July 2009

LONG ONLY JAPANESE EQUITIES

Following the ruling Liberal Democratic Party’s (‘LDP’) defeat in the Tokyo municipal elections, Prime Minister Aso called a general election on 30th August. Although inevitable (an election had to be called by September 10th) the announcement is nonetheless significant as the decision was made from a position of marked weakness. The LDP’s prospects are so poor that any delay in the decision might have invited a challenge to Aso’s leadership, even at such a late stage. Both Aso and the LDP now plumb the depths of the popularity ratings, signalling that the Demographic Party of Japan (‘DPJ’) is very likely to win the election - maybe securing an absolute majority in the lower house of parliament, to add to their position as the largest party in the upper house. A change in government could prove a psychological watershed for the country as the LDP has ruled Japan unbroken since 1945, save for a nine month period in 2002. However, it is likely to take time for it to be a practical watershed because the DPJ, a party made up of old socialists and defectors from the LDP, has never formed a government. Ostensibly its policies differ little from the LDP’s. The electoral mandate will be more an expression of dissatisfaction at the status quo, rather than positive support for differentiated policies. Rather than offering an immediate radical alternative, more likely the new government signals the beginning of an era of change. What is important to recognise is that underneath this change is a generational transformation, reflected in the practical reality that the DPJ’s core electoral support is the urban young, which contrasts to the LDP’s traditional core support, the rural old. Over time politicians in power will pander to vested interests and, with the DPJ likely to be in the ascendancy, consumers will be favoured over producers, likely ushering an era of deregulation and restructuring for the economy as a whole. It is such changes that have the potential to transform the future prospects for the Japanese economy and the stockmarket. But the new party of government, unfamiliar with power and keen to do the right thing, will likely begin cautiously, too cautiously to have any immediate effect on economic prospects. Popularity could drain away quickly. More political realignments may prove necessary. It will take time before new policies emerge and real change becomes visible. For quicker, more dramatic and more effective change, there needs to be more of a sense of crisis, more desperation. Only then will politicians abandon their narrow parochial agendas, address structural problems and act to reform the economy for the good of the country as a whole.

But today there is no sense of crisis, indeed, the stockmarket is discounting recovery. A recovery in demand driven by exports to China and the West as those economies improve in response to the record monetary and fiscal stimulus. We are highly sceptical that any sustainable recovery can occur in the near term driven by the old forces of demand, financed by debt that has reached its practical limit. Instead, more likely the inexorable decline of domestic demand will overwhelm these influences. Certainly our recent company results suggest that profitability will be under severe pressure for some time.

Canon is no exception. It announced its half year results which were better than forecast early this year but still showed a huge (nearly 25%) fall in expected sales this year. Admittedly, some of that is due to currency but still much reflects the squeeze on expenditure by the small and medium sized company, its main customer. Canon has now committed to an unchanged dividend for this year. For this to survive into 2010 sales and profits need to recover much more from here.

Although Ito-En’s April 2008 results were poor as expected, the company signalled improvements for 2009. Like other domestic consumer franchises the company is now benefiting from lower costs (from direct inputs to services), helped by the strong Yen and in addition the company has pared promotional and other expenses. Profits could recover 20%. If so, free cash flow will improve as will dividend cover, which is important as a key attraction of the shares is the current dividend yield of 5.1%. When we visited the company in March the management expected consolidation in the fragmented soft drinks industry and hoped to take advantage of any corporate activity to enhance their market position. Two weeks ago Kirin Holdings and Suntory signalled the intention to merge. Privately owned Suntory is Japan's leading soft drinks beverage company and its combination with Kirin’s soft drinks business will give the combined company an important 31% market position (Kirin 11%, Suntory 20%). We do not know the terms of the merger but strategically at least it looks a smart move for Kirin as its beverage business was subscale, barely profitable and lacked high quality brands. The combination with Suntory should raise efficiencies and improve overall returns. Ito En on the other hand will feel threatened, but not as threatened as the other more marginal participants such as Asahi Beverage, Kagome, Ajinomoto, Dydo Drinko. At least Ito En with its Oi-ocha green tea, a leading strategic market position and brand, will either prove very difficult to assail or more likely will prove a valuable partner or acquisition. We view the Kirin/Suntory news as signalling more consolidation which should raise profitability for the surviving participants.

Kao’s quarterly results continued the negative trajectory of late last year with the specialist chemicals and high-end cosmetics businesses suffering in the current economic climate but, like Ito En, a discernable recovery is evident from Kao’s staple businesses in fabric and home care due to falling input costs. Overall we expect profits to stabilise at end FY 2008 levels, which at the current price values the shares on a 10% free cash flow yield. Cheap in our view.

Good news from Mandom, that produced better than expected results, driven by a recovery in demand in Japan; the Osaka Securities Exchange whose quarterly operating profits suggested that earnings are plateauing rather than falling as most investors think; and Aderans that, in addition to cancelling treasury share sales last month, announced a plan to repurchase 5% of its shares for treasury, further boosting shareholders returns.

Michael Lindsell
July 2009

11 August 2009 LTL 000-080-2