Apollo Investment Management

Crisis and opportunity
Apollo Asia Fund: the manager's report for 3Q2008

The Apollo Asia Fund's NAV fell 15.2% in the third quarter, closing at US$733.65. At the end of September, it was down 15.7% year-to-date, and 16.6% year-on-year.

After extraordinary turmoil in financial markets, and the worst local market declines since the Asian crisis, it is interesting to look back three months and notice that newsflow in East and Southeast Asia has been relatively benign. China's melamine scandal was perhaps the biggest negative story. The second quarter saw extraordinary natural disasters and a huge inflation shock: the third quarter brought the success of the Beijing Olympics, and saw food and fuel prices subside.

Asia is more export-dependent than ever before, and can therefore be expected to suffer from the slowdown in global demand now clearly under way; declining confidence has affected property markets; and corporate earnings will suffer from a reversal of any property and stockmarket gains which boosted recent years. For the Fund's holdings, however, such exceptional gains have been relatively unimportant, and in any case we strip them out of our figures in an attempt to focus on underlying business trends. Overall, our estimate of current-year portfolio earnings has (rightly or wrongly) risen during the last quarter. This is largely due to rebalancing, as we add to holdings in the companies where valuations are most attractive, and occasionally sell or trim the relatively expensive; however, earnings surprises have for once been positive. We place no great reliance on forecasts, in a time of such turbulence, but for now the NAV decline appears to reflect multiple compression.

At the end of September, our portfolio was on an estimated current-year PE of 9.6 ("current-year" here meaning the next full financial year to be reported, including one company still to report for the year which ended in June, and many which use a calendar year). The current-year dividend yield is estimated at 4.4% after local taxes. Price to book (less useful than before, now that some countries have adopted International Financial Reporting Standards) is 1.6. Portfolio ROE is 17%; the average payout ratio is 42%. Over the last three years, estimated current-year portfolio earnings have risen by 16% per annum; for the little it is worth, our current estimates still suggest growth for the year ahead.

Geographical breakdown
by listing; 30 Sep 08
% of assets
Hong Kong
Other equities
Net cash & receivables

The fund's cash level rose in September, as we accepted offers for two holdings: Unisteel, discussed in the 2Q report, and Holcim Philippines. The latter was a tender offer, which in normal times we would probably not have accepted: on our estimates it was on 17 times current-year earnings, a NOCF yield of 11%, and a net dividend yield of 6%, at a relatively early stage of an upswing after years of depressed spending on construction and infrastructure. However, there was a danger that other acceptances might lead to a very small free float, total illiquidity, and margin compression to a PE (judging by Philippine comparables) of the order of 4. This might not have deterred us, if the company had historically shown consideration for its minority shareholders, but it has done so only when forced. It stalled for three and a half years after receiving an SEC order (on 14 February 2005) to extend a general offer at the highest price paid while acquiring control, until forced to do so by a decision of the Supreme Court, and then delayed the 2007 dividend to reduce its effective price. We will take this attitude into consideration when valuing Holcim group entities elsewhere; meanwhile, market conditions make it easier to reinvest our cash into propositions of at least comparable attractions.

Of our securities (rather than the total portfolio), companies manufacturing for export, and subject to demand, FX and input cost risks, make up 24%. Of this, only 4% is China-based, and 21% is at world-leading standards. Modern retail is 33%, split between five companies, and comprises supermarkets, hypermarkets, general merchandise and convenience stores across East and SouthEast Asia, with no independent exposure to fashion or high-street chains. Demographic and urbanisation trends and shifting spending patterns remain highly supportive of modern retail, and these companies have long-run pricing power and supplier-funding. Consumer finance is 8%: these are non-banks, lending small sums to low-income groups, with excellent management focus and tight credit control; again the demographics and gradual access to new markets are highly supportive. Including these companies, 16% of the portfolio has a critical dependence on bank funding which seems likely to remain readily forthcoming; only 2% (one China manufacturer) has a potential funding problem, and its management says they will lock in a refinancing soon. Essential (to at least some degree) domestic services account for another 13%.

We added a small position in one new company, and slightly trimmed one of our most expensive defensive holdings, but otherwise spent most of the quarter adding to existing positions, while pondering the relative merits of a steadily growing number of new names - including large-caps. Many of our existing holdings were never favourites of leveraged investors; some of those which were have fallen more sharply, and forced sellers can provide the liquidity which is often lacking.

With the majority of Topix stocks trading below book value, Japan is an attractive hunting ground, and the capitulation of many who were bullish and disappointed appears to follow valuation compression rather than a significant deterioration in fundamentals. After nearly two decades of retrenchment and restructuring, Japanese balance sheets are in good shape, and many companies are lean and focussed. Corporate governance attitudes may be different from those in the US, but not necessarily worse.

Simon Ogus of the valuably-independent DSG Asia, while far from optimistic about global conditions, is relatively relaxed about Asia, although noting that the extent of deleveraging has often been overstated, and that non-financial corporate debt to GDP remains higher than in the US. He notes that "once things stop getting worse, Asia should still be able to generate 8-10% nominal GDP growth, and in such circumstances, cash-rich companies should in turn be able to produce decent top-line growth."

We have no idea what the short term will bring: valuations can certainly go lower, and have done so in Asia within the last decade. There is yet to be blood on the streets of a financial centre, although the outgoing US administration is rolling geopolitical dice with reckless abandon. But an earnings yield of 10% on sound Asian businesses seems a good margin of safety, for those who do not chase momentum but prefer to take calculated risks - and for those who would rather not have 100% cash, when safe interest rates are negligible and OECD governments will be doing their best to inflate debt away.

Input from our investors, especially on purchase candidates, will as ever be much appreciated.

Claire Barnes, 6 Oct 2008

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