October 2009

LONG ONLY JAPANESE EQUITIES

The story of the last twenty years in Japan is that the combination of a stagnant domestic economy and growth in exports, accompanied by rising government debt, created a benign enough environment to condition the Japanese to the fallout from declining property prices and to maintain social harmony and the status quo in general. Moreover it allowed policymakers to ignore the burgeoning economic imbalances as addressing them would have run the risk of alienating voters and damaging popularity. Thus, it was better to muddle through. But last year’s collapse of exports has changed all that, especially if you believe as we do that export demand will remain depressed for some time as the West rebuilds savings.

We have said in previous monthly’s that the current demise of the Japanese economy - bluntly characterised by deflation of 2.5% per annum, wages 20% down from their level in 1990, industrial production 20% from its peak, debt approaching 200% of GDP, a declining population and a banking sector strapped for capital - is a necessary medicine to swallow. As conditions worsen it should force leaders of industry and government policymakers to tackle head on lingering issues such as excess capacity in most industries and the stifling regulation that emasculates domestic sectors with potential for growth.

So far we have had a change of government, which is not as transformative as it should be because many of the ministers in charge originally hailed from the previous party of government and thus reflect unchanged policies and biases. At the moment the private sector remains hopeful that the large injections of central bank liquidity and prodigious government spending in overseas economies will once again ignite export demand to engender a recovery of sorts in profitability. As a result we have not yet reached the point where policymakers and industrialists change tack and take proactive measures to address the imbalances. Of course, the stockmarket is a barometer of where we are in this journey. With it up just under 20% from its lows, and with other world markets surging ahead, many will take succour from the notion that the worst is past. Thus it will in all likelihood take further declines in the market from here to initiate the changes that we desire and anticipate. Without those declines things will muddle on as before, extending the twenty year stagnation into its third decade until the fudge of policy is seen by all for what it is.

The forces that have driven Kirin Holdings and Suntory to propose a merger, whilst not reflecting the distress that many companies are likely to face, are those that many other corporations need to address. If it goes ahead the combined company will have the leading market share in beer, soft drinks and low alcohol drinks and by dint of its dominance will likely become a price leader in each business. There will be much overlap in distribution and administration that if eliminated could help improve overall margins. In addition, and at last, Kirin has announced an intention to close two of its eleven breweries (as a comparison Anheuser Busch operates 12 breweries in the USA to serve a population 2.5x Japan’s). This is exactly the type of consolidation required by a plethora of other Japanese companies and the potential route to higher returns on capital.

Most likely the politicians will be the last to act, so economic and stockmarket weakness may have some way to run yet before emboldening them into action. But they have within their power the ability to unlock the potential of the domestic healthcare, education and other service industries which are so burdened with regulations and government directed pricing that its prevents the participation of much private sector capital. For instance healthcare expenditure in Japan only accounts for 7% of GDP, compared to 14% average amongst other OECD countries, with spending determined by the national healthcare insurance funds and prices of medical care decided by the state. Deregulating these industries may compromise political patronage but should lead to strong growth for their services and help revitalise the domestic economy. The message is that change is on its way but more pain is needed to induce that change.

Last month, Taisho's Pharmaceutical, a long standing and poorly performing investment we own, made an interesting acquisition of Bristol Myer’s OTC drugs business in Asia adding an overseas leg in its area of core competence. We suspect more acquisitions will follow and plan to find out more when we visit the company later in November.

Aderans anounced a swingeing downward revision to its second half earnings at the same time as beginning a new marketing drive to reclaim lost market share. The economic environment is hardly conducive to selling high priced wigs but even so Aderans has performed poorly, losing market share to its rival Artnature in both the men’s and women’s markets. Shareholders have reacted by changing the board and now the new management has introduced a revamped sales strategy abandoning the aggressive sales approach of the previous regime that alienated clients. Initially this will cause a sharp fall in reported domestic sales with a recovery anticipated in the next fiscal year. Despite wigs' high ticket price, the repeat revenues from loyal customers should allow cash flows to remain relatively resilient and stable. The fact that this has not been the case for Aderans of late is a concern that we plan to address when we visit Tokyo.

Another product category suffering a chill in the current environment is high-end cosmetics, which has impacted Kanebo - an important operating subsidiary of Kao. To a large extent this understandable weakness is offset by the higher margins earned from the household products business, which is benefitting from lower input costs. But an unanticipated product recall of the company’s ‘Econa’ branded products will contribute to a bigger dent in profits this year than previously anticipated.

On a more positive note Meiko Network, Obic Business Consultants, Morningstar Japan and Mabuchi Motor all reported better than expected profits and higher forecasts. Good to see at such difficult times.

Michael Lindsell
October 2009

13 November 2009 LTL 000-083-7