Oct 2004

LONG ONLY JAPANESE EQUITIES

Although most our research efforts are devoted to searching undervalued durable businesses we are prepared to lower the quality threshold so long as we are adequately compensated.

Where we can identify a business that is valued by the market at a discount to its short-term financial assets minus all liabilities (i.e. effective cash) we become interested because in one sense the business, however good or bad, is offered for nothing. It is important we demand a good discount to the value of effective cash, as we are wary of the fallibility of reported accounts. Ben Graham, in his work on value, demanded a discount of 50% and we, for no other reason other than mimicking a proven expert, demand the same wherever possible. Even so some judgement is used to assess quite how vulnerable the underlying business is. If, for instance, it is one that periodically bleeds cash, or where the management conduct grandiose or wasteful non-productive investments or ill-conceived diversifications, the comfort of such a discount can be quickly whittled away. Where possible we try to buy stable businesses that generate some cash so that value should steadily build over time. It has been rare to find stocks with these, admittedly demanding, value characteristics. When Graham wrote in the inter-war periods it was a time of deflation in the wake of the financial crises of the late 1920’s and there were periods when plenty of companies exhibited the characteristics described above. Since the 1950’s, following financial market recovery, few opportunities presented themselves until the last 2 years in Japan when an increasing number of small companies began to appear on the screening work we regularly undertake. By March 2003 20% of our Japanese portfolios were invested in such companies. Following the markets recovery all of them have performed well and some are now valued by the market as having significant business value over and above the effective cash.

Since we began managing the Fund we have had four companies in the portfolio held with a purpose of arbitraging value ascribed to effective cash. Tachihi Enterprises, was sold for 83% profit but two companies Tenma and Ryoyo Electric remain and recently we bought the beginnings of a holding in the Osaka Securities Exchange.

Ryoyo Electric trades semiconductors and earns for this competitive activity miserly 3% margins. On behalf of Japanese assembly and device makers, the company sources semiconductors best suited to their customers’ specifications from manufacturers around the world. There are more than ten Japanese competitors in this business alone and the barriers to entry are low. On the other hand the business, like that of a stockbroker, requires no physical capital only the ability to expand working capital in order to take on inventory when necessary and as a result perennially generates at least some free cash flow. Even today, after the shares have risen 70% from where we first accumulated them, they are trading at the value of their net short-term financial assets. We think they could trade at book value in the future, which gives a further 55% upside. Another positive has been the management’s prudent management of capital. Over the last 4 years the company has bought back 12% of the equity at highly accretive prices and this year it doubled the dividend.

Tenma is our largest holding of the three, at 3.2% of net asset value, largely by dint of its good performance. The company makes plastic storage containers, tupperware and packaging. Most of their products are containers used for storing clothes and household goods in small Japanese houses that lack built in storage capacity. It is easy to envisage how Chinese competition, with low labour costs, could compete away their margins and market share. This process has started as operating margins have halved from the 13% level prevalent in the mid 1990’s, although weak consumer demand has also been a factor. In recognition of this lasting threat the company has rather belatedly begun reallocating production capacity to China. Capital intensity has been low and the accumulated cash flows from many years has been allowed to amass on the balance sheet to such an extent that cash alone today represents 89% of market capitalisation. The company pays a low dividend, which has not changed for 10 years and despite encouragement from its foreign shareholders has yet to decide whether to increase its payout ratio. The company is family owned, and the shares tightly held so there is less pressure to act than in other companies. Even so, this year the company bought back 6% of the equity for the first time. The shares have traded within 10% of the target price twice this year, which has encouraged us to reduce the position but recently have fallen back to a level where there remains 23% upside. The Osaka Securities Exchange monopolizes Nikkei index futures and options trading in Japan as well as trading a few regional stocks and some small companies in the nascent ‘Hercules’ market. Nikkei index futures’ trading also takes place in Singapore on Simex. Operating an exchange requires periodic spending on technology and reserves of precautionary capital in order to underwrite the settlement capability of its members in case of failure or bankruptcy. This precautionary capital is currently in excess of the company’s market capitalisation and would only be required in the most unusual of circumstances. The reliability of revenues derived from a market, whatever the volatility of volumes, where all trades for the foreseeable future have to take place gives the business a characteristic that most others cannot offer and for this reason we are attracted it. That we can access it for the value of its cash on the balance sheet, even if it is there to underwrite its settlement function, makes it even better.

We continue to trawl for new opportunities with these characteristics but following the large influx of foreign capital into the market last year find them few and far between even with market capitalisations below £100m. In addition, we tend to prefer to hold smaller and more numerous positions in these opportunities because of their size and in recognition of the risk of placing our trust primarily in the reported accounts and secondarily in the sustainability of more vulnerable businesses than we would usually invest in.

23 Nov 2004 LTL 000-024-7