Jul 2004

LONG ONLY JAPANESE EQUITIES

Your portfolio has become even more concentrated than when first constructed in February 2004. Now the top 5 holdings account for 40% of the Fund’s net assets, and the top holding itself is 10%.

The next 6 holdings are all over 4% of net assets. We own 21 in all. The portfolio is this concentrated because we choose to invest in durable, stable, cash generative businesses that are undervalued, to the exclusion of others without these characteristics. We find these attributes rare. Our chosen companies have one alluring advantage over competing equity investments in Japan, and that is their ability to generate free cash flow in both good years and bad. Today this characteristic is vitally important as it makes them increasingly attractive to portfolio investors. The weighted free cash flow yield of your portfolio was 5.8% at the end of July slightly up on the 5.6% quoted in the March report, even though the portfolio is up 8% since then. The weighted dividend yield is 1.3% up from 1.2% then. The gains reflect growth in both cash flows and dividends ahead of share price rises. These yields are both prospective for next year using Lindsell Train forecasts. It is the gap between these cash flow and the dividend yields that represents a crucial part of the investment opportunity in the companies we own. Theoretically this margin is what our companies could pay out to us as extra dividends or use for share buybacks, but don’t at the moment. Should that change, as we think it will, more and more investors should be attracted to own these shares.br>
For most of our companies free cash flow yields and earnings yields are equivalent meaning the portfolio trades on an earnings yield of 5.8% or a price earnings ratio (the reciprocal of it) of 17.2x. Although we argue that our portfolio offers good value on this basis, it is not by any means cheap. From an absolute sense the portfolio has downside risk. After all our cash flow forecasts are based on estimates which could be too high and part of our value argument rests on our assumption that our companies begin to pay higher dividends and allocate capital more efficiently, for both of which there is, as yet, only tentative evidence. However, an important attribute of all the companies we own not captured in this price earnings valuation, is that they all have conservatively managed balance sheets. Every one of them, except the financials, has net cash in its balance sheet. On average for the portfolio constituents, net cash represents 24% of market capitalisation. With interest rates so low in Japan this cash is earning negliable returns, hardly affecting cash flows or earnings. How does one value this conservatism?br>
One way is to assume that all this excess cash is used to buy back shares at current prices so that, in aggregate, our companies have no excess cash. Admittedly a theoretical notion as any hint of such action would be bound to inspire rises in market prices. Nevertheless was it to happen we would then be applying approximately the same free cash flows on a market capitalisation reduced by the value of the excess cash. If the portfolio were valued in this way its adjusted free cash flow yield would be 8.2%, for a price earnings ratio of 12.2x, a valuation we judge to be cheap for the type of businesses owned in the Fund. This is why we feel the downside risk would be much reduced the faster our companies implement more rational dividend and capital allocation policies.br>
Looking at the dividend and capital allocation policies of the businesses we own, Kao is most advanced having committed to returning all its free cash to shareholders, Nintendo, Seven-Eleven, Ryoyo Electric, Tokyo Individualised Education and Taisho Pharmaceutical have returned significant amounts but Canon and Takeda Chemical have chosen so far to maintain payout ratios and increase dividends in line with profit growth. As result net cash has risen from net debt to 13% of market capitalisation for Canon and from 12% to 32% for Takeda. Provided that we are correct in assuming that free cash flows, at a minimum, will remain stable the problem can only become more acute in years to come. As it does so the likelihood of management addressing it increases.



Michael Lindsell
Aug 2004

14 Aug 2004 LTL 000-024-7