Japan fund managers debate merits of running a concentrated portfolio

Japan was the focus of this week's Conjecture. Taking part in the debate were Mike Lindsell, investment adviser to the Close Finsbury Japanese equity fund, and Alan Booker, lead manager of the Legal and General Japan Trust.

Could you outline the recent performance of your respective funds?

Mike Lindsell (ML): Our recent performance has been harmed, primarily because we are not invested in cyclical real estate and banking shares which probably led the market during the year.

It was a bad year for us but we make all our investments on their own merits and are focusing on delivering absolute returns when choosing stocks. That means the sort of return we achieved was not that bad from that perspective. The way we run money with a concentrated portfolio means we are always likely to perform very differently from the index and last year was no exception.

Alan Booker (AB): We tend to take the opposite view and that paid off for us last year. However, we are having a stickier time of it so far this year as a lot of the domestic consumption recovery plays that performed so well last year have tended to underperform in 2006.

Nintendo is a very large position in the Close Finsbury Japanese equity fund. Why is it such a core holding?

ML: Nintendo has a very profitable, very cash generative business model. When people buy Nintendo products, they tend to first of all buy the hardware, such as a Nintendo DS platform or a Game Cube, soon to be replaced by a new machine called the Revolution.

Nintendo does not actually make these itself but commissions them so does not have any of the costs of producing them on its balance sheet. It then sells them on for a low margin. In order to use them customers must buy software from Nintendo.

It has been reasonably clever in producing software in that it embeds it with cartoon characters that are recognised by consumers on an ongoing basis. If a customer has a good game experience with one of these characters they tend to buy the next machine. As a result, Nintendo's software business is a lot more predictable than other companies who operate in this area.

Are there any equally compelling stocks in the Legal and General Japan Trust?

AB: For the last couple of years we have been very bullish on Japan's domestic economic recovery and our view has been that stocks like Nintendo and Fuji Photo Film have performed well in the past.

We were trying to focus our portfolio more on the sort of domestic areas that are benefiting from Japan's recovery rather than global exporters like Nintendo.

The yen has been weak over the past year and that has supported some of these exporters but there is now concern about the outlook for the dollar weakening. We see better growth opportunities in some of the domestic sectors in Japan.

How important are dividends as part of total return on Japanese equities?

AB: In the past, dividends have not been a prime mover of stock performance but increasingly over the last year or two, after corporate restructuring and increased profit flow, Japanese companies have been able to reward their shareholders through higher dividends.

Foreign investors are demanding higher dividend yields from the companies they are investing in. Increasingly we are seeing increased risk appetite from individuals and all this money that is parked in bonds and cash in Japan will eventually shift over towards equities or the real economy.

Increasingly individuals are looking for higher dividend yield plays and there has been a lot of investment in funds, set up by brokers in particular, of high dividend yield stocks.

ML: Interestingly, dividends have been a very important contributor to returns over time.

While in Japan yields have been rather low, contrary to general expectations, dividends have been as big a contributor to returns here as is the case in other markets around the world. In the past dividends were not considered to be an important contributor in the short term but in the long term, they have.

There are big changes going on in the market, forcing better shareholder returns from companies and this is because more of the market is being owned by portfolio investors as opposed to cross shareholders who were not particularly interested in investment returns. They were far more interested in the business relationship that is fostered by the cross shareholding.

Now, as portfolio investors have raised their weightings in shares in Japan, the demand for higher dividends and higher shareholder returns has increased.

Is there really the appetite now to give all this money away or is there a sense in corporate Japan of stockpiling money because it has just experienced 15 years of pain.

AB: Japan's banks had encouraged firms to build up cash reserves and not invest it in their businesses.

Over time, there has been increasing pressure on the Japanese to make more effective use of their cash reserves and, over the last two years, both foreign and domestic investors have been moving in to the Japanese market to identify cash rich undervalued companies. They have tried to make them more proactive in the use of their assets so the pressure is on the Japanese to do more with their assets rather than less.

Are you seeing much evidence of Japanese investors pouring into the market?

ML: Not yet. On an aggregate basis, the foreign investor continues to be the predominant net buyer of the market. Individuals in aggregate are selling even though, as the market has been rising in the last year, individuals who trade on margin have bought a lot more shares. However, the domestic investor is still reducing his weightings in the market.

AB: It has been a big disappointment for us that the domestic investor, while he has sold down his cross shareholding structure to international norms, from 50% down to 20%, continues to be a marginal net seller, though not as aggressively as before.

The big hope is that the enormous amounts of cash they have in both cash deposits and bonds will slowly start to shift over to equities as we have seen in the American and UK economies.

Will you become bullish on financial institutions as more Japanese people start to take money out of bank accounts to put into equities?

AB: Japan lags behind western economies in terms of how it uses its assets, particularly in the financial sector.

While bank stocks and profits have recovered at the same time as fee income and mortgage lending have recovered, there is still a big bull case for Japan in that, as interest rates rise, there will be more bank lending and more fee income while hopefully more financial service products will be sold.

What is the attraction of the domestic economy over exporters?

AB: At the moment exporters are clearly benefiting from strong world growth and strong Asian growth, especially China.

We are not negative on exporters, we just feel there is greater upside in domestic stocks, which was the case last year.

In the longer term we are also concerned that if the dollar does have a period of consolidation some of these cheap but good global exporters will suffer if the American economy goes into some sort of slowdown.

At the moment, growth is still very strong so there is no reason to be too nervous about it. We just feel that the Japanese economy is now being driven more by the domestic consumption sectors rather than, as in the past, the export sectors.

ML: Most of my portfolio is in domestic companies, it just happens that Canon and Nintendo, two of the largest holdings, both have a large portion of their sales overseas.

From the top 10 holdings it may seem we that are export orientated but in fact there are many other domestic businesses that we own.

Alan, you said you are not really keen on exporters but you have a big holding in Toyota, why?

AB: Toyota has been a good performer over the last couple of years. It has been one of the best performing Japanese auto stocks.

This has been partly due to valuations and strong earnings growth but is also because Toyota, while a dominant player at home where the market has been a bit slower to recover, has been taking huge market share in America.

It has been a growth stock and we do not want to underweight growth stocks in our portfolio. While we are a little bit concerned longer term about the outlook for American housing and American auto demand, at the moment everything is going great there so we are happy to be holders of Toyota.

ML: Toyota is probably the best auto company in the world. It has done fantastically well recently but I do not particularly like automobile businesses as businesses. They are incredibly capital intensive and have rather low margins. I do not particularly like investing in a business which will finance its customers to buy its product and a large part of Toyota's business is a financial business where it subsidises customers to buy the product.

There are characteristics of Toyota's business that mean we would never invest in it. Its capital intensity means that, even though it is incredibly profitable for an auto maker, not many of those profits are there for shareholders at the end of the day. Most are paid out as dividends and the yield on the stocks is about 1%.

Categories: Equities | Investment

Tags: Conjecture

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