JAPAN EQUITY FUND at 30 September 2008

Seemingly taking its cue from the other developed markets, the Japanese stockmarket has had one of its worst quarters in memory, and at time of writing has plunged 47% in the last year. While your Fund has performed better, being down 40%, that is of small consolation when the price decline experienced by fellow Members is so large. Of greater impact is the fact that, for Members invested in the Yen Class, it should be noted that the purchasing power of their investment has declined markedly less, as the yen has appreciated significantly against just about every other currency in the past year, including 21% and 37% gains against the US dollar and euro, respectively.

Our sense of frustration when we look at recent performance is significantly offset when we shift our gaze to the valuations and prospective returns for the stocks in the portfolio and the many excellent new opportunities now being presented. The Japanese stockmarket is now selling at its 25-year low reached in 2003. This is absolutely remarkable when one considers the great strides corporate Japan has made in terms of earnings and balance sheet strength since 2003. Over this period, corporate return on invested capital has roughly doubled and corporate balance sheets are now the envy of the rest of the world that has just recently come to realise how overleveraged they have become. The Japanese stockmarket carries a debt-to-tangible equity ratio of 30%, clearly standing out when compared to figures of 95% each for the US and Europe. Japan's corporate conservatism has recently begun to pay off, as some Japanese banks with their superior liquidity have begun to purchase the attractive assets of US and European banks at depressed prices.

At times like this it is important to step back and look at a very long-term perspective. The chart below puts the level at which Japanese shares are currently being valued in long term context and demonstrates what an exceptional opportunity Japan is today. The chart below shows the price level of the TOPIX Index from 1965 to today. The orange and blue lines and the blue shaded area represent the levels at which the TOPIX would be if it was selling at its long-term average valuation based on the earnings, dividends and book values respectively at the time. From this chart, one can see that rarely does the TOPIX price sit consistently above or below the average of the three valuation measures, it instead tends to trend away from "normal" for some time, turn, and then shoots through. We can also see quite clearly that the Japanese shares are now as far below their average valuation levels as they have been since the early 1970s!

When looking at the most recent period on the previous chart, it would not have been surprising for 2007 to have marked a bottom for Japanese shares in relation to valuation. But instead things have become considerably cheaper, bringing to mind an investing truism—if something is irrationally priced, it can always become more irrationally priced! So we are reminded that while valuation determines share prices in the long term, greed and fear play an even greater part in setting prices in the short term. Thus, just as attractive valuations didn't lead to higher prices in 2008, so even more attractive valuations may not portend higher prices in the short or medium-term. Therein lies the power of investing for the long-term—being willing to be exposed to short-term loss when fear of losses is rife and being willing and able to hold through further declines in price, enables and usually accompanies outstanding long-term investment returns.

The turmoil in global financial markets that has spread to Japan is, in our view, at the same time creating an environment that could help spur Japanese shares. With 10-year Japanese Government Bonds (JGBs) having been yielding less than 2% per annum, high single-digit to low double-digit yields available in places like Australia, New Zealand and South Africa have been enticing Japanese investors to ship their capital overseas, participating in the so-called "carry trade" in search of higher yielding investments based in other currencies. Further, this flow of capital from yen into the "carry trade" currencies helped bolster those currencies against the yen, often adding further to the total return. Unfortunately for those investors, there is no such thing as a free lunch, and the "carry trade" currencies have devalued dramatically recently against the yen, wiping out years of yield pickup. If history and human nature serve as guides, this painful recent experience should be convincing Japanese investors to bring money back to Japan and keep it there.

Once repatriated, we expect most capital will immediately find a "safe place" in government bonds or under the mattress, but over time a good portion of these funds should serve as an additional source of money flowing into equities that now sell at extremely attractive levels when compared to other Japanese investment alternatives. The chart below compares the dividend yield of Japanese equities to the interest rate of the 10-year JGBs. The cash yield paid by stocks has rarely been higher than the cash yield offered by bonds, owing in part to the prospect of growth offered by shares. Today this relationship is as extreme as it has been in our memory.

Reverting to basics, we have tirelessly studied the fundamental outlook and valuation levels of the Fund's holdings as well as many other shares that have failed to make it through the research process. It is that foundation that makes us bullish on Japanese shares, and extraordinarily bullish on your Fund. As always, however, we find predicting future market movements, particularly in the near term, to be difficult, nay impossible with any useful degree of accuracy. As such, we focus our energies on controlling what we can—performing diligent and disciplined research, maintaining a portfolio we believe has excellent risk-adjusted prospects, and waiting for enough investors to agree with us so that the Fund achieves the hoped-for excess return. We encourage our investors to take a similar approach—invest in a disciplined and diligent way, maintain a portfolio of investments that makes sense for your risk tolerance, and then be patient, especially at times like this when that patience is most assuredly being tested.