April 2010

LONG ONLY JAPANESE EQUITIES

The news from the Osaka Securities Exchange (‘OSE’) has become progressively better over the last year. After all, in the wake of the sharp fall in the market in 2008/2009 you would have thought that a business so exposed to falling market volumes would experience a concomitant decline in profits. Certainly that was built into our expectations and as a result we wanted to add to our position at Y300,000 or below, taking advantage of any such bad news. We had but one bite at the cherry. After that for most of the year the shares have traded between Y400,000 and Y500,000 per share. The company has benefited from good fortune and good strategy and has just reported results unchanged from last year. Good fortune comes from the regulatory requirement for the listing of many options that had traded “over the counter” before. This unexpectedly boosted demand for listed options trading at a time when market volumes were falling. Good strategy came from the continued boost to trading volumes from the Nikkei-mini futures index contract - that was introduced to appeal to individual investors and has proved a big hit in Japan - and from the acquisition of the JASDAQ index which has been quickly turned to profitable and is being merged with the OSE’s existing small company market, Hercules. Add some cost cutting and better volumes recently as markets recovered and OSE’s operating profits today are within 12% of its high even though futures market volumes are down 29% over the year. Some performance. This has allowed the company to raise the dividend by 6% (instead of cutting it as had first been predicted). Next year the company expects to maintain this high level of profitability and on that basis the company’s shares, trading at a 9% free cash flow yield, are too cheap in our view for the quality of the business. As the year improved we succumbed and bought some shares at higher prices and now think forays below Y400,000 are less likely. What is clear is that in bull markets the shares can trade much higher. With profits at half this year’s level the shares traded at a price double the current one which suggests that if market volumes rise from here the shares could feasibly triple in price from where we are today.

We review the holding in Nomura a year from when we were accumulating it. We bought some in the market and some in a new issue of shares at 25% below the current price. Both looked good entry points at the time but were undermined by subsequent share issues. We understood the need to raise capital to bolster capital ratios post the financial crisis but we are more wary about the ambition to expand the company’s wholesale broking and investment banking activities outside Japan that started with the purchase of Lehmann’s European and Asian operations. Such a strategy requires much investment, especially in intellectual capital which is fickle, in a highly competitive arena where incumbents have proven staying power. Admittedly, so far, with the benefit of hindsight the expansion was timed to perfection as markets have risen since but we doubt the returns on capital are likely to be as good as in the domestic businesses and, in addition, we fear that regulation might further crimp returns. Why, you may wonder, do we bother at all? Well, today the market value of the shares is still way below the sum of its parts and there is some truth in the company’s assertion that Nomura needs to participate globally in order to develop the full range of products and expertise to best support the domestic businesses that we most value. We wonder whether today’s expansion is for its own sake rather than to serve the core business. The latest results provide some evidence of how things are going. The bits of the business we like - retail distribution and asset management - continue to perform as expected with nice increases in funds under custody (now Y73.5T) and management (Y25T) respectively. Global Merchant Banking, a grand title for private equity, remains in limbo and threatens further write-offs and the global wholesale business has turned in good revenues but disappointing profits. So far, business performance is in line with our suspicions. Our conclusion is that we remain holders at the current price but were it to rise much we might be forced to reconsider the investment and we would only add to the position a lot lower down to compensate for the recent dilution and the risk of low returns from global investment banking. What is clear is that we have no appetite to make this position into one of our largest ones at the current price based on the unique strength of the domestic franchise, something that we had seriously entertained last year.

Michael Lindsell
April 2010

21 May 2010 LTL 000-090-5