AIMS Asset Management
Floreat Quo Vadis?
Letter by David Crichton Watt, manager of the Floreat Fund, to investors, March 1999

Originally posted on the website of AIMS Asset Management, at www.aimskl.com/FF0399.htm

The performance of the Floreat Fund since the end of 1995 can only be described as "disastrous". The disaster has been all the more difficult to swallow because the markets, with one or two painful exceptions, have largely performed as I had anticipated. So how do I explain that the Floreat NAV is today 75% below its high? (A high at which, incidentally, I confidently subscribed US$5 million.)

What went wrong ?

My stubborn conviction that gold is more than a relic of the past, and even my hopeless timing on short sales in Thailand, Malaysia and the semiconductor manufacturers, or the tragic stop-loss in the Hang Seng Futures short position cannot explain a loss of such magnitude. Alas, the real villains of the piece have been the value stocks! Since early 1994, when I became convinced that Asian markets had no where to go but down, I adopted the strategy of holding long positions in small developing companies which were not owned by the mutual funds and which would not, therefore, be subjected to forced selling, while holding short positions in the expensive companies held by every fund manager with an Asian brief. Throughout 1994, 95 and 96, the short positions continued to lose money until, alas, I cut my losses and reduced the short positions to insignificant levels. Although these losses were minor, they were enough to induce redemptions in the Floreat Fund, which forced me to sell the small companies from my long positions. My strategy was effectively working in reverse for I found myself the forced seller of stocks where there were virtually no bids at all. In some instances buyers could not be found even at 50% of the last traded price and I was obliged to sell stocks down to levels where substantial buyers showed themselves. When the dust settled, as it seems to have done, Floreat was faced with different problems:  whether to seek new subscriptions and restore a better balance to what has become a very concentrated portfolio, or to refuse new subscriptions in the belief that many of the holdings are quite likely to rebound on volume as slim as that on which they fell. As I am now the beneficial owner of more than 50% of the units and more intent on repairing capital than on income, I am refusing further subscriptions for the time being.

Outstanding value in our remaining holdings

To enable you to form your own judgement on this strategy, perhaps it will be worthwhile describing a few of the stocks which contributed the most to our losses and where I expect a strong recovery.

Although these investments would be considered undervalued by most traditional yardsticks, they are small companies and, as such, may not find favour immediately in the stockmarkets. I am not content to sit and wait for a revaluation but, usually in conjunction with the majority shareholder, am seeking industry investors who will acquire the company or its assets at a price closer to book value.

It had never been my intention to hold a portfolio of small illiquid stocks at a time when I anticipated that the markets would be in decline. I have been in Asia long enough to know just how volumes can evaporate during downturns. However, at the time I made the investments Floreat was a $70million fund and each of these investments, except Asian Hotels, constituted less than 2% of the Fund. During the wave of redemptions, I perhaps showed too much compassion to those exiting, and not enough to those, like myself, who were remaining with the ship. I should certainly not have allowed liquidity to be reduced to the extent that I did, for it hampered my ability to maintain the large short position in Hong Kong which should have been so profitable.

Back to the future

However, this is all water under the bridge and it is more important that the way forward is clear. My primary task is to try to restore proper valuations to the stocks we hold. As soon as this can be achieved, I will reopen the fund to subscriptions, because I strongly believe that many of the Asian markets have seen the worst. Although, for most Asian economies, it is going to be a long struggle up the other side of the valley, with a few rockslides to contend with on the way, there are now some stocks offering outstanding value. There will certainly be other opportunities as companies restructure and begin to focus on shareholder value.

I share the sentiment of most value investors that the excesses of Wall Street are likely to end very badly. Indeed, it is not difficult to imagine the present virtuous circle rolling over into a vicious one where a steep fall in share prices leads to a sharp downturn in consumer spending, GDP and government revenue. Corporations have again increased their indebtedness to levels most unsuitable for a period of reduced consumer spending and margin squeeze. Nonetheless, the US economy has done a magnificent job as buyer of last resort, enabling the Asian exporting economies to rebuild their reserves and restore stability to their banking systems. The Japanese have had their heads in the sand for almost a decade now, but finally seem to have realised that this attitude leaves them prone to being kicked in the rear. There are signs that long-overdue restructuring is becoming fashionable in Japan: it is quite possible, and certainly desirable, that this economy can start to take up some of the slack left by a less robust US. This in turn will enable the Asian economies to continue their recoveries without further help from America.

Floreat has certainly not been an appropriate name for your fund during the last two years and for this I apologise. The horrible truth of allowing one's portfolio to decline by 75% is that one has to increase it by 300% simply to regain lost ground! This is difficult, but in Asia it has been possible before, I have achieved it personally before, and I will certainly be trying to achieve it again.

David Crichton-Watt, March 1999

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