May 2005

LONG ONLY JAPANESE EQUITIES

Now that all but two of the Fund’s holdings have announced final results for the 2004 fiscal year it is worth taking stock of the aggregate changes.

Following more dividend rises announced with the results the weighted average yield of the portfolio (before expenses) has risen from the estimate of 1.3% earlier in the year to 1.6%. If cash used by companies to buy back shares had instead been paid out as dividends the yield on the portfolio would have been 2.9%, a relevant figure as share buybacks are another, albeit indirect, way of rewarding shareholders, especially as the buybacks were executed at the prices prevailing in the market today that we judge to be below intrinsic value. The weighted average rise in dividends was 29%. From forecasts made already dividends are due to rise a further 7% in 2005. Average net cash held on the balance sheets of the companies in the portfolio as a percentage of market capitalisation was 15% rising to 22% in 2005. We can conclude that most of the companies in the portfolio earn more cash than they know what to with even following the marked increases in payout ratios seen in the last 2 years. Such is the stability of the cash flows that payout ratios or buybacks could expand materially from here. Indeed, similar companies outside Japan view the predictability of cash flows sufficient to take on debt to finance their businesses in order to improve financial returns for shareholders. For instance net debt as a percentage of market capitalisation for Proctor and Gamble, Anheuser-Busch, Coke and Cadbury was 11%, 22%, 4% and 35% respectively at the end of FY 2004.

The companies in the portfolio should generate a 5.8% weighted average free cash flow yield in 2005. However, we think it is appropriate to adjust market capitalisation downwards by the amount of excess cash on their balance sheets on the basis that all of it could be paid out to shareholders or invested to achieve similar returns as the existing business. On this basis the cash flow yield is 8.2%.

On the basis of these free cash flow yields and of the prospective dividend yield of 1.7%, is the portfolio good value?

Certainly value seems compelling when compared against other financial assets in Japan. After all the yield on cash is zero, 10 year government bonds 1.2%, 30 year government bonds 2.3% and property (the TSEREIT index yield) 3.5%. Except for property all these yields are fixed so can only represent value if deflation continues in Japan. Although deflation, especially if it was severe, could theoretically cause free cash flow yields to decline it has not happened for these companies over the last five years, even though the Japanese CPI fell at an annualised rate of 0.5%, largely because of the quality and durability of the franchises. The difference between the free cash flow yield of the portfolio of 5.8% and the 30 year bond’s real yield (its nominal yield adjusted for deflation) of 2.8% is a measure of the margin of safety inherent in the portfolio if the current pace of deflation continues. It is obvious that in the opposite scenario of inflation holding equities, where cash flows can increase, is massively more attractive than owning an asset with a fixed coupon and long duration. When compared to similar businesses overseas a free cash flow yield of 5.8% for the portfolio is similarly priced. Compared to history and for those investors more familiar to thinking in terms of P/E ratios a yield of 5.8% inverts to a P/E of 17.2x. Jeremy Siegel in his book ‘Stocks for the Long Run’ calculated the median P/E of the US market over 1871-1996 to be 13.7x. As the Fund’s portfolio is concentrated in what we judge to be exceptional businesses perhaps it should be valued at more of a premium. In addition, it must be recognised that the companies in the portfolio have additional value when accounting for their excessive net cash. It can either represented by a higher potential free cash flow yield (e.g. 8.2% - see above) or through additional net asset value per share. From whichever perspective this represents an additional margin of safety, this time over the value of similar businesses in world markets, where, in any case, the competition in terms of valuation from other financial assets is more acute than in Japan. In terms of dividend yield 1.7% compares favourably with 10 years bonds at 1.2% but less so with the current yields on similar companies worldwide. For instance Proctor and Gamble and Anheuser-Busch’s yield is 2%, Coke and Cadbury’s 2.5%. To build an adequate margin of safety more companies in the portfolio need to raise payout ratios in the same way as Kao and Nintendo (from 20% to 40%). On the basis that owning this portfolio establishes a significant margin of safety between both competing financial assets in Japan and similar businesses worldwide and that companies are and should continue to raise payout ratios we are confident that the portfolio represents good value. This is validated by the average difference between current prices of the companies in the portfolio and their price targets, which today stands at 37%.

Michael Lindsell
Jul 2005

14 Jun 2005 LTL 000-02