Nov 2004

LONG ONLY JAPANESE EQUITIES

We like investing in businesses that provide essential products and services to customers because future sales tend to be more predictable.

Unfortunately, for this reason, competition can be fierce with the result that in practice the potential list of investments is much whittled down. Often such businesses, especially transportation and utilities, over time, build themselves into monopolies through many years of management attempting to economise scale, which encouraged government intervention and in turn reduced the commercial incentive and reward to investors. The pharmaceutical industry is another example of a business that provides essential products to consumers but at the same time is hostage to the patent expiry cycle and the subsidies in pricing mandated by government controlled heath policies worldwide. Despite these negatives it is on balance a good business, in our view (see September’s monthly entitled ‘bbbb’). Legal services and accountancy services are essential businesses that we would be interested to own but are impossible to buy as equity investments as almost all are owner owned, for the very good reason that the cash generative nature of these businesses allows them to fund themselves entirely out of their own resources.

It is rare to find educational business quoted. Most education in developed countries is the preserve of the state. Where it is not it is typically established as non-profit making entities sometimes linked to charities or churches. Where there are exceptions the schools are owned privately and tend to serve fast growing market niches. The growth and demand for the school places allows for additional profit to fund the return on capital for a private investor. The Japanese educational system shares similar characteristics although private capital is mostly concentrated in investing in extra-curricular education. Although nearly all Japanese children are educated by the state they also, with little exception, supplement that education with extra-curricular studies in order to prime them for exams, high school and university entry. Most extra-curricular education is an extension of school studies with large class sizes that tend to benefit the more gifted pupils. Over the last 10 years a few companies, pioneered by Meiko Network, Tokyo Individualised Education and Riso Kiyoku have developed a system of personalised education where each pupil is taught either individually or with one or two other pupils with the same capabilities. One feature of education, which either derives from its characteristic as an essential service or as one so important and crucial in the mind of the customer (the parent), is its inelastic pricing. Speaking from personal experience the cost of education is about the last factor most parents take into account when weighting up the benefits of one school over another. The appropriateness of the education in its widest sense is the most important consideration above all others. As result education has a pricing power far stronger than many other less essential services. With this in mind it is easy to see why a tailored extra-curricular education in Japan has proved popular, especially as it caters for pupils across a range of capabilities rather than just the more gifted ones. It now it accounts for 33% of the extra-curricular market with the potential to take more share in the future. This potential should underpin the growth prospects for all three companies that between them have established enough scale and experience to benefit from increased efficiencies. The dynamic of knowing that your customers attach little importance to price over and above other issues is especially reassuring considering deflation persists in Japan, especially for big-ticket items. As a result improving student numbers translate into improving margins.

This is most evident for Meiko Network whose business is built around a franchise model. A franchisee is provided with curriculums, training, equipment and general support. In return the franchisee agrees to pay Meiko a percentage of the gross profits. Meiko also runs some schools directly and has a policy to balance new openings between the franchise (90%) and directly run models (10%). This has allowed Meiko to grow faster than its competitors and to achieve higher margins with less capital commitment. Margins of franchised schools are 75% higher than for directly run establishments, making for a potential combined operating profit margin of 30%. Today the business is cash generative, trades on a 9% prospective (to Aug 2005) free cash flow yield and has a commendable record of rewarding shareholders with increased dividends. The dividend has been raised 120% over the last 2 years. When we first invested in the company we did so on a future dividend yield of 8.5%.

Our other holding, Tokyo Individualised Education (‘TIE’), runs all its schools directly. In 2002 and 2003 the business did badly suffering from over-aggressive expansion. At the time the company was growing the business by more than 20% per annum and could not fill up the schools as quickly as they could establish them. Since the beginning of this year, following a moderation of expansion plans, pupil numbers per school have improved and as a result the business has recovered although operating margins are only expected to reach 12%. As Meiko earns margins more than 50% higher on its directly run schools we think there is more potential as ‘capacity utilisation’ continues to build. Again we have been rewarded with higher dividends. Looking back we originally bought the company on a 6.5% future dividend yield. Normally we would only want to invest in the best of these businesses but when we first came across them Meiko, our preferred choice, it had a market capitalisation of just £20m and TIE £50m. Now that this has reversed with Meiko’s at £87m and TIE’s at £66m we would prefer to concentrate our holding on the former. In October with TIE’s price at 40% above today’s we significantly reduced our holding and would do so again if presented with the opportunity.

The long-term success of these businesses will be founded on the quality of the service they provide. This is more difficult to maintain than in some other businesses as it largely dependent on the quality of the staff, which as they grow may be compromised. In our judgement this represents the biggest risk for us to consider and, as a result, has curtailed our weighting to them both in the Fund when they approach their full valuations.

14 Dec 2004 LTL 000-024-7