February 2009

LONG ONLY JAPANESE EQUITIES

We were shocked by the sudden announcement of the bankruptcy of SFCG, a holding that was approximately 1.5% of the strategy at the end of January. Disappointment and frustration were our immediate reactions. Disappointment because it represents the antithesis of our aim to invest in durable businesses, and thus points to a failure of judgment, and frustration because SFCG, for all its faults, had a dominant franchise providing loans to small businesses, an area of significant growth potential once the economy begins to recover, and one in which we now have materially less exposure. In response, we have reassessed the prospects for the holding in Credit Saison and have become more circumspect about the holding in Takefuji, as we describe below.

SFCG succumbed because of a lack of access to new funding combined with an inability to liquidate property collateral quickly enough to satisfy the demands of creditors. We knew the property market was in poor shape but had not anticipated the extent of the illiquidity. As we have highlighted before, the only other company that has exposure to property is Credit Saison. Although its main business is servicing credit cards, the company has a consolidated subsidiary, Atrium, which invests in property directly and offers guarantees on loans made to property developers by Credit Saison. Atrium has already been recapitalized by Credit Saison and Mizuho Bank, but if property prices continue to decline as seems likely, more support will be needed. Attempts to sell property to reduce risk have fallen short of expectations, corroborating the illiquid nature of the market experienced by SFCG. It is possible that Credit Saison will need extra capital itself and, although its funding position is today more secure than SFCG’s because it has the backing of Mizuho Bank, the situation will most likely worsen from here as banks themselves need further capital to address the deterioration of their loan books and fall in value of their securities portfolios. We continue to like Credit Saison’s dominant position in credit cards and credit card processing and are sure that this business will flourish when Japan’s economy recovers - especially if economic growth is led by domestic consumption as we anticipate - but the company has to navigate treacherous waters in advance of this, which may mean that our economic interest is significantly diluted before we reach those benign times. Even worse, Credit Saison seems to be in denial about this festering problem, choosing not to tackle it head on, which may result in the ultimate losses being much greater than they need be.

With the recent experience of SFCG, we can more clearly understand quite how harmful the combination of Credit Saison’s direct and indirect exposure to property might be to the value of the overall business and as a result have sold the position.

Despite these failures we are determined to continue to seek out cheap, durable financial franchises. Not only do these businesses achieve high rates of return in normal times but also, as large parts of the Japanese financial industry remain underdeveloped compared to those in more advanced economies, these dominant franchises have an unrivalled business opportunity compared to more mature markets. For instance, still today the bulk of Japanese savings are invested in conventional bank deposits that yield almost nothing. In addition, a significant proportion of savings are invested inefficiently based on the strength of business relationships, with little reference to the competitive commercial returns available. The scope for new securitized products (especially mutual funds) and rational competition to claim a larger share of the savings pool in the future is both likely and a material growth opportunity for the companies involved once financial markets have stabilised. Despite the setbacks we have encountered with SFCG and Credit Saison, our long-term approach leads us to continue to try to identify the beneficiaries.

One such beneficiary is our nascent holding in Nomura. Since the beginning of the year, the stock has fallen in value by 43% in anticipation of an impending new share issue needed to bolster capital following a 25% fall in its shareholders’ equity from March 2008 to date (this a result of cumulative quarterly losses attributable to some failed investments and the cost of acquiring the Asian and European operations of Lehman Brothers from the administrator). Now that the new share issuance is imminent and priced into the shares, we have reinvested the Yen value of our holdings in Credit Saison and will likely participate in the share offering at an approximate price of 70% of book value (adjusted for the issuance). As we have outlined before, Nomura possesses some exceptional market positions in retail distribution, fund management and corporate finance. We think the value of retail distribution alone is worth more than the current market capitalization (adjusting for the imminent issuance of new shares). Of course, what is more difficult to predict are the effect of continued problems and potential losses in its other businesses. Clearly, in current market conditions the company’s remaining exposures to private equity, mortgaged backed securities and emerging market debt most of which are classified as ‘level 3’ - hard to value assets, have the potential to harm overall returns, but following the provisions made in the two previous quarters we expect any future losses will much less from here. Then there is the opportunity from the purchase of the Lehman business. Again, in current conditions earning a justifiable return on capital will be tough but even so we should expect some contribution from April 2009 and in normal circumstances a material one given the expansion in the client base and the economies of sales derived by combining the two businesses. It was good to see that has already been a material boost in corporate finance revenues as Nomura was one of the lead advisers in the Rio Tinto/Chinalco deal. Certainly, compared to other US investment banks Nomura’s balance sheet leverage is lower and the exposure to ‘level 3 assets’ less as a percentage of common equity. With the market continuing to fall, the pressure on Nomura’s business will continue for now but this new injection of capital should not only cushion it from further turmoil but also provide it with the flexibility to take advantage of opportunities in the future.

Our struggle with Takefuji continues. Last month it upped its provisions not only against loan losses but also against claims for reimbursement of excess interest paid on past lending, which it now plans to prepay in advance of court settlements. In doing so the company has tried to draw a line under this festering issue. It has forecast its business forward to 2012 and plans significant cuts in operating costs, especially personnel. The business model beyond 2010, when the new lending regulations come into force, is not wholly different than already understood by us but the size of the loan book is materially smaller, at Y600bn versus our expectation of Y900bn, and the scale of the business supporting that is commensurately smaller. What has changed is that the latest provisions have absorbed the cushion in capital, the margin of safety that has always been a feature of this investment. We like the concept of the company putting the past behind them but temper that with the realisation that the margin for error is much less now that capital cushion is gone. Funding remains an issue for the company, even with one contracting its assets so dramatically; not a terminal one we judge but a concern as there are significant refinancing commitments over the next three years that, in the present circumstances in the credit markets and without further changes in the balance sheet, may be difficult to meet. We continue to hold the position but seek more reassurance on the funding issues.

Ozeki, Obic Business and Taisho Pharmaceutical announced share repurchases adding to the impressive tally of companies taking advantage of today’s depressed corporate values. We are pleased to note that this financial year to March 2009 more than 100% of our non-financial companies net profits are due to be dispersed to shareholders either directly as dividends or indirectly through share repurchases, which provides some support to our belief that these companies will gradually raise overall returns on equity by utilizing excess cash more efficiently in the future.

Michael Lindsell
Feb 2009

9 March 2009 LTL 000-074-5