0.5%. Clearly this varies and in good markets, which have not been experienced for some time, fees could be higher. Lately the company has been investing in this business, opening new branches and extending the domestic network further to counter the bigger distribution threat from the banking industry that is now allowed to compete in selling securitised products. The domestic fund management business is also an important franchise. Currently, following market declines, Nomura manages ¥20t in bonds and equities. Average fees, though, are low at approximately 30bp. In the short term, profitability is on the wane following declines in assets under management, which we expect to be addressed through cost cutting. Other businesses include private equity and global investment banking. The purchase of Lehman Brothers’ European operation significantly boosts scale in the investment banking business but at a cost of a big third quarter write-off. Although we rate these two business areas inferior to those of retail distribution and fund management, there is no doubt that there is significant value in Nomura’s domestic corporate investment banking contacts, especially if merger and acquisition activity takes off in Japan as we think it might well do in the future. Like other financials, Nomura is now raising additional capital at unfavourable prices, which has contributed to the weak share price over the last month. Getting a fix on valuation is thus difficult but we think we are buying the shares for approximately 70% of book value adjusted for the expected third quarter losses. Given our approach of buying into weakness, we hope to have the opportunity to add further to the position at even cheaper prices. We would like that.

Michael Lindsell
Nov 2008

09 December 2008 LTL 000-071-3