“Japan – Another Perfect Year”

Pictet Asset Management, Sam Perry February 2011 Japan – everyone remembers the fall from grace

RELATIVE PERFORMANCE OF TOPIX VS SPX 500

1500

1300

1100

900

700

500

300

100 1971 1976 1981 1986 1991 1996 2001 2006 2011

1 Source: Bloomberg Japanese Equities I February 2011 Japan – steady performer since … but volatile

RELATIVE PERFORMANCE OF TOPIX VS SPX 500

160

150

140

130

120

110

100

80 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

2 Source: Bloomberg Japanese Equities I February 2011 Japan is cheap …

VALUATIONS BASED ON THE NOMURA 400

FY10E FY11E FY12E

RP Growth 48.0% 11.0% 13.5%

PER 16.2 14.2 12.5

PBR 1.3 1.2 1.1

RoE 8.2% 8.9% 9.4%

Dividend Yield 1.9% 2.1% 2.3%

3 Source: Nomura Japanese Equities I February 2011 … BUT … Everyone knows it’s cheap for a reason…

It’s a chronically low return market

There is no attention paid to shareholders

The fiscal situation is worse than Greece

The political system has stagnated and resists reform

The demographic situation is severe

4 Japanese Equities I February 2011 Japan Inc. is very cash rich

CASH AS % OF MARKET CAPITALISATION FREE CASH FLOW YIELD

25 10%

20 8%

15 6%

10 4%

5 2%

0 0% Japan Europe NJA World EMEA Latin US UK Japan UK Europe World US GEM NJA ex-UK America ex-UK

Corporate Japan’s cash pile is equivalent to 30% GDP

5 Source: Thomson Reuters, Credit Suisse Japanese Equities I February 2011 Japan – a market of chronically low returns

MEDIAN RETURN ON EQUITY IN THE S&P 500 AND TOPIX (EX FINANCIALS)

0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011e 2012e 2013e

S&P 500 Median RoE TOPIX median RoE

6 Source: Pictet, Daiwa, Nomura, Bloomberg Japanese Equities I February 2011 Japan – a market of chronically low returns

MEDIAN RETURN ON EQUITY IN THE S&P 500 AND TOPIX (EX FINANCIALS)

0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011e 2012e 2013e

S&P 500 Median RoE TOPIX median RoE TOPIX RoE adjusted for tax difference

7 Source: Pictet, Daiwa, Nomura, Bloomberg Japanese Equities I February 2011 Japan – a market of chronically low returns

MEDIAN RETURN ON EQUITY IN THE S&P 500 AND TOPIX (EX FINANCIALS)

0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011e 2012e 2013e S&P 500 Median RoE TOPIX median RoE TOPIX RoE adjusted for tax difference TOPIX RoE adj. for tax and financial leverage

8 Source: Pictet, Daiwa, Nomura, Bloomberg Japanese Equities I February 2011 Improving asset efficiency

MEDIAN ASSET TURNOVER FOR S&P 500 AND TOPIX (EX FINANCIALS)

1.1

1.0

0.9

0.8

0.7 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

S&P 500 median Asset Turnover TOPIX median Asset Turnover

9 Source: Pictet, Bloomberg Japanese Equities I February 2011 Margins headed towards historic highs

OPERATING AND RECURRING PROFIT MARGINS

(%) Operating and recurring margins of NOMURA 400 (ex financials) 8

6.5 6.9 7 6.5 6.5 6.2 6.4 6.8 6.6 6 6.4 5.6 6.3 Operating margin 6.5 5.1 6.1 5 4.6 5.4 4.0 4.1 3.9 3.6 4 3.4 4.1 3.1 3 3.6 4.4 3.2 2.5 2.7 2 Recurring margin 2.7

1.8 1

0 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10 12

10 Source: Nomura Japanese Equities I February 2011 Strong recovery in free cash flow

MANUFACTURING (SA, TRILLION YEN)

-1

-2 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10

FCF Cas h flow Capital inv es tments

11 Source: MOF, BNP Paribas Japanese Equities I February 2011 Japan offers a better yield than the US

DIVIDEND YIELD ON THE S&P 500 AND TOPIX

4.0%

3.5%

3.0%

2.5%

2.0%

1.5%

1.0%

.5%

0% 1993 1995 1997 1999 2001 2003 2005 2007 2009

S&P 500 Dividend Yield TOPIX Dividend Yield

12 Japanese Equities I February 2011 Source: Bloomberg Dangerous debt position?

GROSS GOVERNMENT DEBT AS % GDP NET GOVERNMENT DEBT AS % GDP

200 120

180

100 160

140 80

120

100 60

40 60

40 20

0 0

ia y n y l US UK tr tal US UK ga s I and an Italy u and Japan rance Spai tugal el Japan m rance Spain t el F Au or Ir Greece F Austria or Ir Greece Germany P Ger P

13 Source: OECD Japanese Equities I February 2011 Debt servicing costs are low

INTEREST PAYMENTS AS % FISCAL REVENUE INTEREST PAYMENTS AS % GDP

18 6

16 5 14

12 4

10 3 8

6 2

1 2

0 0

K y y ria n y ia US U an tal US UK r ance I ece an Italy and Japan m r Spai tugal reland Japan m rance Spain el eece er F Aust or I Gre F Aust ortugal Ir Gr G P Ger P

14 Source: OECD Japanese Equities I February 2011 Fiscal position – fiscal burden is still low

PRIMARY FISCAL BALANCE AS % GDP FISCAL REVENUE AS % GDP

y 50 an ria S K erm aly Japan U U G France Aust It Spain PortugalIreland Greece 0

-5

30 -10

-15 20

-20 10

-25

S K y ia l U U r taly ga an I u -30 Japan rance Spain t eece F Aust or Ireland Gr Germ P

15 Japanese Equities I February 2011 Source: OECD What funding crisis?

NET FOREIGN ASSETS vs FOREIGN HOLDINGS OF GOVERNMENT DEBT

Japan is the world’s biggest net international creditor ($2.9tn as of 2009, or 57% of GDP). Only 5% of its public debt is owned by foreigners. 16 Source: IMF, Credit Suisse Japanese Equities I February 2011 What funding crisis?

S&P downgraded Japan to AA- at the end of January This looks like another example of a ratings agency playing to the crowd While the size of the gross debt is high (225% GDP), the net debt is only about 121% (IMF estimate) Almost all debt is held locally – only 5% is held by foreigners The private sector has an enormous amount of cash The corporate sector has a cash pile equivalent to 30% of GDP The household sector holds net savings of about another 4% of GDP Japan is the world’s largest net creditor (57% of GDP) If the Yen fell to ¥120, then net foreign assets would rise to nearly 90% of GDP This would enable Japan to retire a significant part of the debt pile.

17 Japanese Equities I February 2011 USD/JPY exchange rate valuation

170USD/JPY EXCHANGE RATE EQUILIBRIUM YEN40 OVER (+) UNDERVALUATION (-) Yen overvalued 160 % USD / JPY 30 Deviation from equilibrium

150 Equilibrium +/- 1 standard deviation

140 20

130 10

120

0 110

100 -10

90 -20 80

70 -30 90 92 94 96 98 00 02 04 06 08 10 78 82 86 90 94 98 02Yen 06undervalued 10

18 Source: PAM S.A. Fixed Income Japanese Equities I February 2011 Japan’s fiscal 2010 budget

EXPENDITURE REVENUE

General Expenditure (¥ tn) Tax Revenues (¥ tn) Social Security 27.3 Income Tax 12.6 Public Works 5.7 Consumption Tax 9.6 Education & Science 5.6 Corporate Tax 6.0 National Defence 4.8 Gasoline Excise 2.6 Others 10.8 Others 6.6

Local Allocation 17.5 Non-Tax Revenues 10.6 (tax grants etc)

National Debt Service 20.6 Government Bond Issues 44.3

TOTAL 92.3 TOTAL 92.3

19 Source: CLSA Japanese Equities I February 2011 Inefficient corporate taxation

EFFECTIVE CORPORATE TAX RATE Japan suffers the highest corporate tax burden 40 BUT the top tax rate is being 35 reduced -5%

30 Despite this, the corporate tax take is

25 very low More than 70% of companies pay no tax 20 This also affects income tax take

15 Corporation tax then falls on the major

10 companies – who can move offshore

5 The high tax rate also discourages FDI 0 Government has made radical proposals to stimulate FDI A K y U ea US an or ands wan Japan rance ai F erm T METI plans to grant a 20% tax cut for 5 G Sweden S. K herl et Singapore N years

20 Source: METI Japanese Equities I February 2011 Very low income tax take

INCOME TAX TAKE vs G5 RATES (¥ tn) Japan’s effective income tax rate is

¥40 only 5.2%

¥35 Income tax take is less than half other G5 ¥30

¥25 The tax system is light and has many exceptions ¥20 E.g. minimum taxable income for couple with 2 children is ¥3.25mn - ¥15 UK equivalent is ¥900k

¥10

¥5

S K y U U an rance Japan F Germ

21 Source: METI Japanese Equities I February 2011 Consumption tax is also very low

GLOBAL CONSUMPTION TAX RATES Consumption tax is considered the “third 30% rail” of Japanese politics The Hashimoto government’s hike of the tax in 1997 is widely blamed for Japan’s return 25% to recession The Japanese public are believed to be very

20% averse to overt taxation

But the public seems braver than the 15% politicians The new “Your Party” success in the Upper 10% House election was on a campaign of fiscal reform Last May, a majority favoured lifting the tax 5%

a ly k i UK a ral It ugal Japan Korea ust France A Germany Port Denmar

22 Source: METI Japanese Equities I February 2011 Politics – lots of leaders, no leadership…

23 Source: Andrew Sullivan at theAtlantic.com Japanese Equities I February 2011 Politics –…but you can have too much stability

24 Source: Andrew Sullivan at theAtlantic.com Japanese Equities I February 2011 Demography and the aging of Japan

The demographics of Japan are notoriously bad However, a declining population is not by itself a problem The problem comes when the dependency ratio increases The dependency ratio = total population working population This has been happening in Japan since 1995 If the dependency ratio rises then living standards (increases in GDP per head) lag behind increases in productivity Japan’s impressive productivity increases have been paying for the dependents The dependency ratio is now peaking over the next 5 years or so Japan has been the most exposed but the situation is now improving The situation for other countries (e.g. US, Germany, France, UK) is deteriorating

25 Japanese Equities I February 2011 Asia is the most important & highest growth export market

JAPAN’S MAIN EXPORT MARKETS (¥bn)

(¥bn) ASIA LEADING THE RECOVERY

2000 Asia excl China

China / HK

1500

USA

1000

Europe Other 500

0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

26 Source: MOF, Macquarie Research, March 2010 Japanese Equities I February 2011 Exposure to local consumption in Asia is growing

JAPANESE LOCAL SUBSIDIARIES' SALES IN THE LOCATED COUNTRY AS % OF TOTAL SALES

65%

60%

55%

50%

45%

40%

35%

30% 97 98 99 00 01 02 03 04 05 06 07 08 09

All Asian subsidiaries China (incl Hong Kong)

Note: Shows Japanese local subsidiaries' sales in the located country as % of their total sales. Region figures are sum of numbers by country. 27 Source: Nomura, based on METI data Japanese Equities I February 2011 Japan’s labour force is competitive – even in Asia

AVERAGE HOURLY WAGE OF A MANUFACTURING PRODUCTION LINE WORKER (USD, CY2008)

20 * Japanese prefectures in CY2009 15

d A * e n l a n ny ea i* a* a r a zi nd m a r alia UK S it rea ssi a a rla U oka* sak o land iw ra l tn rm Japan u a O K o a B China nesia e e ustr P T Ru Mexico o Denmarkitze G A uk ag ingapo Hungary ng Kong Thai Vi Euro A F N OkinawS o Ind Sw H

28 Source: Mitsubishi UFJ Securities, US Dept of Labor, IMF, MHLW Japanese Equities I February 2011 Domestic Japan showing signs of life

BUSINESS CONFIDENCE

120

110

100

50 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 NFIB Small Business Optimism Index Shoko Chukin Small Business Confidence Index

29 Source: Bloomberg Japanese Equities I February 2011 Unloved by the sell side

TOPIX – BY NUMBER ANALYSTS COVERING STOCK S&P 1500 – BY ANALYST COVERAGE

2 20-25 1 16-20 >25 0 11-15 3-5

20-25

6-10

16-20

6-10 3-5

2 1 11-15

63% of companies have 2 or less recommendations 4% of companies have 2 or less recommendations

30 Source: MF Global Japanese Equities I February 2011 Underappreciated by the buy side

GLOBAL RETAIL FLOWS TO JAPAN JAPANESE EQUITIES IN GLOBAL MUTUAL FUNDS

Japanese equity funds just starting to see inflows Global fund managers still 2.2% below benchmark

31 Source: EPFR, Credit Suisse Japanese Equities I February 2011 If Japan’s cheap for a reason – what’s the reason?

It’s a chronically low return market X Returns have improved dramatically.

There is no attention paid to shareholders Corporate governance and shareholder X returns are much improved.

The political system has stagnated and resists reform Well, true to a point. But the public want reform.

The demographic situation is severe Demography is a challenge for all developed markets. Everyone else is catching up with Japan.

The fiscal situation is worse than Greece The fiscal situation is bad, but the X tax burden is still very light.

This time it’s different?

32 Source: MOF, Macquarie Research, March 2010 Japanese Equities I February 2011 Japanese Equity Team Wealth of experience in London and Tokyo

Experience Adrian Hickey 20 years Sam Perry 14 years Adrian Hickey – Head of Japanese Equity Team Serena Tyrrell 12 years Takeshi Suzuki 23 years Sam Perry Takeshi Suzuki Go Shiina 12 years Senior Investment Manager Senior Investment Analyst PAM Daily Serena Tyrrell Go Shiina Review macro events Senior Investment Manager Senior Investment Analyst News on sectors and companies Changes in recommendations

Japan Weekly Stock movers held and not held Pictet Asset Update on research activities Smaller Management Developed Review of Target Prices Companies Equity Equity Equity Research Japan Monthly Risk analysis Sectors/themes Ideas from the screens

33 Japanese Equities I February 2011 Japanese Equity Product characteristics

Japanese Equity Japanese Equity Selection 130/30

Approach Strong, bottom-up within a sector framework

Sectors: +10% active bet Construction Guidelines Long: +4%, Short: -3% Stocks: +4%

Ex-Ante Tracking Error 3 – 7% 3 – 8%

Target Information Ratio > 0.5 > JES

Alpha Target 3% + 4% +

Benchmark MSCI Japan Topix

Focused Portfolio 50 – 60 holdings c.100 holdings: 80 long, 20 short

Exposure No “micro” caps Full market cap spectrum

The performance target, risk figures and exposures given above provide an indication of the probable characteristics in normal market conditions and are not intended to be legally binding outside of the Investment Management Agreement

34 Japanese Equities I February 2011 Investment approach

We are active managers with a focus on valuation

We have a disciplined approach which makes systematic use of proprietary valuation screens

Our focus is on stock-level research - we build portfolios from the bottom up

We have an integrated approach to portfolio construction and risk management

We believe that the best results are achieved by a focused investment team drawing on a broad range of internal and external research inputs

35 Japanese Equities I February 2011 Valuation has worked in Japan over the long term

JAPAN CUMULATIVE LONG AND SHORT RETURNS BY HOLT TM % TO BEST

7 Most attractive decile Least attractive decile 6 TOPIX 500

0 Jan 03 Jan 10 Jan 02 Jan 95 Jan 96 Jan 97 Jan 98 Jan 99 Jan 00 Jan 01 Jan 09 Jan 08 Jan 93 Jan 94 Jan 04 Jan 05 Jan 07 Jan 06 Jan 88 Jan 89 Jan 90 Jan 91 Jan 92

Japanese companies, Feb 1987 to 2010 inclusive. Frequency: Monthly. Universe includes the largest 500 market cap companies in the database - all active companies at the relevant point in time. Bankrupt and merged companies drop out of the sample in the month they stop trading on the exchange. Only companies that have published earnings estimates are recorded in the database. Returns are calculated gross of transaction costs and are price returns in local currency. source: Credit Suisse HOLT 36 Japanese Equities I February 2011 Screens

A structured approach towards idea generation Directs the research effort

Generate short and pair ideas as well as long ideas

A comprehensive and objective snapshot of the entire investible universe And a reality check for existing holdings

GARP and CFROI screens

Flexible approach Different stages of cycle Opportunistic

37 Japanese Equities I February 2011 GARP screen – Telcos and Utilities

NAME FY0 FY1 FY2 RP P/RP RP growth Q1 Q2 Q3 Q4 NIPPON TELEGRAPH 701 693 728 693 5.6 5.1 9432 KDDI CORP 88,044 99,165 110,172 99,579 4.8 10.6 9433 NTT DOCOMO INC 17,743 19,032 19,162 19,080 9.9 0.4 9437 SOFTBANK CORP 99 312 378 320 10.7 18.1 9984 TOKYO ELEC PWR- 74 148 208 157 21.0 32.9 9501 CHUBU ELEC POWER- 30 215 186 224 10.4 -16.9 9502 KANSAI ELEC PWR- 13 185 172 193 14.8 -10.7 9503 CHUGOKU ELEC PWR- 85 138 130 146 17.1 -11.1 9504 HOKURIKU ELE PWR 67 95 142 96 28.3 48.4 9505 TOHOKU ELEC PWR- 75 94 128 100 26.3 27.2 9506 SHIKOKU ELEC PWR 195 151 154 149 23.0 3.1 9507 KYUSHU ELEC PWR 118 126 123 126 21.6 -2.6 9508 HOKKAIDO ELEC- 145 64 110 72 33.4 52.9 9509 ELECTRIC POWER D 195 214 314 214 19.0 46.6 9513 TOKYO GAS CO LTD 25 32 38 32 16.8 19.4 9531 OSAKA GAS CO LTD 30 38 33 38 11.9 -14.0 9532 TOHO GAS CO LTD 18 32 43 33 21.1 31.1 9533

38 Source: Bloomberg Japanese Equities I February 2011 CFROI Screen – Materials

CFROI 7 Value /Cost EC P/E Market P/E P/E Current Current Year Past Ratio 7 Yr TOP 10 Cap FY1 FY2 P/B DY Median Current Med OSAKA STEEL CO 62 17 31 0.5 2.6 7.8 0.5 6 PAC METALS CO 142 18 14 1.4 1.2 18.6 1.3 7 SK KAKEN CO LTD 39 9 9 0.7 1.6 8.5 0.6 8 C UYEMURA & CO 40 13 11 1.2 1.5 10.7 0.9 8 SHIN-ETSU POLYME 55 33 21 0.9 1.3 6.9 0.6 9 OSAKA TITANIUM 125 959 -38 2.5 0.5 16.0 1.5 9 MITSUB STEEL MFG 29 -30 10 0.7 2.1 7.0 0.7 10 NITTO DENKO CORP 610 16 14 1.6 1.1 10.3 1.1 11 NETUREN CO LTD 30 118 20 0.6 1.6 4.6 0.5 11 FUJI SEAL INTER 57 11 11 1.2 1.6 8.8 1.0 11

CFROI 7 Value /Cost EC P/E Market P/E P/E Current Current Year Past Ratio 7 Yr BOTTOM 10 Cap FY1 FY2 P/B DY Median Current Med TOKYO ROPE MFG 39 122 24 0.9 1.0 2.3 1.0 43 TENMA CORP 30 9 44 0.5 2.0 1.0 0.4 44 NIPPON PAINT CO 158 18 18 1.4 0.7 2.2 1.0 46 OKAMOTO INDS INC 44 18 17 1.1 2.0 1.6 0.8 49 MITSUB RAYON CO 230 -26 28 1.6 1.1 1.6 0.9 53 NIPPON SODA CO 60 7 15 0.8 1.5 1.2 0.7 57 TAIYO NIPPON SAN 346 24 18 1.7 1.5 1.9 1.2 62 SHINAGAWA REFRAC 28 21 10 0.8 1.8 1.1 0.7 63 HOKUETSU KISHU P 98 15 16 0.7 2.5 1.1 0.7 64 DAISO CO LTD 26 20 18 0.8 2.6 1.0 0.6 65

39 Source: Credit Suisse HOLT Japanese Equities I February 2011 Research

Around 160 company meetings annually Includes conference calls and research trips

Maximise benefit from in-house expertise Includes PAMJ and PSTs

Intelligent use of sell-side research Best analyst in each sector

Ownership is key

Conclusion is the Target Price

40 Japanese Equities I February 2011 Research: what we look at

WE LOOK AT... Business franchise