March 2009

LONG ONLY JAPANESE EQUITIES

We have thought for some time that something good might arise from the current economic demise in Japan as disaffection with the status quo might provide a catalyst for both political and economic change. Political change because economic hardship, especially unemployment, will inspire voter resentment which will manifest itself with a rejection of the ruling party in the ballot box probably in the autumn. And economic change because the looming reality of a current account deficit caused by declining exports and investment income may require Japan in the future to seek funding from overseas investors. Political change looks more imminent but initially at least if the LDP lose their majority and the opposition DJP take power there is no discernable difference in policies and thus the policy paralysis that has been a feature of the last two years will probably endure. Trade is already in deficit but income from foreign reserves is now falling following cuts in overseas interest rates. If demand from overseas does not recover and interest rates remain low in due course the current account will itself fall into deficit. As Japan's vast debt burden would then be financed at the margin by overseas investors we would expect long-term bond yields to rise. Higher interest rates will accelerate corporate restructuring as companies reliant on debt and low interest rates will be forced to restructure. At the same time politicians (probably a different lot than the ones who win the election) having abandoned hope for overseas demand to recover would be forced to seek new ways of expanding domestic demand through deregulation and service sector growth. Then we would have something to look forward to. Unfortunately these changes will take some time, are unpredictable and to work will probably require more economic pain in the interim and more angst in the stockmarket. However as we have said before some shares are already unquestionably cheap and at some point whatever bad news is thrown at them they will fall no more. It seems we are not quite there yet but we are close, which is why long-term investors should be happy to own them now.

Japan's economic stagnation is as much a function of excess supply as anything else. This excess capacity has not been weeded out because interest rates have remained so low allowing zombie firms to survive while demand overseas has remained strong. To make the situation worse the population is now declining. Should industry tackle this problem, as they must eventually, it will be the firms with the strongest financial position and the leading market shares that will most likely prevail. Making sure we own leading companies in our preferred industries, or ones with attractive market niches that might be alluring to others, will be important for the future.

An example of such a leading business is Obic Business Consultants. We visited the company on a recent trip to Tokyo. The company is the leading supplier of business application software to small and medium companies in Japan. The great characteristic of this business is that customers hardly ever leave as the benefit of changing legacy software in small businesses is rarely worth the hassle. Thus once a customer is hooked, provided it continues in business and is not taken over it is a captive market for maintenance fees upgrades and new versions of software. Of course in times like today companies crimp spending, putting off software upgrades, and profits fall. This is what is happening to OBC. But even after such a poor year, with sales down 10%, margins are still 25% and cash flow prodigious. In a perverse way the company welcomes this challenging environment as in such difficult circumstances it has a more realistic chance to consolidate its market position through merger or acquisition, which it is keen to do. Indeed it already has minority stakes in some of its listed competitors. Such corporate activity can be transformative as growing customers organically is tough given that new customers are few and far between in a recession and with a diminishing pool of non-users. In what is proving to be the worst economic downturn in Japan since the 1970's there is a better chance for some consolidation in the business than ever before. Unfortunately, OBC has an Achilles heel and that is its investments. Its legacy cash flow has been invested not only in cash and its equivalents but also equities and private equity funds. The latter investments are risky, illiquid and have connotations of late 1980's behaviour when companies routinely invested excess cash in stockmarkets only to lose it when prices fell. Actually, many of OBC's equity investments are in similar software businesses in other jurisdictions, including emerging markets, which at least represent an area of proven expertise. However, those that are not confer unnecessary general equity risk on shareholders. We have made this point forcibly to management pointing out that selling general equities and repurchasing their own shares would be the most favourable resolution. We have no great confidence of this happening overnight and have made allowance in our valuation of the business for a diminution in value from such investments.

An example of a niche business is Mandom, another one visited on the recent trip to Japan. Mandom's primary products are male cosmetics, a market they share with Shiseido - the market leader in cosmetics generally in Japan. Mandom's Gatsby brand is the market leader in hair care products in Japan and accounts for 60% of total company sales. In addition the company has the largest market share in male cosmetics in Indonesia, a growing market in a country with a population of 130m people. Profits have been hit this year due to slower sales of cosmetics in Japan (all companies have been hit including Shiseido and Kanebo, the subsidiary of Kao Corp, another one of our holdings) and a big depreciation of the Indonesian rupiah versus the Yen. But the expectation is that sales will trough at this year's level and stabilise or continue to grow in the future driven by growth overseas. Mandom may not be the market leader but nonetheless it has a highly important strategic market position, both in Japan and Indonesia, that others might covet. Mandom remains a family owned business, treasures its independence and should be able to grow its business without the help of others so we should not expect any corporate activity, but you never know.

Other leading businesses we visited included our holdings Aderans, Mabuchi Motor, Earth Chemical, Meiko Network, the Osaka Securities Exchange and Shinwa Art Auction . All aspire to bolster market share in the current downturn and all have the leading market positions from which to do it. Three others we visited - Rohm, Namco Bandai and Takefuji - are not as dominant and we must judge whether that in itself makes the investment in these companies more risky in current circumstances.

Michael Lindsell
Mar 2009

9 April 2009 LTL 000-076-0