Arcus Investment was established in the mid 1998 by three partners who own the company, Peter Tasker, Robert Macrae and Mark Pearson. Arcus runs two other hedge funds, Arcus Japan Long/Short Fund and Arcus Zensen Fund.

1. For new investors, can you explain Arcus' investment approach? Specifically, how are the principals' macro, fundamental and quant expertise incorporated into this approach?

   The three principals share a straightforward value philosophy - we like buying stocks where you get a lot for the money and selling stocks where you don't. Each of us brings a different set of skills and experiences to the task. Peter Tasker has worked as a strategist in Japan for over twenty years and his deep knowledge of the market and macro-economy provide a context for each of the stock-specific decisions. Robert Macrae is a quant, providing tools that assist in stock screenings, portfolio construction and risk control and allow us to handle large and idiosyncratic portfolios. Mark Pearson has worked since 1987 as a Japanese fundamental analyst and fund manager and has an extensive knowledge of Japanese companies. The stock-level knowledge that he has built up over 17 years is a key part of our edge.

   At Arcus we work together to build and monitor portfolios of undervalued longs and overvalued shorts, taking into account the risk that each position brings to the portfolio, our view on the company and its environment, and the risk profile of the portfolio as a whole. This is the approach we have followed for the last five and a half years.

2. The Arcus Japan Long/Short Fund (AJLSF) and Arcus Zensen Fund have a reputation of being focused mainly on small/mid capitalisation stocks; why has the firm decided to launch a hedge fund focusing almost exclusively on large caps?

   One of the reasons that we are known for small caps is that this area has consistently generated the best stories. That is where our 10-baggers come from, and that is where the most exciting undiscovered gems are unearthed. Small-cap stocks have certainly made a significant contribution to returns, particularly over the last two years, but these returns have been highly volatile. AJLSF and Zensen have always invested in stocks of all market capitalisations, and in fact over the five and a half year track record of AJLSF large-cap stocks have actually contributed greater returns than small caps. This performance attribution suggests that the large-cap element of our trade should now have a risk profile at least as good as that of our existing funds.
   
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   I'd contrast the current situation with where we were in August 2003 when we closed Zensen. Back then small caps had made much less of a contribution, but we saw great prospects for them - and that is also why we launched the small/micro-cap Arcus Japan Value Fund a few months later - but now the extreme valuation discount that we saw for small and illiquid stocks has narrowed considerably so prospects may not be so bright. It is often dangerous to chase returns, and to us it looks like a good time to focus somewhere else.

3. Since large-cap stocks in Japan and Asia are so well covered by the major investment banks, what investment insight can Arcus offer on these names?
   
   We have run a large-cap long-only fund, Arcus Leaders Fund, for four years and it has outperformed Topix by 79%, or 16% per annum. This and the performance attribution suggest that we do have some edge in the large-cap universe. However, it is still reasonable to ask how this can be possible in what should be a relatively efficient market. There is no single answer, but I would like to suggest four ideas:

   a. No area of the market is efficiently priced all of the time. For example, the TMT bubble was a large-cap phenomenon and represented the greatest mis-pricing we have ever seen, and investment bank coverage did little to improve the situation.

   b. A contrarian approach that buys cheap stocks that are out of favour and sells expensive stocks that are currently fashionable should be profitable more often than not, for large stocks as well as small stocks, and there is a long history of academic work supporting this idea. Of course there will be many months and some years when the strategy does not work, but we think the odds favour our approach.

   c. Our knowledge of many companies in Japan may give us an advantage even when we look at only the most liquid stocks. When we want to make a decision on a large company we will also have spoken to many of its smaller competitors, suppliers and customers, providing a context that large-cap only specialists may not have.

d. Many investors seem to approach companies with an open mind, listen to what the company has to say and then make a judgement based on what they hear. We are not like that at all. We go in to companies with a clear preconception one way or another about the company's potential attractions. When we visit a company the choice is either "Buy or Ignore?" or else it is "Sell or Ignore?" and we have a list of questions we want answered. Unless we already have a strong view we don't visit. If we leave the meeting with ticks to all the items on our shopping list, we trade; in other words we go in with a defined objective and come out with a definite answer. This habit is as applicable to the large companies as to the small, and I think it makes us less susceptible to the stories and fashions of the moment.

4. Arcus Investment is known as having a "value" investment approach, which hurt in 1999. However, 2003 was a terrible year for value investors while Arcus Zensen Fund was +31%, top quartile of Japan L/S equity funds. How come?
   
   Our strategy has always been to look for a variety of different types of mis-valued stocks. For example on the long side we seek exposure to a range of different kinds of undervalued stocks - deep discount value stocks, net nets, low P/Es, GARP ("Growth At Reasonable Prices") stocks, undervalued new economy stocks, some quasi-distressed companies and relatively undervalued major companies. We are generalists, not specialists; at any point in time we will be tilting exposures towards the areas that we believe to be the most interesting.

   For example during 2003 the fund profited from its exposure to GARP stocks such as contents providers for mobile phones, innovative restaurant chains and growing specialist retailers. We also held quasi-distressed stocks in industries such as real estate, retailing, steel, textiles and banking - some of which used to be called "Zombies" but are now "Pure-Play Japan Recovery Stocks". These types of stocks would not necessarily have appeared in a typical value index or portfolio but they certainly met our criteria, having potential that was not in the price.

   The 2003 bounce was a great time for our kind of value because investors were looking at a real recovery and seeking real opportunities. 1999 was about chasing dream stocks; 2003 was about investing in companies with real businesses.

5. The Arcus Zenkei Fund can have up to 20% of its net exposure outside of Japan. After focusing primarily on Japan for the last ten plus years, what is your edge in investing outside of Japan?
   
   Japan has been our main focus at Arcus, but both Mark and Robert have managed non-Japanese money. The approach and tools we use in Japan have also been tested and used overseas, and to understand Japan we already have to understand other markets and companies in other countries.

   Just as in Japan, our edge is that of the generalist. Any specialist has a single area and must invest in it come rain or shine, good times or bad. A generalist can cherry pick, putting on positions just when the opportunity is there. When we see potential investments overseas we already have the option of including them in the Zensen portfolio, and going forward we anticipate that foreign positions will play an increasing - though still subordinate - role in both funds. The focus will remain firmly on Japan.

6. Can you explain how you will manage the fund's risk and try to maintain annualised volatility of 10% or lower?

   Zenkei will use the same risk control systems that we use for all our existing funds. Our objective is to take a large number of small bets, preferably uncorrelated. In practice this means that we try to keep the exposure to any particular stock or sector relatively small. We also try to get exposure to a range of different types of value. Before we trade we estimate the contribution each position will make to risk, so that we can keep the fund's expected volatility within its 10% budget. This is a very conservative, broad-based, approach to portfolio construction, which has two major benefits.

   Firstly it avoids us having to be reactive. We don't use stop losses at all, and we rarely feel obliged to trade in reaction to market events. This lets us take a considered approach, and perhaps make better decisions because we are not under pressure from returns. It also helps us control transaction costs.

   Secondly it allows us to be much more aggressive on stock selection. We can go into a position knowing that we might take a 50% or 100% loss, provided the odds look favourable. If we were running a fund that was more aggressive at the portfolio level (say taking concentrated 10% positions) I think we would have to play safe and be less aggressive on the individual names. Playing safe is not calculated to maximise returns.

   In Zenkei we can keep the tracking error between longs and shorts lower than for our other funds because we don't have the hard-to-hedge small-cap longs, so overall risk should be slightly lower than for Zensen.

7. For the Arcus Zenkei Fund, will your marketing efforts focus on any specific type of investor and geographical location? Are you looking to diversify your investor base outside of those in the Arcus Zensen Fund?

   The core investors for Zenkei are mainly existing Zensen investors, but we are also open to new money. We aim to maintain a diverse investor base, with classes for onshore and offshore investors in US Dollars, Euros or Yen. As with our other funds, Zenkei has early redemption penalties aimed at protecting long-term investors and will not be ideal for investors with a short-term perspective or for those seeking Japan exposure with a substantial long bias.

   It might also be worth mentioning another aspect of our approach that may be unattractive to some investors. Like any contrarian, we are betting that the market is wrong and sometimes it will be right. We see significant drawdowns as an inescapable part of the approach, and given our track record a drawdown of 10% or more should be expected at some stage.

8. As contrarians, how do you view the consensus that the Japanese economy has finally turned the corner from a liquidity trap to sustainable growth?

   We have seen a gradual improvement in the Japanese corporate sector over the past several years with companies in general becoming more focused on profitability and cash flow. The strength of the global economic cycle has also allowed companies to accelerate the repair of their balance sheets, and companies are now more profitable than they have ever been, even at the height of the bubble. So far so good.

   On the other hand, it is not clear that Japan is yet at a stage where domestic demand can support growth without a supportive external environment. This is not guaranteed. Coupled with intense investor interest in some of the sectors associated with domestic reflation (for example real estate, retail, banking and highly indebted companies), this suggests that there is room for disappointment even if progress continues at the moderate pace that we expect.

   Bottom line is that, having been well positioned for the recovery and having made considerable returns on some of the beneficiaries, we are now concerned that the pace of recovery may not match the market's high expectations. On a five-year timescale we expect Japan to continue on the road to recovery but that road is unlikely to be smooth. We see plenty of opportunities on both sides of the market, and suspect that a well-hedged approach may now be the best way to benefit.

Contact Details
Robert Macrae
Arcus Investment Ltd
Tel: 44 20 7861 9661
Email: info@arcusinvest.com