A Pacific Century - if
not for Cyberworks
Apollo Asia Fund: the manager's report
for 1Q2000
If America can look forward to significant gains from IT and the Internet, then the rewards to other economies could be even bigger.
Thus the Economist, in their edition of April Fool's Day - but they weren't joking, and I shall argue that their arguments are particularly compelling with regard to Asia. The article is well worth reading in its entirety, but I would just like to highlight a few of their comments while adding my own.
The Internet allows producers and consumers to seek the cheapest price in the global market... Asia is very hard to beat as a low-cost producer. For large-scale export manufacturing, the efficiency / productivity / cost proposition of southern China is awesome. Likewise India for large-scale software programming. Given the labour pool of those two countries, the country-to-country shifts seen in the past with the migrations of the textile, footwear and low-end electronics industries may go no further. The competitive proposition of many Asian industries is highly compelling, and durably so.
In Europe especially, by making cross-border purchases easier, the Internet will increase tax competition and so put pressure on governments to reduce taxes... By exposing firms to more intense global competition, the Internet should force governments and businesses to rethink their old, inefficient habits and seek new ways to get around or eliminate market rigidities. It astonishes me that, when I visit Hong Kong manufacturing companies in a wide range of industries, so many are exporting 90% or 98% to the US. If asked about Europe, a market of comparable size, they all cite fragmentation, language, and other barriers. Others have suggested that the relatively small numbers of Chinese resident in Europe have made it difficult to establish trade bridges. Thus Norwegian companies are still making tents, and German companies hiking boots, with some of the world's highest-cost labour. This may make sense for the very highest-tech equipment, but surely not for the mass market. This helps to explain why European prices are often 60% or more above US prices, and presents an enormous opportunity in the long run for low-cost manufacturers - as well as for those middlemen who still have a role, such as Li & Fung and HSBC.
By increasing price transparency, the Internet will give more power to consumers... and not only to consumers. From central Africa to remote inland China, there are reports of farmers newly informed of world prices through the internet connection in the nearby village or local market town. More information, more bargaining power. Over time, distribution networks become less inefficient, and the insidious grip of market economics becomes more compelling. Asian economies still have a large agricultural component.
The Internet could also accelerate the process of economic catch-up by speeding up the diffusion of information, which will help new technologies to reach emerging economies... also the diffusion of know-how about business practices, and ideas about business models, which I'd suggest are economically even more important to a region of entrepreneurs. The social changes caused by access to information on medicines or political developments, and to global literature for students, also accelerate the catch-up process. This is all Asia-ex-Japan needs to do, for fast growth: play catch-up - and eliminate the barriers and inefficiencies which curb the natural process.
The Apollo Asia Fund will take this as an encouraging secular backdrop, despite the evident cylical risks to US consumer demand and the US dollar. In practical terms, we will continue to play the game that we understand, investing in excellent companies at reasonable prices - and our tests of an excellent company include cash flow - real cash flow, generated from operations. Naturally, an excellent company should be able to take advantage of any new technology, systems, or market opportunities available. Our companies have balance sheets ranging from appropriate to fortress-strength, and in the last round of turbulence were able to seize great opportunities.
We won't be investing in Pacific Century Cyberworks, at least until it develops a strategy other than momentum and opportunism - for which I give Richard Li full credit, but not money. Pundits have been telling us that the Hongkong Telecom bid will go through - a notable exception is David Webb, of Webb-Site.
By way of one contrasting example, we shall be holding on to Bumi Armada. This is not our cheapest holding, but is now our largest. During 1998 we were buying the stock at RM 3.10, 2.80, 2.65, 2.01 and 1.92 - in that order. The amount of stock available was never great (it took several months to build up a reasonable position), and liquidity became minimal at the lower levels - which I remembered as RM 1.60, but I have just looked it up and the stock touched an absolute low in September 98 of RM 1.34. The price now is RM 7.60. At this price the current year PE is, on my estimates, a little over 8. We believe the company can sustain EPS growth of at least 20%, which would bring the PE down to 5.5 two years from now. Bumi Armada supplies support services to the offshore oil and gas industry, and has moved steadily up the ladder of value-addition, from tugs and accommodation boats to the operation of a Floating Production and Storage Platform (FPSO). This is essentially a mobile oil rig, ideal for Malaysian waters where there are many small fields which can be fully exploited in a few years, with the platform then moving on to a new site. Bumi Armada builds its vessels against long-term contracts from the major oil companies (Esso, Petronas etc), and is the quality operator in a sector where efficiency and lack of downtime are of vital importance to these customers, as they nevertheless seek to outsource more and more. Bumi Armada's return on reported equity last year was 38%, but this was an aberration as the company took a large provision in 97 against US$ loans, under standard accounting principles, without writing up the commensurate assets. Given a prudent degree of leverage against the security of its contracts, we believe Bumi Armada can sustain a "real" (FX-neutral) ROE in excess of 20%. Given our confidence in the company's management to generate good returns, we are happy with a high level of retentions; the dividend payout ratio last year was 14%.
The NAV of the Apollo Asia Fund was US$108.92 at the end of March 2000, after all deductions; up 5% for the quarter. Performance charts, and a table of the monthly figures, may be found on a new performance page.
As of 7 April, when the NAV was an estimated US$109.63, the current-year PE of the portfolio is estimated at 7.3, and the PE one year out at 6.2. The dividend yield, net to the Fund, is estimated at 5.5% for the current year, and 6.6% one year out. The price-to-book ratio is 1.42.
By "current year", for these purposes, we mean the next full year of earnings to be reported - which for five of our companies (four in Indonesia, one in Hong Kong) is still calendar 1999 - and for Indonesia especially, 1999 was still not a great year. If we strip out these companies, the PE for the rest of the portfolio comes down to 6.6 current, 5.7 prospective, and the dividend yield rises to 6.4% current, 7.3% prospective.
Going back to the whole portfolio, the implied EPS growth for the group of companies which we hold today is 41% for the current year, and 17% for the year after. (The former figure will be boosted by rebounds - in Indonesia for example - but I would guess that the latter may err on the side of conservatism.)
We don't do these valuation calculations every day, and if we go back a year we have to do so approximately. Between 16 April 1999 and 7 April 2000, the Fund's NAV is up 107% (linking the Apollo Asia Fund with its predecessor Apollo 001 Fund). However, the estimate of "current PE" has risen only from 6.0 to 7.3 - ie the gains include an element of re-rating, but a relatively small element, with "portfolio EPS growth" of 71% over the year. This is an example we would hope to be able to repeat. Our present companies can comfortably sustain earnings growth of 15-20%, in my view; we can hope to do better, by selling some holdings which become excessively priced and reinvesting in stocks which seem more attractive.
There can be no guarantee that these numbers will remain so attractive, as we do not wish to be caught in the trap of chasing cheap valuations at the expense of quality, nor in the trap of being forced to sell our winners. We have bought individual companies on much higher valuations, and will continue to do so if we think that we are getting good value for our money. However, we have no intention of chasing concepts without regard to value.
Comments and questions are most welcome. Thanks to all of our investors
for your support and interest.
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