Given the broad based market sellof in Japan this past week due to the earthquake and tsunami, I screened for stocks that have a good margin fo safety given the current market uncertainty. My recommendation is to invest in Fujishoji (6257 JP), a company trading at below net-net working capital, a classic way of investing from the traditional Benjamin Graham approach of looking for cigarette butts. The market had a healthy bounce on Friday, but i still think the stock is trading below its intrinsic value and at minimum expect it to trade back to its pre-earthquake levels (+20% nominal returns). Current market cap (as of March 18 2011) was JPY18.6bn, relative to their balance sheet (as of December 2010) which includes JPY22.5bn cash & equivalents, JPY5.1bn accounts receivable, JPY3bn inventory, and JPY7.4bn total liabilities. In addition, trailing P/E is about 11.8x and price to book of above 0.4x.

My two major concerns with investing in net-nets is whether the Company is legitimate and management's motivation for maximizing shareholder returns.

According to bloomberg, Fujishoji develops, manufactures, and sells pachinko slot machines in Japan. The Company is based in Osaka (west of Tokyo) and has generally been unaffected by the earthquakes and tsunami, as compared to the major eastern coastal areas of Japan. The business started operating in 1966, and mainly relies on capex spend by pachinko parlors for new machines, or machines upgrades due to introduction of new characters or technology. Revenue generation is not consistent, due to the fact that replacement machines or new sales are not on a 12 month cycle which makes it difficult to project earnings, but nonetheless, should be less of a concern given that the thesis is to invest in a mispriced security trading below net-net and to trade out once the share price is no longer trading below liquidation value. This writeup is not as focused on the longer term prospects for this business, given that my diligence was not as focused on where we are in the pachinko machine replacement cycle and how Fujishoji may benefit from this, given that (1) speed of execution was more of a concern for me, and (2) i was unclear how long Mr. Market will misprice this security

Playing pachinko is a favorite Japanese pastime. It resembles a pinball machine and is found in establishments called pachinko parlors, similar to slot machine dens in the western world. The industry is not legal, but operators get around the law by defining their business as a game (like arcade games) and allowing for customer's gaming wins to be exchanged for toekn prizes, which can then be taken outside the pachinko parlor and traded in for cash at a buinsess that is a separated entity from the pachinko parlor. The practice is currently accepted by the police but not perfectly clean. For full details on how the business works, see link: http://en.wikipedia.org/wiki/Pachinko

The pachinko hall operating industry accounts for >40% of all leisure sector spending in Japan. Total pachinko related spending is estimated to be US$350-$400bn including gaming device manufacturers and peripheral elements. Japan has >15,000 pachinko halls with over 5mn installed gaming devices. The industry is extremely fragmented with over 5,000 hall operators. The largest operator controls less than 2% of the market. During the past decade, the industry has undergone consolidation and modernization to become more sophisticated, transparent, and professionally managed. During 2007, regulatory changes required operators to replace substantial inventories of slot machine devices. As such, you can see that there was a significant uptick in Fujishoji's revenue in the subsequent fiscal years, especially notable in the cashflow building up in FY09.

My second concern with investing in Japanese small-caps, or Japanese equities in general, is what drives management. There are far too many situations where maximizing shareholder returns i far down the list. Nonetheless, there are several pieces of information which have given me further comfort with investing in Fujishoji:

- As with many Japanese corporations, insider ownership is strong. The President (Kunio Matsumoto) and Executive VP (Masao Matsumoto) combined own 63% of the Company

- Management has been consistent with returning cash to investors, with even a special dividend made in 2008. Current dividend yield of ~6%

- Company has been buying back shares in the market. In October 2010, they announced that they will repurchase as much as 1.18% of its outstanding shares for up to JPY300mn. Unclear to be what extent that has already been complete, but is a good indication that management is shareholder friendly

- Management seems to be open with communicating iwth investors. Although the full extent of the earthquake is still currently being evaluated, management has been communicating to the market on how their operations may be affected. There have been two press releases to-date, one of which confirms that there may be short term delays to delivery of their goods and machines

Legitimate company trading at below net-net working capital due to mispricing by the market