May 2004

LONG ONLY JAPANESE EQUITIES

Two months ago we concluded that the companies we own could yield 5% if their managements responded to shareholder demands and paid out the majority of their free cash flow as dividends.

We went further to suggest that should they do this they were likely to attract a wider constituency of investors to own their shares, which may include individuals and domestic institutional investors both of whom have a great need for income returns, something singularly lacking from equities since the early 1980’s. In addition the companies would be able to stand up on their own merit in terms of value and ROE and in some cases look decidedly cheap versus many comparable businesses in the world. This is important because there are many quoted businesses in Japan that represent a good chunk of quoted market capitalisation that yield less than 1% and have inconsistent records of generating free cash flow and plenty who have never generated any at all. For these yields to rise to a level to satisfy the demands of new investors it is more likely to come about through falling share prices rather than increased payouts. It may prove that a strategy of avoiding these companies as investments is as important as one orientated, as ours is, to companies with high dividend paying potential.

The good news is that following this year’s corporate results 9 of our 21 companies have signalled a significant rise in dividends, by increasing payout ratios or have engaged in meaningful share buyback programmes at sensible prices. Last week our largest holding Nintendo predicted a potential 90% rise in its 2004/5 dividends and Mabuchi Motor’s tendered for 7% of its own equity. We expect more of our companies will follow the trend. So far investors have bid up the shares in response. Although buying back shares is one way of returning cash to shareholders we tend to prefer dividend payouts as we then control the price at which we subsequently reinvest the cash. Putting it simply we think some companies overpay for their own shares and in doing so dilute the returns to us as investors. They never overpay by much, after all we are happy holders, but some of the shares we own we bought at much lower prices and would be happier if the company held out for better opportunities rather than investing now. An exception to this rule has been Takefuji, a consumer lending company we own representing 7% of net assets. Takefuji’s business is one with a lousy reputation but with tremendous returns. They specialise in making small loans of no more than Y1m (£5,000) on a short-term unsecured basis to consumers. Consumers access the loans through ATM’s and manned booths around Japan. The business is risky but the net interest rate (income from loans minus funding cost divided by the average loan balance) of 23% is commensurate to that risk. Over the last 8 years Takefuji’s annual provisions were 5%, others costs and tax 12% leaving 6% as free cash flow. Unlike many other financial businesses in Japan Takefuji is backed by a rock solid balance sheet. Loans have averaged 230% of equity (and is today 180%) so financial leverage unusually low (Household International, a similar US business recently bought by HSBC, had loan more than 800% of equity), just what you would want in a consumer recession. Should the environment change Takefuji has plenty of scope to increase leverage and grow the loan book. Meanwhile the shares trade just above book on a free cash flow yield cash flow of 7%. Arguably, one reason why the share price is low is due to the chairman and founder’s prosecution on phone tapping charges. Although he has resigned he still owns the majority of the shares either directly or indirectly through family controlled companies. He has already sold some to foreign investors and may sell more as he is old and succession is not clear. Interestingly a new President has been appointed from outside the company who to clean up its image. The company has rationally been buying back shares at book value or below which is as an accretive investment as we could ever make. Together with the dividend they paid 40% of free cash to shareholders last year using the rest to reduce leverage. Based on our target prices we have most opportunity for gain in this company versus any other we hold which explains the recent increase in its weighting in the portfolio to 7% We own a similar business SFGC, 3% of net assets, which specialises in small lot loan to companies backed by a guarantor (usually a relation or close friend). Like Takefuji the risk is high and net interest rates set accordingly, at 18%. Average cash flow returns from loans have been lower at 3%, with loans at 189% of equity yet the shares current are valued at a lower 3.5% free cash flow yield, which accounts for the lower weighting. Unlike Takefuji its provisions have fallen for the last 3 years, which may account for its higher valuation today. The potential from the business is similar and most dependant on a sustainable pick up in economic activity.

1 Jun 2004 LTL 000-024-7