Mar 2004

LONG ONLY JAPANESE EQUITIES

One important characteristic of the Fund is its relatively high weighted average free cash flow yield of 5.6%.

What does the figure mean? It is our conservative estimates of the aggregate excess cash generated by the businesses in the Fund after accounting for all their ongoing investment requirements. Should this cash remain on their balance sheets it would most likely hinder overall investment returns unless used to buy back shares at accretive values. If the companies paid it to shareholders their weighted average dividend yields would be nearer 5% and not 1.2% that they are currently. In other words our companies have a high dividend paying potential. Whether they chose to fulfil this potential is another matter. What we are as certain about as we could be is that this ratio will narrow as a greater percentage of the market's ownership passes from relationship investors to portfolio investors who are and will increasingly demand tangible returns from their investments. Portfolio investors include Japanese pension funds, foreigners, mutual funds and individuals. Although the former two categories of investors have been increasing weightings in stocks for some time, individuals have been consistent sellers both through the bull market of the 1980's and ever since. Now only 2% of individuals' financial assets are invested directly in the stock market, which compares to far higher figures in other countries such as the USA or UK. From this we conclude that historically companies have failed to offer to individual investors what they seek in terms of return. Some think that the allure of capital gains might have been enough but even when it was considered guaranteed in the 1980's individuals still sold. We suspect it all boils down to yield. Since the early 1970's yields on Japanese stocks have been wholly uncompetitive as compared to other financial products until the mid 1990's when deflation forced down short-term interest rates to zero. Even though equity yields have been higher than cash and approximately the same as bonds for some time individuals still sell, most likely because they require more of a premium to account for the risk of investing in equity. Even the government has done its bit to increase the relative attractiveness of equities by cutting the double taxation on company dividends from 20% to 10% last year.

What is the required premium to make individuals consider re-weighting their financial assets to stocks? We don't know but suspect substantially higher than most bulls of the market would care to contend. Perhaps we get a hint from the Japan Real Estate Investment Trust ('JREIT') market, which over 2 years has grown from nothing to having a market capitalisation of ¥1T. Originally most of these Trusts were marketed to individuals who were keen buyers on yields of approximately 5% or more. If individuals were offered dividends of a similar size from companies that could at the same time offer a realistic prospect of maintaining them we think this multi-year trend of declining individual ownership of the market could reverse. Unfortunately not all companies can afford to increase their dividends to the extent that individuals might require today, implying that their share prices would have to fall in order to reach the required yield. We take some comfort that the companies in our long portfolio do have capacity to yield as much as 5% today and that in addition we think that the cash flows of our companies can grow modestly fueling higher dividends in future years. This may even be one better than JREIT's. Their cash flow is dependant on rents, which are still falling. Only though increasing leverage or cutting costs can they maintain their dividends.

We continue with the review of the companies we hold in the Fund by discussing our second and third biggest holdings, Canon and Fuji Photo Film. They are international businesses, like Nintendo, that source a significant proportion of their revenues outside Japan. Both share a characteristic that makes their core businesses highly attractive as investments in our view. A large proportion of their revenues and the bulk of their profits rely on sales of consumables used in the functioning of their products. Their products include copiers, printers, cameras or image developing machinery that in common with most manufactured goods earn them a small margin even though they may cost a lot to buy. In most cases these products consume varying amounts of paper, film or ink over the course of their depreciable lives that are usually supplied exclusively by the companies and attract far higher margins. It is this repeatable revenue stream that makes these businesses more predicable and durable than others.

Canon is the larger company with a market value of ¥4.6T. The jewel in its crown is its printer business, which is supplied though Hewlett Packard in the UK and the USA. Canon has developed a range of colour printers whose quality is so good that businesses such as ours no longer need to outsource the printing of our presentations to the local print shop. In order to justify this capital expenditure we calculated that despite the high cost of the printer and the cartridges costing 6 times more and lasting for 80% of the time as compared to ones for our black and white printer, buying a colour printer and abandoning the need for the print shop was cheaper on a three year view (its assumed depreciable life). This increased utility and quality is helping increase colour printer diffusion in offices around the world. It began last year and should continue for the next 3 years, at least. As diffusion increases Canon's repeatable revenue steam not only grows but marginal profits derived from it increase as well. This should remain the most important source of increased cash flow for the company for some years and has already allowed it to generate more than ¥700bn of free cash flow in the last 3 years.

Fuji Photo is probably best known for selling silver halide camera film as a competitor to Kodak. With the onset of the digital age this is now a business in decline. Despite this obvious headwind Fuji has been adept in reinforcing and repositioning its business in three areas. It has continued to expand its share of the developing market. Fuji provides most film (whether analogue or digital) developing machines found in specialist developing shops, pharmacies or corner shops around the world. Crucially these require consumables such as chemicals and paper which Fuji supply as well, though not exclusively. A better business is the medical imaging business where margins are higher and competition less, though obviously there is a practical limit to the scale of this business. Where Fuji has repositioned is in its purchase of a majority of Fuji Xerox from its joint venture partner, Xerox, 2 years ago. This is a copier business largely concentrated in Japan specialising in high-end large print run machines. Fuji have been rationalising the business and expect to be able to raise margins from here though reduced production cost and new product introductions. Fuji's profits have stagnated over the last 2 years. We expect the benefits of the repositioning to filter through to higher cash flows imminently.

Both companies are involved in a number of other businesses that we rate less highly. Both sell digital cameras where competition is rife and prices risk falling precipitously, Canon makes semiconductor testing equipment and is due to make large flat TV screens and Fuji is involved in liquid crystal display components, profitable now but at a high risk of becoming less so in the future. For both these companies the diversion of capital to these less lucrative areas whilst at the same time paying modest attention to dividend payouts remind us that old habits die hard. Nevertheless, we think that habits are changing slowly and the importance of these peripheral businesses to the whole will remain modest enough to influence our likely return.

5 Apr 2004 LTL 000-024-7