March 2007

LONG ONLY JAPANESE EQUITIES

In March two companies announced plans to repurchase shares. Canon bought a further ¥100bn worth of its shares, on top of the ¥100bn bought in February; and Meiko Network announced plans to repurchase ¥5bn worth of its shares over the next six months which, if completed, would amount to 15% of the current shares in issue. These companies, although vastly different in size, both generate free cash flow significantly in excess of their investment needs. This cash flow can currently be invested back into the equity of each company at earnings yields of at least 6%, making such an investment highly accretive for surviving shareholders such as us.

Kirin announced satisfactory results for 2006. Operating profits were up 4% following a successful year of winning further market share from Asahi in Japan's new genre beer markets. As a result Kirin ended the year with an overall beer market share at 38%, equal to Asahi's. It was good to see the dividend increased by 17%, the third such year of successive dividend hikes. Despite this the payout ratio remains unnecessarily low at 30% and the company still exhibits a return on capital of just 7% - a depressingly low figure compared to the approximately 20% return of overseas majors such as Anheuser-Busch and Heineken. The company continues to make the right noises about improving its capital efficiency even if the pace of change is painfully slow. And, to demonstrate that action does follow words it was good to see the recent announcement of the sale of the 18% stake in meat processor Yonekyu as this is another small step in focussing the business.

Two other of our companies, Aderans and Nissin Food, revised down their FY2006 profit projections. Aderans' new (as opposed to repeat) sales of their wig products have been poor, largely due to the company's loss of market share to Artnature, their major competitor, in a mature market. The share price has been weak for the last six months as investors have priced in this profits decline but has held up more than otherwise might have been the case on account of the stake building by Steel Partners (a US private equity firm) who now own 25% of the company. Although there is undoubtedly a poor outlook for the new sales of men's wigs, as the traditional stigma of baldness lessens with the passage of time, women's wigs should grow in the future driven by the vanity of the quickly aging female population. At the same time the company can rely on the repeat sales of existing wig wearers to generate a base level of sales in years like this one.

Nissin Food's profits were apparently affected by an overly warm winter affecting sales of instant noodles. Like Aderans the share price held up reasonably well because Steel Partners have been building a stake in the company. Since Steel Partners sold their approximately 25% stake in Myojo Foods to Nissin following the latter's tender offer, increasing Nissin's share of the Japanese instant noodle market by 10% to 55%, Steel Partners have further increased its stake in Nissin from approximately 5% to currently 12%. The fact that Steel Partners dominates the share registers of these two companies in addition to owning stakes in other companies we own or have owned, such as Ryoyo Electric, Osaka Securities Exchange and Sotoh, is a coincidence. Nonetheless, it probably suggests that the value criteria we search for in certain businesses is similar. That Steel Partners have the financial muscle to accelerate the extraction of that value by making tender offers for the entire company, as occurred in the case of Sotoh, is useful.

Ryoyo Electric, a 3% holding in the Fund, also announced disappointing results caused by the bankruptcy of a distributor of its IT equipment trading business. 63% of Ryoyo's business is trading semiconductors, with 30% trading IT equipment. Like a stockbroker, the business has large volumes but low margins and almost no requirement for capital other than financing its inventory and accounts receivable. For this reason the financial strength of their customers is a key risk of the business. The failure of the distributor resulted in an increase of provisions for bad debts of approximately 10% of last year's pre-tax profit as well as the cancellation of some anticipated revenues. A positive outcome is that this has caused a review of all the company's counterparties. Aside from the one-off effect of the bad debt provision we think there will be little lasting damage. Current business is doing well and the company anticipates a decent profits recovery this year. The shares are now cheap trading on a 2.7% dividend yield with 60% of the market capitalisation accounted for by net cash alone. On this basis, we plan to add to the position.

Kansai Electric Power announced increased capital spending plans for the next three years which will crimp free cash flow and may influence the likelihood of dividends rising more in the short term. Although we remain confident further out, this announcement could trigger stagnation in the share price especially as this year's performance of the shares has been inexplicably good. We reduced our weighting by approximately 30% in reaction to the strength of the shares earlier in the year and may reduce it further on any rebound

Michael Lindsell
Apr 2007

08 Mar 2007 LTL 000-044-8