Fun while it lasts
Apollo Asia Fund: the manager's report for 4Q2003

The Apollo Asia Fund's NAV rose 28% in the fourth quarter, and 142% for the calendar year, closing at a new high of US$428.92. In the six years since inception, it is up 8.9 times; compound growth has been 44% per annum. This performance, although enjoyable, is not sustainable. (Performance charts.)

After nine up-months in a row and a rise of this magnitude, it seems prudent to be prepared for a setback, and perhaps a sharp setback. Exuberance is back; Asian entrepreneurs and governments are pumping out securities as fast as the corporate financiers can prepare the offerings (or as fast as the regulatory bureaucrats will approve them, and the constraint is rarely prudence); US financial markets, the sliding US$, and years of excess present unprecedented dangers to the global financial system.

However, we would not expect to surrender all of the gains, because some of our highest-flying shares have already gone from the portfolio. Shipping companies were major contributors to the year's gains (it seemed reasonable to expect the group to triple over time, but everything beyond was sheer luck), and they would by now be a huge proportion of the portfolio had we not been trimming meanwhile - prematurely, as it transpires; investors would have been much better off if we had taken no action. The exposure to shipping is now quite modest (the outlook has improved dramatically, but this is increasingly well priced in). At the year-end, we had 21% in cash, on a frictional rather than strategic view.

We chose, incidentally, to limit new subscriptions, in order to maintain some selling discipline and to restrain the growth towards a more difficult portfolio size. In a bull market it is easy to dilute existing positions rather than sell them, and we are reluctant to accumulate too diversified a portfolio of lobster-pot stocks (easier to enter than to exit).

Part of the cash has been reinvested since the year end, in somewhat safer shares than those which we sold - including some stodgy but well-run utilities which we will sell when we find something more promising to buy, and which meanwhile give us net dividend yields in excess of 5%.

It is often a timing trap to seek apparent and illusory safety in such stocks, but this time round we feel that growth companies are overvalued relative to the stodgies: an absence of immediate growth attracts unwarranted contempt. The small-cap space has become more crowded than usual, and inexperienced buyers have caused considerable price volatility (mostly so far in the upward direction, which is a nuisance for us as habitual buyers). Meanwhile, some low-growth blue chips seem relatively undervalued by normal institutional parameters. There are few large businesses which are as attractive as the carefully-selected smaller ones which have done so well for us in the past, but there is a price for everything.

A sharp fall in financial markets would not surprise, and in that case cash would be ideal, but the desperation of the US and Japan to inflate makes us wary of holding too much; eventual hyperinflation is a possibility, and in that case it would be best to hold shares in sound, well-run businesses with pricing power. Asian economies are sounder and have better growth potential than most, good companies can be found within Asia, and while no longer as spectacularly cheap as in recent years, the valuations are better than elsewhere, and can still be readily justified in absolute terms.

At the year-end, the shares in our portfolio were on an average historic PE of 14.9, and an estimated 'current-year' PE of 12.4. By 'current year' we mean the next full-year figures to be reported, and these are in many cases for the year to December 2003; thus 72% of portfolio earnings are already operationally 'in the bag', although yet to be counted and reported. EPS growth of the present holdings is estimated at 20% for the 'current year' (approximating 2003). Our estimate for the year ahead is 5% - this may be conservative (and this time last year we were forecasting 10%), but the profits of nickel miners and shipping companies surged in 2003, and we are wary of extrapolating from a high base.

The dividend yield on our portfolio is estimated at 3.6% after Asian taxes, for the 'current year', and 3.8% for the year ahead, representing a payout ratio of 44%. The earnings yield, being the inverse of the PE, is 8.0% for the current year, and 8.5% looking forward. Earnings and dividend yields continue to look reasonable relative to bond yields and the present very low deposit rates, taking into account the potential for growth as well as the inherent equity risks.

The growth in 'portfolio earnings per share' has historically outpaced that of the component companies, because we can sometimes sell shares which have become relatively expensive and buy those which are relatively cheap. This may not always be possible. It is not as simple as it sounds, since we firmly believe that qualitive considerations are key, that reliance on any statistic such as PE would be fatal, and also that precision is unattainable. When we hold a company in which we have long term confidence, we tend to err on the side of patience unless the valuation becomes exorbitant in either absolute or relative terms. While we are unsure how long such outperformance will be feasible, and 2004 looks more difficult, the growth in 'portfolio earnings per share' during 2003 was 50%. The compound annual growth over 3 years has been 27%; over 5 years it has been 33%. The figures for dividend growth are similar.

At the end of 2002 we held a larger position in Thailand than in Hong Kong, and commented at the time that this seemed anomalous but resulted from bottom-up decisions. Southeast Asia then accounted for 66% of portfolio securities, more than double the 32% weighting of Hong Kong / China. The broad weightings looked rather more normal by end-03, at 54% HK-listed and 43% Southeast Asia. The intra-ASEAN balance remains volatile and is, again, stock-specific. The relatively large weighting in Indonesia, to which we would at some point apply a country-risk cap, has occurred through stock appreciation rather than by purchasing to that level.

Looking back a year, our largest single holding was Bumi Armada. This was an excellent company, from which we were forced out on a PE of 6, only to see the oil & gas sector come roaring into fashion, with Malaysian companies of lesser quality commanding multiples of four times that. Official apathy condoned this maltreatment of minority investors. The system also leads to poor capital allocation, and honestly run growth companies have been in short supply, although we must be missing some. Our present low weighting in Malaysia is not entirely coincidental.

Portfolio turnover in 2003 was a relatively high 70%, in contrast to 2002's unusually low 23%. The average of the two is in line with the 40-50% of previous years.

Thanks to Masya Spek and Mary Paterson for their analytical input, to Hue See Leng and Lyn Kam for their administrative assistance, to all contributors of ideas, and to the managers of the fine companies in which we like to invest.

We have a fortnight to go before the Year of the Monkey, characterised (according to one book in my house, written decades ago) by political squabbles, unstable governments, shaky finances, gyrating currencies, and economic chaos - 'a great test of nerve', accompanied by opportunity for survivors, with 'sound and firm management an absolute necessity'. This sounds all too plausible. Good luck to my co-investors.

Claire Barnes, 7 Jan 2004