Sep 2006

LONG ONLY JAPANESE EQUITIES

The end of September is at least half-way through the fiscal year for 90% of the portfolio. Thus, it is a good moment to monitor the ongoing progress of the companies we own.

In terms of aggregate earnings per share ('EPS') we anticipate weighted average growth of between 0- 5% this year for the portfolio. Although Canon, Mabuchi Motor, Nintendo and Namco Bandai should experience above average increases, such positive results will be offset by larger than expected provisions at Takefuji and declining profits at Taisho Pharmaceutical, Ryoyo Electric and Impact 21. Takefuji's woes were reviewed in detail in the July monthly review. Taisho's tonic drink sales remain disappointing and are such a dominant part of the business that until they stabilise it will be difficult for the company to turn around profits. We have no real confidence that this is to happen in the near future but console ourselves with the quality of the brands, the dominant consumer healthcare franchise and the low enterprise value ('EV') of 1x EV/Sales. Ryoyo's semiconductor trading business has been suffering for 3 years from the loosening relationship with Mitsubishi Electric on which it was highly reliant. Like a stockbroking business, it is notoriously difficult to predict revenues but even at these depressed levels of profitability the company generates free cash to add to a cash pile that today equates to 65% of its market capitalisation, which together with the dividend yield of 2.5%, we think makes the downside limited. Impact 21, the company behind Polo Ralph Lauren in Japan, is absorbing the impact of an inventory writedown following poor merchandising. Again, no sign of a stabalisation in earnings yet but we think, given the backing of its balance sheet cash and the dividend yield of 3.0%, there is little risk from here. Free cash flows for the whole portfolio should increase at about the same pace as earnings overall but increased capital expenditure burdens for the Osaka Securities Exchange and Fuji Photo should depress cash returns for these individual companies.

Despite this pedestrian pace of EPS growth, weighted average dividends are expected to increase by 12%. Although we can foresee the potential for further increases later in the year from Meiko Network, Sansei Food, the Osaka Securities Exchange, Rohm, Medikit and Takeda Pharmaceutical there is a possibility of a cut from Takefuji given the short term pressure on its business. As a result the balance of probability suggests that a rise if 12% looks like an average outcome. The portfolio yields the same today as it did on average in the last fiscal year, 1.8%, following this year's 10% rise in the value of the NAV. This is a yield 75% higher than the current yield of the market, which we continue to think anomalous over the long-term. In general, we would expect predictable, cash generative, conservatively financed business (i.e. our portfolio) to yield less than the market and cyclical, cash consumptive businesses (i.e. what we don't own) to yield more on account of the increased business risk. That is the practice in other more mature capital markets where portfolio investors dominate the ownership of shares. Now that such investors influence is increasing in Japan, following the reduction in cross-shareholdings, we expect the anomaly to lessen in the future.

We estimate that this year's expected rise in the growth of dividends relative to earnings increases the payout ratio to 46% from 37% last year. If this is adjusted for the share buybacks that have occurred already, the payout rises to 55%. We know from the announcements from Takeda, Astellas and Aderans in particular that further buybacks are in the offing in the second half so would expect this overall adjusted payout ratio to rise to nearer 60% by the year end. This is more evidence suggesting that companies are slowly improving shareholder returns, in response to pressure from investors. Despite this, as a significant minority of this year's cash flow will likely be retained, we expect a small increase in excess cash balances held on the balance sheets, which will maintain the pressure on these companies to do more in the future.


Michael Lindsell
Oct 2006

23 Oct 2006 LTL 000-040-4