May 2006

LONG ONLY JAPANESE EQUITIES

Now that all the FY2005 results have been released we can conclude that the companies we invest in have made further significant strides in improving shareholder returns.

Weighted average cash flow yields, calculated on average FY2005 prices were 5.4% up from 5.2% from the previous year. This helped fund a dividend yield of 1.8% which resulted from growth in dividends of 31%, following on from 30% and 20% in the two previous years. Dividend payout ratios rose to 37% from 25% three years prior and total payout ratios (including share repurchases) rose to 54%. The companies we invest in on average had net cash which represented 16% of average FY2005 values, making the free cash flow/enterprise value yield 6.5%, which if inverted to equate to a quasi P/E ratio was 15.4x.

Thus far, accounting for expectations in FY2006 makes little change to these figures. I remember at this time last year dividend growth projections were approximately 10% higher, today they are 6%. This makes us sanguine about the prospect for absolute returns from the portfolio in the future as we believe investors should find a 5% real yield attractive compared to 2% nominal from long term bonds. Clearly there is a risk that these equity yields can fall (if revenues and profits fall in a recession) and bond yields can rise but some comfort must be drawn from the stability and predictability of the free cash flows generated from these businesses as distinct from those, that would be much more vulnerable, in the wider stock market. Certainly compared to a portfolio of similar businesses in other markets in the world, where discount rates tend to be higher, the values still look reasonably compelling.

One late surprise from the May company results announcements was Kansai Electric Power's decision to raise in FY2005 dividend by 20%. For other companies, especially those with excess cash reserves or with rapidly improving profitably such a rise was not so unusual. However, KEPCO has neither of these attributes. Its profitability maybe increasing, but only slowly as cost cuts simply offset falling electricity output prices as the company passes many of the benefits of deregulation through to consumers. In addition, KEPCO remains burdened with ¥3T of debt. Admittedly this is ¥1.5T less than just 5 years ago but still 1.7x its equity. We had thought that 3 more years of debt reduction might be necessary (so that debt and shareholders equity were equal) before the dividend was likely to rise (see February 2005 monthly review). In raising the dividend this year the company signifies that rewarding shareholders is a more important consideration than in the past and that the debt levels the company has today are manageable, balancing the predictability of the businesses cash flows with the threat of rising interest rates. We think this a first step of many and one that should begin to restore the electric utilities' traditional dividend yield premiums over other companies in the future.

Another surprise was the planned increase in dividend from Nissin Food. The company has approximately 50% of the instant noodle market in Japan which is an important and valuable franchise. This is validated by the company's strong historic cash flows which, like many other businesses, have been allowed to accumulate on the balance sheet as excess cash reserves. Following the acquisition of more than 5% of its equity by a US private equity investor the management has begun to introduce measures to improve shareholder returns. Following a share repurchase programme in late 2005, on the announcement of its results it raised its projected dividend for FY2006 by 67%. As a result the shares now yield 1.3% and the payout ration is 28%. Clearly the company can do more, but at least it's a beginning.

Although the strategy has weathered the 8% fall in the market (TOPIX index) during May well, some of our smaller companies have been caught up in the savage sell off in small company shares. Meiko Network fell 14%, making it even more attractive as an investment with a free cash flow yield of 9%. We have added to the position. In addition, we have been accumulating shares in Sansei Food at better prices than we anticipated and we may get another opportunity to buils our position in Medikit if the shares remain weak. Within large companies we continue to accumulate shares of Kao Corp, whose shares have been trading at lower prices than we expected. We were surprised to learn, having met the company that the synergy benefits from the takeover of Kanebo have not, as yet, been accounted for in company forecasts. We are sure that significant benefits will in due course transpire. We continue to think that this will prove a transforming acquisition for the company. Nintendo performed particularly well during the month rising in value by 11%. We sense that more investors are coming to the view that with the launch of the new home console in the autumn, together with the successful handheld Nintendo DS and the company's policy to broaden its appeal to a wider audience, the company now have the ingredients necessary to grow its business. The recently released company forecasts themselves suggest a 20% sales increase in FY2006. Should this prove correct we should expect materially better performance from the shares compared to what we have anticipated thus far, supported by, we suspect, further significant tangible rewards for shareholders.


Michael Lindsell
June 2006