Apollo Investment Management

Thai-phoon battered
Apollo Asia Fund: the manager's report for 4Q2006

The Apollo Asia Fund's NAV rose 9.1% in the fourth quarter, and 29.3% for the year, closing at a new high of US$740.11.

Rising tides lift all boats, and December saw the NAV rising on a tide of complacent euphoria (even though a new generation of Chindia bulls tends to bypass our holdings), until pre-Christmas reverie was rudely shattered by the Bank of Thailand's unexpected introduction of ill-conceived exchange controls, followed by reversals and extreme volatility which were exhausting to watch (even though that was all we did). The following week we were intending to take a close interest in year-end price volatility and corporate disclosures (not expecting it to be the US SEC which made the cheekiest pre-holiday announcement), but were stymied by the Asian Communications Crash caused by the Taiwanese earthquake on the second anniversary of the tsunami. The volatility may have been reduced thereby; in the event we don't seem to have missed much, and after a week of disrupted correspondence, internet access in Southeast Asia is moving back towards normal. Presumably telecommunications backup has risen sharply on the priority list of non-US finance ministers seeking sensible infrastructure investments to make a change from dollar reserves.

Geographical breakdown
  as at 31 Dec 06
% of assets
Hong Kong-listed equities
Indonesian equities
Malaysian equities
Philippine equities
Singapore equities
Thai equities
Other equities
Net cash & receivables

In the last quarterly report we expressed some enthusiasm for the new Thai government. It has made little demonstrable progress, and has gravely disappointed many former supporters in recent weeks. Dwindling confidence has caused sharp setbacks in Thai share prices after the New Year bombings, but we have at least enjoyed a few months' relief from Thaksin's assaults on checks, balances and budget. Moreover, over 60% of our Thai weighting is represented by the two shares which we believe are the best bets in modern-retail and in automobile components, sectors of strong secular growth, and we see no reason to panic about these or other Thai holdings, all small and mid-cap companies, for which business is as usual, and their shares are cheaply or reasonably priced.

It is unusual for our Thai weighting to be higher than Hong Kong's, and we would be more comfortable if we found enough good Hong Kong holdings to reverse this. We sold out of one long-standing holding, where business still appears respectable but our confidence in management was gradually dented by strange capital allocation decisions and a long period of limited success in its strategic ambitions. We gradually added to other positions but liquidity was often a limiting factor (and if it is, that affects the percentage we are willing to hold at any given confidence / valuation level). Meanwhile, the three Hong Kong holdings with plunging share prices, of which we complained in the 3Q report, have yet to show much improvement, either by way of share price or by announcements which should restore confidence: ours is dented too (so we have not been buyers), but the bad news that we know is in the price (so we have not been sellers). This may explain why brokers don't bother to call us much. Turnover of the fund in 2006 was 34%, which approximates the historic average. Cash was a single digit percentage of assets until the closing weeks of the year. Interest rates on deposit have gradually become slightly more respectable than they were, but we continue to marvel at the lack of effective access for investors like us to the Asian-currency bond markets which strategists blithely assume comparable. (If there are any readers who find them investible, please let us know.)

I am not sure whether the higher-than-usual number of setbacks in the fund this year is due to the dwindling brain cells of your fund manager or to the stage of the cycle. As evidence of the latter, we see rising competition, dwindling pricing power, and insider-sellers. There is also clear risk of the former, and redemption forms are always to hand.

Repeating information already on the performance page for the permanent record: "Our shares at end-Dec were on an estimated current-year PE of 13.7, with a net dividend yield of 3.7% after Asian taxes, and for what it is worth our most recent guess is for EPS growth of the order of 11% for the year ahead. The valuations are more expensive than for most of the period since inception, but not unreasonable, for a portfolio of good businesses with strong balance sheets in one of the stronger regions of an unbalanced and therefore unstable world. They remain prey to earnings and governance shocks, and we have had more this year than usual: by our calculations, the present group of companies have delivered no earnings growth over the last twelve months, although the reported figures might be better. (Whenever relevant, we calculate earnings dilution the old-fashioned way: I have strong reservations about the new accounting standards & believe they tend to overstate EPS - which also means that market-PE figures are not comparable with the past.) Due to changes in portfolio composition, EPS growth for the portfolio was 11% over the year, with the rest of the performance coming from rerating." I should have added that the portfolio holds many illiquid shares, and I do believe that a valuation discount for illiquidity is appropriate.

I agree with Chris Wood of CLSA on big-picture risks and appropriate personal asset allocation:

Thoughtful equity investors in Asia face, therefore, a tricky predicament. The good news is that they are invested in a long-term secular bull market for reasons which have often been explained here. But the bad news is that excesses are so extreme in terms of the ultra-low credit spreads globally that some macro shock could trigger a deflationary unwind, in terms of a sudden rise in risk aversion, which would have massive collateral impact on markets everywhere including in Asia.

If this is the risk, it is also true that this risk has been around for some time. Those who have not invested in Asia in the past four years because of this risk have missed out on a bull market and may well continue to do so. GREED & fear's practical advice continues to be to remain fully invested in the Asian secular growth story and to hedge this systemic risk with ownership of gold, which is the best hedge of all of the above mentioned risks.

I noted with interest Friday's large FT article and cartoon on the eventual necessity of a monetary role for gold - which David Watt has been arguing for years, to the benefit of investors in the Phoenix Gold Fund. When actually implemented, we may be at the top, but that is years away: serious press mention and academic discussion however seems psychologically interesting, after years of foolish scoffing at the 'barbarous relic'.

Thanks to investors, colleagues and readers, best wishes for 2007, and don't eat all the fish. Other inhabitants need them too, and I'm overdue to go diving.

Claire Barnes, 6 January 2007

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