Feb 2004

LONG ONLY JAPANESE EQUITIES

As new advisors to your Fund we have recommended and had implemented changes that materially alter the disposition of the portfolio.

In our first monthly we explain the rationale for the changes by outlining the way we invest and what attributes in companies we seek. We illustrate our approach with reference to one of the new positions in the Fund. In future months we hope to write about all the companies we invest in.

Lindsell Train seeks to earn returns for you by recommending investment in companies whose pricing is materially lower than the intrinsic value we ascribe to them. In determining value we pay particular attention to the likely durability of the business, recognising the unpalatable fact that, over time, most businesses fail, a statistic the investment industry cares not to advertise. We make conservative, qualitative judgements about not only whether a business will survive but also whether it has the capacity to deliver real returns for us over the indefinite future, for reasons that are understandable to us. In such a way our valuations have built into them a margin of safety to allow for misjudgements and events that we can't possibly predict but we know are likely to occur in the rough and tumble of the world we live in. In placing this emphasis on durability, we aim to exploit the undervaluation that we think the market perennially accords a long term steam of stable or growing free cash flows over the delivery of short term but ultimately ephemeral bursts of reported earnings that the majority of investors rate so highly. This is an approach that has a number of distinctive characteristics. As durable businesses are rare and undervalued ones even rarer we have few holdings and hope to hold onto them for some time. As a result, we expect the portfolio to be relatively concentrated with low turnover and low transaction costs. The emphasis on stable and growing free cash flows could mean that at some juncture in the future, if companies distribute more to shareholders, a greater proportion of the return of the Fund would be attributable to dividend payments rather than purely capital gain.

We observe that the Japanese stock market is changing in response to pressures brought about by 15 years of a bear market in stocks and 8 years of deflation in prices and 7 years of declining nominal economic activity. The change began slowly but is quickening and will likely speed up more. It has a long way to go. It is best illustrated by the changing ownership of the stock market and specifically the decline in the traditional practice of relationship investing characterised by the cross shareholding ratio that peaked at 50% of the entire market in 1989. The web of cross shareholdings was established when Japan's economic growth was high and capital was in short supply following its reindustrialisation after the war. At the centre of the web were the Japanese banks and insurance companies whose loans were allocated dependant on strength of the relationship between the financial institution and the company. This had a benign effect of helping the company shield itself from foreign takeover and allowing it preferential access to scarce capital to grow, and provided the banks with participation in the value creation of a growing business. As the economy matured with Japan producing more than it could consume itself, access to capital eased. It was then that the practice of cross shareholdings had a malign influence as the plentiful capital was invested in low return assets especially property and ultimately created the bubble economy of the 1980's. Since then companies and financial institutions have been constant sellers of stock in recognition of the massive misallocation of capital as they attempt to repair their balance sheets. As a result the cross shareholding ratio has declined, but only to approximately 35%. Relationship investing still remains a considerable influence in the market. The decline may continue until cross shareholdings represent only a marginal proportion of the market, say 10%. The pace of decline has recently quickened and is likely to accelerate further in the months ahead. Since the collapse of the economy in the early 1990's the only long-term buyers of the market have been Japanese pension fund managers and foreigners both of whom ultimately require a tangible return from their investment, namely a high and/or growing dividend. 14 years of a bear market with at least 3 failed recoveries have proved that capital gains cannot be relied upon. As a result the priorities of portfolio investors are beginning to become the dominant influence on the pricing of shares much in the same way as it is in Western markets. Already the market has become a riskier place for all participants as the safety net of relationships is not be there to support underperformers in bad times. Company failures are increasing. A compensation for this increased risk is a greater reliance on tangible returns in the form of dividends. Corporate activity has begun increase as company capital both from abroad and domestically is reinvested to optimise economies of scale and take advantage of business synergies.

The portfolio now has 23 recommended companies. The top 5 recommended holdings account for 38% of net assets. The largest holding is Nintendo, the computer games company. This company possesses more of the characteristics that we look for from a durable business than any other we own. It sells computer game hardware and software for 2 platforms the hand held 'Gameboy Advance' and the console 'Gamecube' that connects to the television. The hand held franchise is a virtual monopoly although Sony is planning to enter the business later this year. The company competes with Microsoft and Sony in the Console business. In software, which is Nintendo's core business, they compete against many other software developers the largest being Electronic Arts. Most others are unlisted. Nintendo only allows its software to be played on its consoles and in doing so ensures repeatability to its sales. Once customers have bought Nintendo hardware it is most likely they will buy Nintendo software thereafter. Nintendo out sources all the manufacturing of its hardware to third parties and in doing so ensures that it invests in no factories and employees in the production process. In fact for a company with sales of Y550bn (£2.7bn) it has just 3,000 employees. Its annual capital expenditure and depreciation are 1% of sales. The company is a specialist in developing software for its platforms. All its software is proprietary and is developed around characters such as 'Mario', 'Donkey Kong' and 'Pokemon'. These characters have become household names much in same way as Disney's characters did a generation earlier and provide the company's products with a degree of recognition that further encourages repeat sales. Top selling software games sell in excess of 1 million copies at approximately $50 a copy. The biggest cost of developing the software is the intellectual content expensed by the company as cost of sales, any other production costs are minimal. The margins on these popular games probably exceed 80%. Not surprisingly, with average operating margins of 25% and negligible capital costs the company generates free cash flow of at least Y60bn a year. The market values the business (when subtracting net cash on the balance sheet) at Y550bn. On this measure the company is valued at a free cash flow yield of 11%, twice the average of the last 14 years and 3 times an appropriate discount rate. In this valuation there is no allowance for growth, which is probable. A conservative share price target would be 70% higher than the current level, which explains our enthusiasm for the company and our recommended 10% weighting in it.

12 Mar 2004 LTL 000-024-7