Relative resilience
Apollo Asia Fund: the manager's report for 3Q2002

Asian stocks struggled in the third quarter, but the Apollo Asia Fund was relatively resilient. NAV at the end of September was US$168.26, down by less than 1% for the quarter, compared to a fall of 17% in the MSCI regional index. (Performance charts.) Some of our shares fell significantly - notably those in Hong Kong, where small cap stocks were unusually fashionable with institutional investors earlier in the year - but this was offset by the resilience of prices in Thailand and Singapore, and markups in Malaysia resulting from the partial restructuring of the Land & General bond and a general offer for Bumi Armada.

Writing from London in the aftermath of the Bali bomb blast, which has understandably sent Indonesian stocks and the rupiah reeling and is damaging to the whole region, I remain acutely concerned about the unwinding of the US credit bubble and the fragility of global markets. Those concerns are heightened by the dangerous interplay of crowd psychology, domestic politicians, and international distractions.

Asia remains relatively resilient, because of high savings rates, relatively limited personal and corporate indebtedness (symptomatic of an 'underdeveloped' financial system perhaps, but certainly helpful at this stage of the global credit cycle), and a familiarity with booms and busts reinforced by painfully recent experience. On the negative side, export market weakness is the most obvious problem, compounded by overcapacity and the forces of deflation. Dependence on banks and capital from outside the region may also be an issue, although I have not seen good numbers on this.

Many Asian market commentators would like to believe that Asia can decouple from the sagging economies of the western world and grow through regional trade and stimulated domestic consumption, while prospering as the world's least-problematic home for portfolio investment. Can the traditional dependence can be shaken off so easily? My own instincts are to expect a severe cyclical downturn in Asia (part of which is already discounted, but many people assume that the US and Europe are in a 'normal' cyclical downturn, whereas I fear this is much more serious), but with Asia strongly outperforming other regions on a ten-year view.

China, North Asia and India also have a long-term advantage: their output of science and engineering graduates. This will be relevant on a trend basis, more than over a single cycle.

"The developing world - notably Asia - is increasingly expanding its share of the world’s skilled human capital. Developing Asia is generating scientific and engineering talent faster than any other region, a trend evident from recent figures from the US National Science Foundation. In 1999, universities in Asia produced more graduates with engineering degrees (322,100) than the US, Japan, and the European Union combined. For every engineering graduate in the US in 1999, Asia produced over five graduates. China, home to the region’s largest pool of graduating engineers, produced nearly 200,000 engineering gradates in 1999, over three times the level of the US, nearly double Japan’s engineering output, and 45% higher than Europe. Against this backdrop, is it any wonder that the world’s leading manufacturers and service companies are flocking to China? At 147,000, India ranks as the nation with one of the largest pool of graduates with a bachelor’s degree in science. The US produced nearly as many science graduates (144,441) as India in 1999, although we note that around 10% of US graduates in science and engineering in 1999 were foreign-born students, many of whom were from China and India. Combined, India and China produced roughly 23% of the global total of graduates in science in 1999 and nearly 26% of the world’s newly minted engineers."

Joe Quinlan & Rebecca McCaughrin, Morgan Stanley

The fall in the Hong Kong percentage of the portfolio during the quarter is entirely a function of falling share prices; not one Hong Kong stock was bought or sold during the quarter, which explains why we operate in relative tranquillity uninterrupted by brokers' calls. In general, despite the well-known difficulties of the business environment both in Hong Kong and in the-world-outside-China, underlying business profitability appears to have been steady. The outlook has not improved, overall, but for our companies it has not deteriorated to the extent of the share prices - ie Hong Kong shares have become more attractive, and we may in due course resume buying there.

Wiik & Hoeglund disappeared from the portfolio during a remarkably share price rally which appeared unconnected with the fundamentals; Thai retail investors (and market manipulators) have retained a capacity for exuberance which has recently vanished elsewhere. The United Tractors holding has gone too, with the exit rather less perfectly timed. Two new names were added to the portfolio during the quarter, and one more since, but holdings are small as yet.

Otherwise the major change was in the Malaysian holdings, as described above. These are likely to be realised during the present quarter, adding to the 10% end-Sept cash balance, giving us significant ammunition for investment. (Good ideas are therefore very welcome, although we have a number under the research microscope, and are much happier with valuations than a few months ago.) We do not hold cash as a strategic asset, taking the view that (a) market timing is impossible (probably for most people, but certainly for us); (b) valuations of our shares remain attractive in terms of earnings and dividend yields and internal cashflows relative to bank deposits and bonds; (c) our investors give us money to invest in carefully-selected Asian companies, and will look after their own cash balances. However, when considering a number of possible investment alternatives and/or awaiting opportunities to invest in illiquid companies, retaining a cash balance does not alarm us to the extent that we feel the need to invest at all costs with a temporary deployment (the merits of which might be eaten up in transaction costs).

With thanks, as always, to my co-investors.

Claire Barnes, 17 Oct 2002