Mar 2008

LONG ONLY JAPANESE EQUITIES

The market's 17.8% fall in the first quarter (as measured by the TOPIX index) was the worst first quarter return since 1990, which was the start of the demise of the market after the 1980's boom. Our strategy fared better but even so there were some companies, such as our holdings in the pharmaceutical companies Astellas and Takeda (down 21% and 37% respectively) that should have proved more stable at a time when the market is discounting a profits recession. After all, of all companies pharmaceuticals should be immune from the vicissitudes of the economic cycle. We think such steep price falls materially undervalue the prospects for these companies and we have thus added to our positions in these companies during the month.

All drug companies are reliant on the efficacy of their research and development 'pipeline' i.e. the sales potential of future new compounds that are required to replace the sales of existing drugs whose patents expire and thus become subject to competition from cut price generic drug producers. Both Astellas and Takeda have promising new compounds, extensive research and development budgets and most importantly a culture and accomplished record of bringing successful products to market in the past - a characteristic we rank highly. However, at the same time both companies have particularly important drugs facing patent expiries over the next three years and it is this imminent threat that probably lies behind today's weak share prices.

Taking Takeda as an example its anti anti-ulcer drug, Prevacid, and its anti-diabetic drug, Actos, together make up 40% of sales. The challenge for the company is to extend their product lifecycles with improved formulation for as long as possible whilst at the same time bringing forward new compounds to counter the expiration of these patents. The company has a history of innovation, spending as much as 15% of current revenues on research and development, and has a pipeline of new products with much potential especially in the growing therapeutic area of diabetes. At the same time the company has substantial cash resources to licence-in promising new drug candidates to supplement its pipeline. For instance, just recently the company licenced-in new compounds from Amgen (US), as well as buying Amgen's Japanese subsidiary for Y90bn. The biggest threat to the company is a failure to secure regulatory approval for new compounds in the late stages of development especially over the next three years with the expiry of patents on Actos and Prevacid. Indeed, last year the FDA in the US requested further tests on a promising new cholesterol lowering treatment that was due for launch in 2009/2010. At best this will delay the drug's introduction, at worst it could be dropped from development altogether. This event highlighted the risk to Takeda's revenues and is no doubt another contributory factor to recent share price weakness that has lowered valuations so much that the shares are priced at a 10% free cash flow yield and 3% dividend yield. Interestingly, Takeda's situation is not so different from GlaxoSmithKline, a larger London listed global pharmaceutical business, which has similar patent expiry issues to deal with. Takeda trades on an equivalent earnings yield, a lower dividend yield (as Glaxo has a payout ratio of 66% versus Takeda's of 36%), has similar margins but importantly has cash that equates to 48% of current market capitalisation as compared to Glaxo's net debt. Not only does this provide a useful margin of safety for investors but also it gives Takeda the resources to invest heavily to counter the patent expiry issues should it need to. As we believe that the company's innovative ability is as good if not better than in the past, the cash could be used instead to boost the payout ratio (it is rising: up from 21% five years ago) or to buy back shares (5% of shares outstanding have been repurchased in the last two years).

Astellas has similar issues and, like Takeda, will at best grow earnings marginally in the near future. It has a slightly smaller cash hoard, 36% of current market capitalisation, a dividend yield of 2.8% and an equivalent free cash flow yield of 10%. However marginal or no growth is just fine for companies on such high free cash flow yields as these are real yields more than three times the yield on 30 year nominal government debt. Most investors don't realise how such high starting yields for an investment can be tremendously accretive for companies if generating that yield requires investment of little capital and if the cash flows delivered are reinvested rationally. As both companies continue to improve their allocation of capital, most particularly Astellas with its plan to raise return on equity to 18% by 2011, the compounding effect of such high yields will quickly show through in even more attractive valuations. After all compounding returns at 10% doubles your money in just over seven years.

The combination of a fall in prices and the 20% growth in dividends for our strategy (this figure has been revised up as companies have announced dividend hikes in the last quarter of the financial year) has resulted in a material increase in the dividend yield of the portfolio which at the end of March, admittedly a low point for the market, hit 3.0% a 25% premium over the 30 year generic government bond yield at 2.4%. Like for these pharmaceutical shares this represents good value for the strategy as a whole.



Michael Lindsell
Mar 2008

07 April 2008 LTL 000-062-0