The Importance of Being Micro

In recent years, we have made two major geographic bets that, at the time, seemed to fly in the face of macro-economic fundamentals. By and large, they served us well and I believe that they validate our approach of using a contrarian economic and market backdrop but stressing bottom-up value analysis in stock selection.

Japan 1998-2002: A Growing Bet on Corporate Restructuring

In 1998, we had a Japanese epiphany.

For years, we had owned next to zero Japanese shares. My own aversion to them dated back to the late 1980s, when the Japanese stock market had experienced a bubble not dissimilar to the American one in the late 1990s.

Then, leading Japanese companies had been routinely selling at price/earnings ratios of 45, 50 or more. “Experts”, as usual, had managed to justify the prevailing trend -- explaining the huge valuation premium over other major stock markets by accounting differences that understated Japanese profits and by the much lower interest rates prevailing in Tokyo. Furthermore, enthusiasm about Japan’s economic miracle had been running high. To me, that kind of price/earnings ratio is seldom justifiable, if ever, and I also had some doubts about an economic miracle based on fierce mercantilism in a few “strategic” sectors and on real estate speculation.

I settled comfortably into the belief that the unavoidable correction, when it came, would take years to complete. Sure enough, by 1998, after an agonizing and devastating decade, the Japanese stock market had shed 60% of its late 1989 value and investors had become vaccinated against Japanese stocks.

Loyal to our contrarian bias, we became intrigued. Yet, on the surface, valuation criteria remained far from our preferred value range.

This is when the head of research at one of Tokyo’s leading brokerage houses visited us. As he was pouring through his list of favorites stocks, selling at still-lofty multiples, Robert Kleinschmidt and I made a double take. He had just passed over a medium sized, but leading developer of computer games (Enix) that had a “very low” price/earnings ratio of nearly 20, because their profits were expected to experience a lull between major upgrades to their best-selling games. What really intrigued us about Enix, however, was that the company had no debt while sporting cash on the balance sheet equal to one third of its total stock market value. How much interest did that cash earn? About 1%. Theoretically, therefore, the company could have bought in one third of its outstanding shares with a negligible impact on total profits. Earnings per share would have been boosted by more than one third and the stock would then clearly have qualified as a growth stock selling at a value price.

Shortly thereafter, on a visit to Tokyo with our Asia analyst, we visited Nitto Kohki, a manufacturer of fluid power systems which presented very similar balance-sheet characteristics. When I asked the English-speaking CEO (a rarity) what kind of return he would demand from a new investment (as opposed to the 1% he was getting on his cash pile), he stated a very conservative 7.5%. In other words, a mere rise in interest rates would boost profits by a big margin; any smarter use of the company’s excess cash would do even better.

It began to dawn on us that the balance sheets of many Japanese companies were similarly loaded with valuable assets including not only cash, but also real estate and corporate cross-holdings, which were contributing next-to-nothing to earnings. The Nitto Kohki CEO even remarked that, since he never borrowed money, he did not need to own the shares of various banks that graced his balance sheet (a then-widespread courtesy in corporate Japan) and saw no problem with selling them. “But, for the moment, their dividends pay me more than I could get on a deposit at the bank…”

We started accumulating Japanese shares that we felt represented “hidden value” in a very progressive fashion. By then, of course, the notion of a Japanese miracle had evaporated and the consensus was fixated, instead, on the country’s structural problems, shaky financial system and mounting deflation. We received a large amount of mail and calls from clients and fund holders, worried that we were taking risks on a country “we did not know and did not understand”.

Still, we became increasingly convinced that momentous change was afoot in corporate Japan – regardless of the apparently hopeless macro-economic situation. Accordingly, we persevered in building up our position in Japanese equities.

From next to nothing (3.2%) at the end of 1997, Japanese equities came to represent more than 35% of total equities in the Tocqueville International Value Fund at the end of 2002.

(This fund invests primarily in non-US shares and constitutes a good indicator of the firm’s strategy toward international investments).

Today, with the Nikkei 225 index having doubled in less than three years, enthusiasm about Japanese shares is, once again, running high, and many investors are beginning to see more to the story than there may be. Japan’s is a mature economy with a fast-aging population and a household sector that, generally, owns everything it needs – indicating little pent-up demand. Most of the recent recovery is due to some stabilization in the real estate sector and, principally, to strong exports (mostly capital equipment) to China. While well-positioned consumer brands could offer growth opportunities in China in the future, Japan’s domestic economy has very little potential to accelerate in the next decade. As to the much-touted Koizumi government efforts to restructure the economy and financial system, they are encouraging but experience tells us that political change, especially in Japan, takes time and seldom moves in a straight line.

Meanwhile, as the chart below (from BCA Research) illustrates, Japanese corporations’ rate of return on assets has essentially caught up with that in the United States, leaving less room for improvement than a few years ago.

I would suggest that a good part of our rationale for buying Japanese shares in the first place has played out and that the recent investor enthusiasm for everything Nippon is becoming suspicious.

Europe 2002-2005: Buying Survivors and Winners in a Mediocre Economy

Around 2002, we became intrigued by the fact that our analysts were finding many high-quality, medium-sized European companies selling at valuations well below those of equivalent US companies.

At the time, the news on the European economy was all gloom and doom (as, indeed, it remains today). Still, on my following trip to Europe, I decided to meet with a number of economists and investment strategists. Too often, this tends to be a fruitless exercise, but I was desperate... The purpose of my endeavor was to try and identify some “straws in the wind” that could support a more positive investment stance at Tocqueville towards Europe. But to no avail: all I heard was a litany of problems and dour forecasts. I could not identify one good macro-economic reason to increase our exposure to European companies.

Meanwhile, however, our analyses of individual companies by my co-manager James Hunt and his research team were uncovering more and more compelling values. Very often, these companies were world leaders in specific niches and had managed to survive and prosper through a difficult and slow-growth economic environment in Europe. So, faithful to our bottom-up discipline, we started buying these survivors more aggressively.

European stocks, which in December 2002 constituted only 25.7% of total equities in our Tocqueville International Value Fund, had climbed to 52.3% of the total by December 2004.

As the charts below illustrates, the S&P 350 index of European stocks has comfortably outperformed the S&P 500 index of US stocks over the last three years – admittedly with some help from a weak dollar. In my opinion, these still understate the performance of European mid-cap value stocks over that period.

NB: Both indexes expressed in dollars (Source: Bloomberg)

Source: Pacific Exchange Rate Service

Unfortunately, today, the valuation gap that existed in 2002 between European and US stocks has largely been closed, as illustrated by the following chart from BCA Research. And this is confirmed by our increased difficulty in identifying compelling values in our bottom-up search for European investment ideas.

Meanwhile, the macro-economic situation in Europe has not improved materially since 2002. France and Germany are still growing slowly if at all; the shackles of European regulation and budget constraints imposed by the European Commission are impairing the necessary restructuring of the older economies; political leaders lack the will or the courage to implement anything but marginal reforms; and there appears to be no strong will for change among the electorate.

The timid election of a presumably free-enterprise chancellor in Germany is encouraging, but no overhaul of “old” European economies is likely until a similar-minded president is elected in France. This will have to await 2007 and not much change should be expected until then.

* * *

The increased concentration of our international investments in Japan and Europe has served us well, in the last five years.

(*) Through 12/27/05 – Not including the reinvestment of 2005 dividends on the MSCI index

Normally, at this juncture, it would now seem logical to increase the diversification of our international portfolios by looking for contrarian/value investment opportunities in other regions. Yet, we are currently faced with a serious lack of obvious alternatives.

I have previously expressed my reservations about currently investing in China and most of the regional economies that have grown increasingly dependant on its markets. Most of the other, more exotic markets – from India to Russia and the leading Latin American markets – have doubled or tripled over the last three years, at least in local currencies. At the very least, this indicates that they no longer represent contrarian ideas, and it can be assumed as well that they now represent less compelling values. Usually, these markets also offer less opportunities to identify (and reliably analyze) undiscovered “values” beyond the large companies included in their stock market indexes. Finally, we are equally hard pressed, these days, to find compelling values in the US markets as well, while being worried that the coming years might bring some negative economic or financial surprises.

At this juncture, we simply have a hard time building contrarian economic or market backdrops against which to look for outstanding investment.

Some opportunities might exist, of course, in being contrary to the current complacency: for example the Saudi Arabian market, after an almost uninterrupted rise of 600% might represent an attractive short sale. But I believe this is too exotic a gamble, even for the most adventurous among us.

As we enter the year 2006, the cautious attitude professed for a number months remains in force.

François Sicart

January 9, 2006

This commentary is not an advertisement or solicitation to subscribe to The Tocqueville International Value Fund, which may only be made by prospectus.

The Fund's holdings are also subject to change without notice. The mention of specific securities is not a recommendation or solicitation for any person to buy, sell or hold any mentioned security. The securities mentioned in the article are not representative of the entire portfolio of The Tocqueville Int'l Value Fund which can be viewed on this website.

There are special risks associated with investing in foreign securities, including: the value of foreign currencies may decline relative to the US dollar; a foreign government may expropriate the Fund's assets; and political, social or economic instability in a foreign county in which the Fund invests may cause the value of the Fund's investments to decline.

For more complete information on any fund including management fees and other expenses, please obtain a free prospectus by downloading a copy, by contacting one of the broker-dealers listed on this site or by calling 1-800-697-3863. Read the prospectus carefully before you invest.

The performance quoted represents past performance, but current performance may be higher or lower than the performance quoted. Fund performance to the most recent month-end can be obtained by visiting www.tocquevillefunds.com. Past performance does not guarantee future results. The investment returns and principal value will fluctuate and the investor’s shares, when redeemed, may be worth more or less than their original cost. The average annual total returns of The Tocqueville International Value Fund for the periods ended

12/31/05:

one-year 21.06 %

five-year 15.71 %

ten-year 7.14 %