What should you look for in Japanese companies? Every issue, a professional investor tells MoneyWeek where he’d put his money now. This week: Michael Lindsell, investment adviser, Close Finsbury Japanese Equity Fund picks the Japanese stocks with the greatest scope for growth.
My portfolio is made up of what I believe are some of the best Japanese companies – durable business franchises bought at prices that significantly undervalued their business prospects. These firms all have one key characteristic: they should be able to pay steadily growing dividends. Why? Because I expect dividends to make up an important part of future Japanese equity returns.
Traditionally, ownership of the Japanese stockmarket was dominated by corporate cross-shareholders who used the market as a source of cheap capital while stifling savers’ returns. But now the dominant investors in the stockmarket are portfolio investors from Japan and overseas – all keen to get decent returns. This is putting pressure on the boards of Japanese companies to improve the way they manage retained earnings. In light of this, I have invested in a range of exceptional firms with the scope to improve their future allocation of capital. Of the 24 shares in the portfolio, 22 have excess net cash, which, on average, equates to as much as 22% of their market capitalisation, based on estimates for this financial year.
Japanese companies: finding the exceptions
There are two exceptions. One is electrical utility Kansai Electric Power (JP:9503), which had excessive debt that has gradually been cut to 180% of equity from 370% a decade ago. The other is Kao Corporation (JP:4452), the ‘Proctor & Gamble’ of Japan, which five years ago was the first Japanese company to address this endemic problem of poor balance sheet management. Since then, Kao has succeeded in raising return on equity (ROE, defined on page 44) to 15% from 8%, raising dividends by 150%, and cutting the number of shares in issue by 12% through share buybacks. More significantly, its recent purchase of Kanebo Cosmetics, entirely financed by debt, gives the group another growth avenue. Debt is now 56% of equity, which should fall steadily over coming years as cash flows accumulate.
So far, the other firms we own are just scratching at the surface of the problem. They have responded to shareholder pressure, collectively raising dividends by 27% over the last three years, but even so, their dividend payout ratios were just 37% last year. With payouts forecast to rise to 46% this year as dividends rise further, these firms still retain more cash than they disperse and, as a result, cash reserves are increasing all the time.
A Japanese drugs company with a proactive approach
Recently, Astellas Pharmaceutical (JP:4503) has taken a more proactive approach. Astellas is Japan’s second-largest drug group but only ranks 16th in the world by sales. This shows how much bigger it has to get to have the resources to spend on the research and development needed to compete with the US giants dominating the industry. Astellas’s current ROE is 10%. Over the next five years, Astellas plans to raise its dividend/shareholders’ equity ratio from 3.5% to 8%, and ROE to 18% by buying back shares (we believe shares in issue may fall by up to 25%, shrinking today’s net cash balance by 40%). As a result, earnings per share will rise at an annualised rate of 16%, double the increase in operating profits, and dividends per share by 18%, assuming that share repurchases take place at an average p/e multiple of 20. Based on today’s share price, that would give it a dividend yield in 2011 of 3.4%.
As other firms see the beneficial effect such changes have on corporate value, we expect many to follow Kao and Astellas’s lead.
The Japanese companies Michael Lindsell likes
12mth high 12mth low Now
Kansai Electric Power ¥3,300 ¥2,400 ¥3,190
Kao Corporation ¥3,420 ¥2,675 ¥3,360
Astellas Pharmaceutical ¥5,470 ¥3,910 ¥5,330