October 2006

Is the penny dropping?


We see two distinct opportunities in our long only Japan strategy. One is a conventional investment opportunity. The portfolio comprises what we consider to be some of the most exceptional and predictable businesses in Japan bought at prices that significantly undervalued their business prospects. We think this exclusive collection of, currently, just 24 companies, should grow the real value of committed client capital meaningfully over the foreseeable future. Exceptional companies with such durable business franchises are rare and even more difficult to find at undervalued prices. But we look for one more crucial characteristic: the ability to pay steadily growing dividends. We expect dividends to comprise an important part of future Japanese equity returns, just as they have in the past. Japan is no different from other markets: over the last 50 years dividends have made up 69% of the total returns from the Japanese market. Once we have identified our companies we then hold onto them for as long as possible in order to capture the full benefit of compounded cash flows and dividends, the advantage of which tends to be underestimated by other investors. Inactivity has the added benefit of minimising transaction costs, considered by us to be a tax on future returns. This approach is identical to Nick Train’s in the UK, but, interestingly, his UK portfolio is currently trading at a dividend yield premium to the market of 15% (i.e. its yield is 3.45% versus the market’s of 3.00%) whereas in Japan the current yield premium of our portfolio is 75% (i.e. the portfolio yield is 1.85% versus 1.05%). This suggests to us there is much more relative upside from the strategy in Japan compared to the UK and this leads us on to the second of the two opportunities.

This other opportunity is unique to Japan and has arisen because Japan’s economic system and stock market is less mature than in the UK. Only in the 1970’s were the Japanese capital markets opened to foreign investment and right up until the late 1990’s the stock market’s ownership was dominated by corporate cross-shareholders, that used the market as a source of cheap equity capital, whilst stifling savers’ returns. Now that Japan’s economy has mostly caught up with the West with, for example, per capital income exceeding the UK, it is becoming more dependant on services as opposed to manufacturing. In particular, as its population ages, Japan needs a more efficient financial services sector, as people become more reliant on savings. The changing ownership of the stock market is helping to initiate such improved efficiencies. Now the dominant investors in the stock market are portfolio investors, from Japan and overseas - all keen to extract optimal financial returns from equity investments. This is forcing Japanese managements to improve their management of retained earnings with the aim of boosting shareholder returns. Recognising that pressure from portfolio investors would, in due course, force Japanese management to tackle this issue, we have deliberately invested in a range of exceptional businesses which, coincidentally, have suffered from a mismanagement of retained earnings for many years. The coincidence is perhaps not surprising. Durable, predictable businesses tend to be highly cash generative. In the past the prolific cash flow returns from these companies have been allowed to accumulate on balance sheets earning little if any return, especially recently, with interest rates so low, and undoubtedly much lower returns compared to the operating business that generated the cash in the first place. As a result, over time return on equity (‘ROE’) for even these exceptional companies fell to uncompetitive levels.

Of the 24 shares in our portfolio, 22 have excess net cash that, on average, equates to as much as 28% of market capitalisation based on estimates for this financial year. The two exceptions are an electric power utility, Kansai Electric Power, which had excessive debt that has gradually been reduced to 180% of equity from 370% 10 years ago and Kao Corporation, the ‘Proctor and Gamble’ of Japan, which was the first Japanese company to address this endemic problem of poor balance sheet management 5 years ago. Since then Kao has succeeded in increasing ROE to 15% from 8%, dividends by 150% and initiated share buybacks that have resulted in 12% fewer shares in issue. Even more significantly Kao’s recent purchase of Kanebo Cosmetics, a purchase entirely financed by debt, gives the company another material growth opportunity. Debt is now 56% of equity, which should fall steadily over the coming years as cash flows accumulate. Kao is now allocating its capital as rationally as any global business having recognised it needed to, with global competitors such as Unilever and Proctor and Gamble. For Kao the penny has dropped.

That cannot be said for the rest of the companies we own. Even though they have responded to shareholder pressure and have collectively raised dividends by 27% over the last 3 years, their dividend payout ratios were just 37% last year (or dividend cover of 2.7x). Even with the payout rising to 46% this year, with further dividend increases, these companies retain more cash than they disperse and, as a result, cash as a percentage of market capitalisation is increasing all the time, even as market capitalisation rises, from 23 % in 2003 to 28% this fiscal year. In other words, measures undertaken so far are just scratching at the surface of the problem.

However, this week, a second company, Astellas Pharmaceutical, has taken a more proactive approach, similar to Kao. Astellas is Japan’s second largest pharmaceutical company, a result of the merger of Yamanouchi and Fujisawa completed just a year ago. The management recognise the trend toward consolidation in the industry in order to boost research and development budgets and optimise distribution. The company specialises in two therapeutic fields, urology and immuno-suppressants and has leading products sold globally in both areas. Following its merger, Astellas only ranks by sales 16th in the world, illustrating how much more it probably has to do to remain competitive in the global arena. Although very cash generative Astellas’s growth in the next 5 years is most likely to be hampered by patent expiries on two significant drugs. As a result, its operating profits are expected to rise by just 8% per annum. Current return on equity is 10%. The company has announced that over the next 5 years it will raise its dividend/shareholders equity ratio from 3.5% to 8%, and return on equity to 18%. This it will do by repurchasing shares (we forecast shares in issue might decline by as much as 25%, resulting in a 40% reduction in today’s net cash balance). As a result, earnings per share will increase at an annualised rate of 16%, double the increase in operating profits, and dividends per share by 18% on the assumption that share repurchases take place at an average 20x multiple. Today’s dividend yield on its 2011 dividend would be 3.4%. It seems that the penny has dropped for another company.

In our view it is no coincidence that these two businesses have introduced such radical initiatives first. These are international businesses competing with the best companies in the world. Their managements recognise that allocating capital inefficiently put them at a competitive disadvantage versus their global competitors. We judge that many of the other businesses we own will shortly come to the same conclusion.

In order to gauge the extent of this opportunity, we have calculated an adjusted ROE for our portfolio, reducing equity by net cash. The implicit assumption is that these companies could buyback shares at current prices or pay dividends with excess cash resources. The weighted average adjusted ROE for the portfolio on this basis is 25%, compared the actual unadjusted ROE of 10%. This illustrates and characterises the unique additional opportunity we have in Japan to generate extra returns. Two companies doing the right thing is not the same as the whole portfolio, but is indicative of a trend that we think will hasten as managements recognise the beneficial effects of their action on both corporate value and shareholder satisfaction. It took two and a half years for 23 of the 24 companies we own to start hiking dividends materially. It may take longer for them to take such assertive action as Kao and Astellas, but all have the capacity to do it.


Michael Lindsell
November 2006