The current well publicised issues surrounding Japan have provided a feast for the financial press to present negative comments over the last two months. Budget deficits, the strong yen, erosion of competitive advantages within Asia in the corporate sector, are all undeniably worrying but the key as always is to look ahead rather than become fixated with current affairs. Whilst the track record of the BOJ hardly inspires confidence, the 4-4 split on interest rates late in CY 2009 provided a good example of their reluctance to act, monetary policy is unquestionably too tight and would appear likely to ease further in 2010 despite recent comments citing a recovery in the Japanese economy. The plethora of negative expectations on the US $ is hard to argue against today but if US employment has bottomed and consumer spending marginally improves then will investors remain content to short the dollar to fund the carry trades? Mr Kamei has certainly made the headlines but again on closer inspection his bark would appear louder than his bite as even he concedes that zombie companies should not be ongoing recipients of further bank lending. Furthermore there is a strong suspicion that come the elections in 2010 the DPJ leadership will have tired of his populist outbursts but for now they are content to allow him his moment as they put together a more coherent economic strategy, especially as many within their senior ranks emanate from an LDP background and understand the need to try and engender some domestic growth.

The reason for the ongoing correlation of the Japanese equity market to any global equity weakness is more simple; heavily dilutive corporate fund raising is sapping the strength of the last few buyers, domestic institutions are sellers and finally there is the issue of valuations. Japan still has many world class manufacturing businesses but even allowing for a strong recovery in earnings over the next two years, this is today largely priced into valuations whilst seemingly cheap PBR valuations on banks are unreliable until the true extent of further equity financing is more visible. Cost cutting is underway in Japan but again an important distinction here needs to be made between fixed and variable costs as the latter are quickly added back into any sales recovery. The decline in global output has critically exposed the high fixed costs of the corporate sector resulting in the erosion of profitability. So why bother to be an investor given the apparent attractions elsewhere?

The answer lies in the ongoing change in corporate mindset towards restructuring which we expect to be accelerated early next year when the strong yen finally leads to a greater sense of crisis, aided also by fears that the banks may no longer hold such large numbers of cross shareholdings as they seek to offset the Basel 2 implications by reducing risk weighted assets. Where is the evidence? Throughout this year many new incoming corporate presidents of larger companies, such as Fujitsu, have embarked on a restructuring programme, critically including the divestiture of previously sacrosanct businesses. At the mid to smaller company end, even more draconian measures have been taken with reductions of over 30% to the breakeven rate implemented within a few months. Having lived in Tokyo for 15 years one appreciates that the Japanese are slow to embrace change initially but once accepted they can move quickly as evidenced by the Koizumi inspired corporate restructuring some 8 years ago, inspired by fears that banks would call in corporate loans. Ultimately this next stage of corporate restructuring will drive industry consolidation which will significantly improve the investment appeal of certain companies.

The case study of Noritz illustrates the point. We visited the company in August 2008 at a time that Steel Partners were trying to force through restructuring. Management admitted that they needed to change but disliked the robust approach from their foreign shareholder. Subsequently Steel Partners tabled a formal tender offer but were unsuccessful leading to the impression that corporate Japan had yet again repelled the gaijin. Predictably Steel Partners retired hurt and have been reducing their stake. However, only today, 14 months later, the management of Noritz announced a sweeping restructuring. The message therefore is straightforward. Criticise Japanese management for their slow decision making but never interpret this as a sign that they are not prepared to embrace change. We expect many similar examples over the coming two years and are therefore not totally disillusioned like many foreign commentators but we accept that near term the direction of the market will be a hostage to events outside of Japan until such restructuring virtues are more widespread and or the valuation extremes have diminished due to further price declines.

With the Fund now successfully launched, our early investments have been focussed towards several restructuring situations which appear largely ignored by the market to date.

Earnings results for H1 3/10 overall would appear to have exceeded forecasts but share price reactions suggest that much has already been discounted. Furthermore significant yen depreciation is required to allow manufacturing earnings to move well ahead of consensus and more importantly to narrow valuation differentials with Asian competitors. Over the next month attention is likely to return to possible bank equity fundraisings, the size of which will have an important bearing on investor sentiment. Down but not out is our summary on Japan currently.

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