Apr 2008

LONG ONLY JAPANESE EQUITIES

Lower market prices have been an important factor behind the inclusion of holdings in Hogy Medical and SFCG in the strategy earlier this year (see January 2008 monthly). Shinwa Art Auction is a third new holding which we have been buying into falling prices through the first half of 2008. The shares have fallen 85% from their 2006 peak so today at least provide an alluring entry level compared to the past. The company is Japan's largest antiques and art auctioneer, with one third of the market and by far the highest hammer prices. Its nearest competitor (with a quarter of the market) has a different business model with average hammer prices at a quarter of Shinwa's and as many as 1,900 lots in each auction versus 150-200 at Shinwa. There are six other competitors, aside from these two, none with a share more than 12%. Foreign auction houses used to be active in Japan, trading in western art, but withdrew after the collapse of the economy in the early 1990's. Shinwa was first established in 1989 but adopted the business model currently prevailing today from 2001, to sell Japanese art, ceramics, jewellery and antiques in public auctions (in the past 50% of the business was in dealer-only closed auctions). The model is similar to the UK auction houses Sotheby's and Christie's, with both sellers and buyers paying a premium, which varies depending on the value of the lot. The art market in Japan is immature, partly because there is less heritage than in Europe but also because of the continued existence of outdated market practices. Until Shinwa established today's auction model, art was sold through art dealers and department stores. There was hardly any secondary market. If it existed at all dealers would buy at heavily discounted prices as compared to the primary market. Now that Shinwa has succeeded in establishing a transparent secondary market in art and antiques in Japan it has the opportunity to create the main liquidity pool for trading in such goods. For us, the attraction is that the bigger and more established the marketplace becomes, the more difficult it is for others to compete. After all, sellers and buyers will always favour the marketplace where there is the most liquidity and the most efficient pricing. As Shinwa has only been focussed on public auctions for six years, we cannot be certain that it has yet developed the oligopolistic franchise status that characterises Christie's and Sotheby's, or the monopolistic features of operators of other marketplaces such as securities exchanges, but there is, in our view, a strong probability that this is the case. Shinwa is today a small company with a market capitalisation of just $50m. At this time we plan for a holding of up to 1% of the Fund's NAV. The shares are weak in anticipation of lower Japanese asset prices generally and slower auction volumes, and today are valued at a dividend yield of 3.4%, and enterprise value of just $15m, one times expected sales.

The annual results season is upon us. It is interesting not so much from the results themselves, that are by now well anticipated and discounted by the market, but for the forecasts, the first official insight on the forthcoming fiscal year from corporate Japan, and for the tally on FY 2007’s dividend growth. Overall forecasts for profits next year are cautious and down. That is not such a surprise - with the market falling 25% from its peak, it was clearly signalling that something was awry. What is more of a revelation is the nature of these forecasts. They show pressures on margins from rising costs but little pressure from stagnant or falling sales volumes. We think for many companies this will become an increasing problem as demand slows domestically and especially overseas and would expect further downward revisions to earnings as the year progresses. Our companies are not immune. Consumer franchises such as Aderans, Kirin, Morinaga, Ito En and Nissin Food have all had to cope with steeply rising input costs and will record falling profits as a result. Kao Corp is struggling but nonetheless likely to succeed in maintaining FY 2006 levels of profitability for a second year, a great result in the circumstances and a testimony to the strength of their market position and brands. Not surprisingly, Rohm, Mabuchi Motor and Ryoyo Electro expect profits declines as the capital spending cycle contracts. Canon may be affected to a lesser extent for the same reasons but we think the market may be too sanguine about current prospects. We expect better profits from Nintendo (even better than the forecasts released with the announcement of their excellent FY 2007 results), Meiko Network, Obic Business Consultants and Namco Bandai. Our pharmaceutical and healthcare companies should be able to maintain profits and cash flow (adjusting for expenses, such as purchased research and development costs, associated with acquisitions). As for dividends: a flurry of upward revisions in the last quarter resulted in dividends for our strategy rising by 20%, materially higher than the 7% rise in the market’s dividends. Next year growth will be slower both for our companies and the market and, depending on the severity of the earnings declines, falling market dividends may even be a possibility.



Michael Lindsell
Apr 2008

29 May 2008 LTL 000-063-8