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View on Japan and Experience of Managing Both Long Only and Long/Short Funds
Graeme Sinclair, Aberdeen Asset Management Asia

March 2003

Graeme Sinclair is Head of Japanese Equities at Aberdeen Asset Management Asia Ltd. and runs the Aberdeen Japan Absolute Return Fund, a Japan only equity long/short hedge fund which launched in October 2002. Aberdeen Asia runs approximately US $5 billion in long only assets. It is based in Singapore. Mr. Sinclair wrote the following article on the Japanese markets and the Aberdeen Japan Absolute Return Fund.

"Now, news of a massive stock market fall", announced the BBC, one cheerless morning. "Not Tokyo", I whispered to myself under the bedclothes. "Over to Tokyo where the stock market closed down another six percent…!"

That was in November 1993. Since then the Japanese market has certainly provided challenging work for fund managers. A series of economic recessions and political scandals, falling stock, real estate and land prices, deflation, a volatile currency and a technology boom and bust, have ensured the main indices have mainly moved in one direction: down.

Still, portfolio managers have been able to generate positive returns in Japan over this period through effective stock picking. But these gains have come despite policymakers' disagreement - and thus collective inertia - over how to address the country's underlying economic problems.

The measure of that failure is huge. Whole areas of the economy are dominated by the living dead - companies that survive because of zero interest rates and the indulgence of banks. Businesses are refusing radical restructuring, banks' bad loan problems remain largely unresolved and the economy appears likely to remain weak. Consequently, making money in Japan for the foreseeable future will, on the whole, continue to be about individual stock ideas, both good and bad.

To capitalise on this, in October 2002 Aberdeen Asset Management launched the group's first long/short fund, the Aberdeen Japan Absolute Return Fund. The fund's long position provides exposure to leading global businesses such as Honda, Canon and Kao Corporation, which are shareholder-friendly, and should continue to enjoy strong profit growth. On the short side, we aim to take advantage of ongoing structural changes. Specifically, we are short stocks: a) that are under threat from increased competition in China; b) that have been heavily exposed to the bad loan problems in the banking sector; c) whose product range is becoming obsolete; and d) whose share price simply appears overvalued relative to the prospects for future profits growth.

In addition, there are opportunities to arbitrage mis-pricings between the underlying equity, CBs and ADRs. At present, the range of the fund's net exposure is -20% to +50% and the gross exposure 60% to 150%.

Operationally, the management of the portfolio has gone very smoothly. A lot of time was spent prior to launch planning the new procedures that would be required, and this has paid off. In addition, the Japanese market is fairly accommodating for long/short funds in that borrowing stock is relatively easy and inexpensive, the market is diversified in terms of industrial sectors and liquidity is not a major issue. The performance of the fund has been respectable, a gain of 70 bps over the four months to the end of January, in a falling market. This puts it in the middle of its peer group.

We visit over 200 companies a year, which provides a platform for short stock ideas. One example is Aeon Credit, the financial services business. When we last met its management we had an open mind about future prospects, thinking the stock could be a candidate for either the long or the short portfolio. We soon concluded that its valuation was excessive given difficult business conditions. Also, most of its operating profit comes from cash advances, similar to consumer finance companies. Yet while Aeon's customer base is of higher quality, it doesn't seem to justify a 50% plus valuation premium to the consumer finance sector. A short position was established at Y4000 and closed out a few weeks later when the stock price hit our target of Y3200.

Our experience with Aeon is illustrative in another way. Contrary to the widespread criticism that long-only managers lack the skills to successfully gain alpha on the short side, short selling has posed few problems for us. The bigger challenge we have faced is in the constant need to generate new short ideas. Many of the best ones are in the unfashionable and structurally unattractive industries that as long only managers we have had the luxury of ignoring for many years. For example, we have included airlines, textiles, land transport and real estate on our "radar screens" in order to develop a proper understanding of the valuations and relative strengths and weaknesses of stocks within each of these sectors. We have made good progress in our coverage, but to be thorough takes time. We will continue to develop this aspect of the investment process.


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