December 2008

LONG ONLY JAPANESE EQUITIES

In the last quarter we started a new position in Keyence, a company we have been monitoring for some time. For us it is an atypical holding as the company supplies manufactured components, sensors, to industrial and commercial companies. As such it produces capital equipment, exclusively bought by companies rather than individuals and thus potentially subject to the pricing pressure from beady corporate buyers. Also corporate capital spending is notably volatile and much influenced by underlying corporate profitability, making for unpredictable demand trends. But in categorising Keyence in this way it is important to recognise that sensors are generally low ticket items vital to the functioning and efficiency of any manufacturing process and thus are different from most capital expenditure items that tend to be much pricier. Keyence has three complementary differentiating characteristics that make its business so successful. The company has a highly efficient sales and marketing network. All sales are direct, through well trained company employees who consult directly with the engineers of customer companies to ensure that products fulfil their role and, if not, that alternative products are found or developed to satisfy customer requirements. This highly efficient direct sales network is important as the customer relationships have franchise-like qualities absent in most other competing businesses. Keyence’s franchise is well established in Japan and is expanding in other jurisdictions including North America, Europe and Asia with an emphasis on China. Overseas sales represent 25% of the total and are expected to grow relative to domestic sales. Linked with the strong customer relationships is a prolific new product capability. Over 25% of products are less than two years old and customer loyalty is as much inspired by strong sales relationships as problem solving and the ability to develop the optimal product for the customer’s need. There is much interchange of ideas and requirements between a customer’s engineers and the salesmen and product engineers from Keyence. Again this level of customer service differs materially from competitors. Finally Keyence operates a fabless system of production. In other words only 10% of the highest specification products are manufactured by the company. The rest is subcontracted to other small manufacturers with whom the company has had relationships for years. Like Nintendo this obviates the need both to invest in expensive facilities and to carry a manufacturing workforce, to the benefit of profit margins which have averaged 44% over the last 15 years. With minimal manufacturing, capital costs are low and cash flow strong allowing the company to boast excess cash resources of ¥440bn, up from ¥40bn in FY1994. Its business model is dependent on the quality and training of its staff. It has grown steadily since 1974 with the exception of four years when it recorded declining sales. For all its strengths the company is not immune to capital expenditure downturns. Sales, profits and margins this year, and possibly next, will decline and this general expectation has provided us with an opportunity to access the company at undervalued prices. We bought an initial position at an enterprise value 1.3 times its annual sales, a price a quarter of what it might trade at in more normal circumstances. Keyence is an example of a cash rich company that has not as yet succumbed to pressure to improve shareholder returns, something that we hope will change for the better in the future. The dividend yield is a miserly 0.5% and the payout ratio a lamentable 5%. We intend to add our voices to the chorus for improvement.

For SFCG, a non-bank financial company dependent upon wholesale financing, it was encouraging to see that it achieved a material reduction in its loans - and, as a counterpart, its debt - in its first quarter results. Most encouragingly, this was achieved at a faster rate than its original business plan suggested. That it needed to expand provisions more was anticipated by us and thus no surprise. We expect continued sharp reductions in the size of the balance sheet over this year and next, with some further collateral damage to profits through provisions and write-offs, but continue to think that the market capitalisation of a business with a near monopoly in specialist lending to small companies at only 20% of its current equity capital seems unduly cheap, even in such straitened circumstances as faced today.

There were some truly awful economic statistics reported in Japan in late December. One of the worst was industrial production that, in the space of six months, declined 14.5% from its peak, more than in the entire recessions that began in 1992, 1998 and 2001 and this one has only just begun. The difference this time is the collapse of exports which will provide a harrowing environment for some businesses selling abroad. Canon will be affected, as will Rohm and Mabuchi Motor who sell products for onward assembly. It is clear that for these companies even our cautious estimates will prove too optimistic. But in both cases cash and investments should provide some barrier to further share price depreciation especially in the case of Mabuchi that now trades at a small discount to net cash even after its recent share repurchase.

Michael Lindsell
Dec 2008

14 January 2009 LTL 000-072-5