Apollo Investment Management

A new high & cautious optimism
Apollo Asia Fund: the manager's report for 4Q2002

The Apollo Asia Fund's NAV rose 5.3% in the fourth quarter, and 37.8% for the calendar year, closing 2002 at a new high of US$177.19. (Performance charts.)

Most of the overall NAV gain was in the first half of the year. However, the gyrations of share ratings are of less concern than the underlying performance of the businesses in which we participate, which tends to be rather steadier. Despite deep and self-reinforcing economic gloom in Hong Kong, caution about the prospects of any company exporting to the US, and dark fears of the global systemic risk, I remain comfortable with the resilience and balance of our companies. Overall, these are cash generators with strong balance sheets (clean and straightforward accounting, little debt); domestically or regionally focussed; and run by managers of integrity, competence, and common sense.

These managers are not infallible of course, although most do a better job than their auditors. We discovered during the quarter that a Big-4 accounting firm had signed off on a description of money-market fund holdings as 'cash equivalents'. Regular readers will be well aware of our paranoia about money market funds (most recent comments on 4 Dec and 22 Nov). In this particular case, the uncash was equivalent to several years' profits and a considerable percentage of market capitalisation, and turned out to be entrusted to a single offshore money market fund run by a US investment bank, now declining rapidly towards par. We hastily surveyed all other companies which we hold, and are relieved to report that this is the only such case in the portfolio. We retain the holding, for the time being, as the probability of that particular fund imploding before we persuade the managers of our view seems acceptable. We have made an internal note to discuss the pitfalls of money market funds with as many cash-rich Asian companies as possible, before the investment banks reach them in a search for new cannon fodder.

The shares in our portfolio are on an average 'current-year' PE of 7.7, falling to an estimated 7.0 for the year ahead - ie we currently expect EPS growth of about 10% from the present group of companies, although we do not set too much store on forecasts and concentrate more on understanding the characteristics, risk profile, and growth potential of the underlying businesses. By 'current-year', as always, we mean earnings for the next full year to be reported; 55% of the 'current-year' earnings are for the twelve months to December 2002, so already 'in the bag' although yet to be counted and disclosed. The average return-on-starting-equity is 19%, payout ratio is about 43%, and NAV is currently about 1.5 times book. This is an attractive group of growth businesses.

'Portfolio earnings-per-share' - which reflect not just business growth but also changes in the list of companies held by the fund - have over the last twelve months risen 14%, and 'portfolio dividends-per-share' by 15%. These rates are lower than in the past (since inception, both measures have grown by about 30% per annum) but are clearly satisfactory. Inverting the PE, the earnings yield for the year ahead is 14%, and the after-tax dividend yield over 6%; comparing these with present bond yields or deposit rates, and making allowance for both the uncertainties of equity ownership and the expenses of fund management but also for the growth potential, valuations appear attractive.

The demographic and strategic case for Asian investment has been well set out recently by CLSA. At their recent KL conference, Yuwa Hedrick-Wong of MasterCard made an excellent point about China. Whereas other Asian countries have started with labour-intensive manufacturing and climbed a ladder of value addition, with lower-value industries migrating progressively, China is highly competitive simultaneously in low-tech, medium-tech and high-tech sectors - and will remain so. Its pool of labour is so deep, especially with the relaxation of regulations on internal migration, and the infrastructure of inland provinces is improving sufficiently rapidly, that there is no immediate challenge to its super-competitive position in low-end manufacturing and assembly. The 470,000 science and engineering graduates each year, plus rapidly improving research infrastructure, augur well for the high end; major international IT & telecom companies are voting with their investments. Meanwhile, market 'normalisation' and middle-class spending power ensure growing demand for higher quality goods and services, while the availability of capital and a skilled and disciplined work force, in combination with a rapidly developing institutional infrastructure, ensures the means to supply the process and logistics-intensive middle market.

This week brought the ceremonial opening of the Maglev train service from Shanghai's new airport, which reduces the journey into town from most-of-an-hour to a mere eight minutes. Journey times from Beijing to Shanghai, and Beijing to Guangzhou have been discussed; the latter would come down to three hours. Imagine the economic impact, and the efficiency gains in a country the size of China. The cost would be huge, but China is the one country which can contemplate single infrastructural investments in the tens of billions of dollars with equanimity. Most infrastructural investments would be a better use of excess savings than buying the securities of an insolvent US government and its agencies; and China has economic planners who, on the whole, are taking pretty sensible decisions.

Thailand, in Dr Hedrik-Wong's opinion, is in an enviable position compared to much of Southeast Asia, due to its agricultural base (gradually adding more value by processing the products), relatively large market (the automobile companies are an obvious example of a new cluster with critical mass), location (with increasing land connections to China), and alternative-base attractions (many companies will have to hedge their bets rather than putting all eggs in the China basket). Add to that the tourist and cultural attractions, and a reasonably functional institutional infrastructure... we construct the portfolio bottom-up, and not by top-down analysis, let alone this sort of big-picture view, but we agree with this generally-favourable backdrop to the 70% of our portfolio which is in Greater China and Thailand.

Top ten holdings
  as at 31 Dec 2002
Bangkok Insurance
Bumi Armada
Cafe de Coral

Jusco HK

Ocean Glass
S&P Syndicate
Thai Stanley
Thoresen Thai
Geographical breakdown
  as at 31 Dec 2002
% of securities
Hong Kong-listed equities
Indonesian equities
Malaysian equities
Malaysian bonds
Singapore equities
Thai equities
Other equities

A second quarter passed without a single purchase or sale in Hong Kong, where share prices were again relatively weak, so that appreciating Thai companies now have a larger weighting in the portfolio - which does look anomalous, even though our geographical balance is a result of bottom-up stock decisions: Hong Kong has a larger universe of companies from which to choose, the business opportunities in China remain among the most interesting on the planet, and the small-cap euphoria of early 2002 has largely evaporated, along with part of the share price rerating. It's a pity about the leadership of government, the stock exchange, and the SFC, but still... at a guess, we will be focussing more on Hong Kong over the next few months, although happy with most of our Thai holdings.

The Malaysian weighting reflects the interminable red tape of the local bureaucratic process. I wrote in July that the Land & General restructuring had taken a multiple of the time we thought possible, but that we expected completion within the quarter. Here we are six months later and the partially-settled trade remains a dead weight, while awaiting approvals from various official bodies (and delivery of the November interest payment, which seems not to concern anybody but the hapless bondholders). Meanwhile the possible forced privatization of Bumi Armada is another sorry tale of delay and possible filibustering. The price is miserly and the rules unfair to minorities (see comments of 27 Sep), but if it is going to be forced upon us then let's have the money and go. We hear reports that Malaysian officials tour the world on roadshows enquiring why investors are unenthusiastic...

Portfolio turnover for the year was 23%, about half that of all past years. To some of our investors, the lower the better - an instinct I share, but in practice I think that 40-50% may be more typical, so lets examine this year's figure. In part it reflects the Malaysian frustration, which we hope is non-recurrent. The more interesting part reflects our general inaction during the rise in Hong Kong. Prices rose very steeply, and in some cases were high relative to history, but when we still considered the businesses to be worth more (on what is in effect a discounted dividend valuation), we stayed put - even when the shares were becoming over-loved and where the expectations were a setup for disappointment. Most of these shares fell back subsequently; Jusco for example halved, and Cafe de Coral fell from HK$7 to HK$5. With the benefit of hindsight, this inaction may look like incompetence; those who argued with me on individual cases at the time will be quite sure of it. But I would probably take the same decisions again, so investors in the fund should be aware of the mindset. When some shares rise steeply and alternatives of similar investment-quality remain undiscovered, the decisions may be different, but the rising tide was at the time lifting most boats, and earnings yields were still more than respectable relative to cash.

The fund has now been in existence for five years, so we are pleased to be celebrating that anniversary at a new high. We are however concerned by the lacklustre performance of the regional stockmarket indices over the same period (see charts), especially in the context of our discussions during the year on scalability. (These are ongoing, so inflows into the funds are limited - see terms.) We are quite sure that the fund's approach (succinctly described as school-of-Buffett) will always tend to achieve better long-term results than alternatives, but are unsure how rapidly the potential returns fall away with size. We have hitherto found more attractive investment opportunities among small-cap stocks than amongst the more liquid shares in which larger funds are compelled to invest. To some extent this reflects a market inefficiency which is understandable, given the commercial imperatives (or perceived imperatives) of large-scale fund management, and a discount for illiquidity - but what is of rather more concern is the possibility that there are fewer large companies in Asia which are as attractive, as businesses, as their smaller brethren (ie, before worrying about valuation). We own many small companies which have critical mass and a defensible franchise, but generate good returns on capital, retain only the capital they need, and remain extremely focussed. We are keen to identify large companies of comparable quality, as valuations can change quite rapidly - and we are very encouraged by a chart in Chris Woods' latest Greed & Fear showing how CLSA's Asia-ex-Japan universe has derated over the last few years, as this implies that its profit performance has been significantly less dismal than the regional share price charts. The PE of the CLSA universe appears to have fallen over the last two years from 20 to 12 - a period over which the PE of our companies has risen from 5.7 to 7.7. We prefer our companies, but if we cannot accept US$100m with some confidence that it can be invested as sensibly, this is interesting only in an academic sense - and to our existing investors... who, believe me, are by far our most important concern, but it would be nice to demonstrate that larger amounts can also be sensibly handled.

In this context, CLSA's data is extremely interesting, and I hope to discuss it in more detail. Meanwhile, I can spot many larger companies with attractive core businesses, and apparently attractive PEs, which do not stack up on close inspection. The 'Korea discount' is notorious, and given the track record, seems appropriate. In Singapore and Malaysia I have visited a number of companies with excellent core businesses but where retained earnings are too high and sub-optimally invested (my first draft said 'frittered') - at least from the viewpoint of minority shareholders. (In some cases in exchange-controlled Malaysia I do understand the different position of controlling shareholders.) The apparently-attractive PE must then be notionally based on adjusted earnings - the paid-out-portion plus the well-invested part of the retained earnings. For example, taking a business where the payout is a third, half of the retained earnings are sensibly applied in the core business, and the same amount is 'invested' in projects which I expect to break even on balance, the adjusted PE is 50% higher than the reported PE - and one may see a superficially attractive dividend yield with subdued growth prospects. (We are quite relaxed about subdued growth prospects, as long as the capital not required for expansion is available to the shareholders for reallocation.)

Comments on these issues, and ideas on individual companies, will remain much appreciated.

With thanks to Hue See Leng and Lyn Kam for their assistance in the administration of the fund, thanks to my fellow directors for sage advice and good-humoured tolerance over the years, a warm welcome to Masya Spek who will boost the research team, and best wishes to all co-investors for a peaceful and prosperous 2003.

Claire Barnes, 3 Jan 2003

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