Apollo Investment Management

The fully-invested bear
Apollo Asia Fund: the manager's report for 2Q2007

The Apollo Asia Fund's NAV rose 6.6% in the second quarter, and 22.9% over the twelve months to June, closing at a new high of US$821.99.

At the portfolio level, almost all of the gain came from rerating: the current-year PE rose 6% during the quarter to 14.1. This is not outrageous (7% earnings yield), but is the highest in the history of the fund, and not all of our holdings are large and liquid.

In fact even the large companies are not always liquid, and the last couple of days of June were interesting. A good flavour is given by a US article, 'The smell of contagion in the air'; here in Asia, I had the same feeling. We have a couple of holdings in the US$5-20bn market cap range: even in these, bids dried, and it seemed that a very small amount of determined selling would have knocked prices for six. It would surely be fanciful to imagine the collective holding of breath, with institutional investors (more aware of global market news than the date-neutral man in the street) keen to see highs maintained for the end of another month, another quarter...

... but this month we are again off to the races, with the regional index shown in our charts up 4% in the first 4 trading days. (As usual in such conditions, your fund is moving only slowly in the same direction. We like to think of Aesop's tortoise, but maybe our investors are just missing out.)

Panic can work in both directions, and there are many conservative investors who are only now reaching the conclusion that Asian equities look relatively attractive. The markets from which they are keen to diversify are large, so it is certainly possible to envisage inflows continuing for some time, and keeping up with Asia's entrepreneurial abilities to meet market demand for highly-priced securities.

Geographical breakdown
by listing; 30 Jun 07
% of assets
Hong Kong
Other equities
Net cash & receivables

I incline to the view that Pandora's box of dodgy risks cannot be marked-to- model (or marked-to-myth) for much longer, and that a tipping point may have been reached in awareness, litigation, and financial practice. Developments on this front have been mentioned on the what's new page.

Should this be correct, I would not be surprised to see savage deflation in financial assets worldwide. I believe that Asian markets will then prove as correlated as ever to those of the US, and Asian economies likewise.

However, there is a highly respectable argument that carefully-chosen equities are the best store of value in the long run. (How could I contradict Warren Buffett? although personally more enthusiastic on silver and gold.*) This depends of course on the starting valuation, and on the quality and sustainability of the earnings. I have not attempted to compile an Asian version of the Nifty Fifty, comprising the companies which I expect to fare best over the next few decades, but can think of many names for inclusion which now trade on PE multiples between 30 and 80 (based in some cases on growth expectations or earnings which may prove unsustainable, risking a double whammy). We prefer to focus on growth at a reasonable price. PE is certainly not the only important measure of value, but as it happens the highest current-year PE among our portfolio companies at end-June was 26, and we've been trimming that position as it scales new highs. This decision is easier because we currently feel we can still buy equivalent fundamentals more cheaply. (If we couldn't, it might be harder to decide how much is too much before moving to cash: 4% earnings yield plus 6% nominal growth would be enough to take expected returns into double digits - before risk, on the downside, or the possibility of much higher figures on the upside.)

There is also a respectable case to be wary of holding too much cash, not only in opportunity cost (my track record precludes any claim of ability to market-time) but in the possibilities of high or hyper-inflation (Zimbabwe may not prove to be the only textbook example of our time), of bank instability and political turmoil. Similarly, I am not convinced that an equity portfolio such as ours should in current conditions be hedged. I have no firm view on the level of cash which we should hold or may hold in future, which has tended in practice to reflect either bottom-up decisions made for stock-specific reasons, or a desired degree of flexibility, but assume that (a) the Apollo Asia Fund represents a reasonable Asian-equity portion of our investors' portfolios, and that you form your own views on asset allocation based on the fund's current profile, prospects and illiquidity; and (b) that you have invested in the Apollo Asia Fund in the hope that we can add value in the long run through share selection, and that we should continue in that attempt for as long as that possibility is not too slim.

So here we are; your constructive opinions, as ever, will be welcome.

Claire Barnes, 6 July 2007

* But heartily in agreement with the desire that auditors who insist on valuing warrants more highly than the directors should bid for them, after lengthy discussions in respect of the 2005 accounts of Phoenix Gold Fund.

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