The Apollo Asia Fund's NAV fell 16% in the fourth quarter, and 29% for the year, closing at US$615.94.
After observing in our last quarterly report that the Asian news for the third quarter had been benign, the climate worsened suddenly and dramatically in October. Asian exports fell precipitously, as did the revenue of many other businesses. Some orders will have been postponed due to inventory adjustments; some cancellations will have used trade finance as an excuse of convenience; but end-demand has clearly contracted in a wide range of industries, and in many cases the sustainable level of demand has yet to become clear. Trade finance remains a problem, according to recent comments by Victor Fung, who would have broad input. Whether this is because of capital constraints as the banks deleverage, or the usual cyclically indiscriminate tightening of lending criteria, credit is scarcer, and for many companies much more expensive - even as the returns on cash shrink.
Assessing sustainable demand for many industries now seems difficult. When, if ever, will global construction activity regain the levels achieved in a worldwide synchronised boom, assisted by a credit bubble, coinciding with what may have been the most construction-intensive stage of China's recovery? Thinking of the excesses of the Middle East, and of the conviction with which many individuals around the world have accumulated multiple properties "for investment" without any regard to the rental yield and maintenance costs, I would guess this will not be for many years. This may be just as well for the planet, but I am not sure how one should currently evaluate the manufacturers of steel or construction machinery. Riding out a couple of bad years against a rising global demand trend is one thing: assessing the costs of adjustment to lower demand and the profitability thereafter seems more difficult. Of more immediate interest to us are those Japanese companies with world-leading technologies and reasonable 'normal' returns, for which valuations are cyclically depressed but with identifiable limits to how far a replacement cycle can be stretched and where it may therefore be possible to estimate sustainable demand with sufficient reliability to invest with a margin of safety. My sense is that there are significant opportunities here, and suggestions would be appreciated.
At present, I am uncertain how to prioritise various different types of equity opportunity - for example the steady cashflow generators which may still command PEs in the high teens, versus capital goods makers which may be on fractions of book and less than 4 times historic earnings, but with no certainty as to when earnings, or in some cases even revenues, may resume. We have accordingly been rather cautious - probably too cautious - in making changes to the portfolio. Turning however to the characteristics of what we hold:
At the end of December, our portfolio was on an estimated current-year PE of 7.8. "Current-year" here means the next full financial year to be reported, which in many cases will have just finished - although the December quarter may bring more shocks than usual in both operating results and on balance sheet items marked to market. The current-year dividend yield is estimated at 5.4% after local taxes. Price to book (with IFRS caveats) is 1.24. Portfolio ROE is 16%; the average payout ratio is 42%.
Despite the low confidence we'd place on any forecasts for 2009, we consider the portfolio's earnings quality to be high - by which we now mean this: not likely to collapse totally, even in a very rough year, and in the long run sustainable at approximately the present level or higher. On that basis, a 13% earnings yield is enough to offer (a) good value by historical standards, (b) a good margin of safety over the derisory interest rates now available on Asian bank deposits or on US treasuries. Whether it is a a better bet than Asian corporate bonds on double-digit yields is another question; during the Asian crisis the Fund was active in distressed convertibles, but this time we have so far remained in equities. One reason is that the market for Asian corporate debt appears to have become even thinner and less transparent over the last decade. Reforming and developing the corporate bond market should be (but never is) treated across Asia as an urgent policy issue, with the multiple objectives of improving (i) corporate access to long-term funding, (ii) financial security of individuals, by offering access to reasonable interest rates at appropriate levels of risk which can be diversified, (iii) vulnerability to banking crises and cycles, (iv) efficiency of capital allocation.
| Geographical
breakdown by listing; 31 Dec 08 |
% of
assets |
| Hong Kong | 19 |
| Japan | 10 |
| Malaysia | 11 |
| Singapore | 19 |
| Thailand | 20 |
| Other equities | 10 |
| Net cash & receivables | 11 |
100 |
In the fourth quarter we added to existing holdings and bought five new names - however, four of these in only limited size, due to liquidity (the cash balance would be lower if only our recent ideas had been easier to execute). We sold the remnant of one holding where we had lost confidence in the calibre of management, at a time when management competence is crucial. There is one other holding which we would be happy to exit, if only we could, but the market price although not actionable in any worthwhile size has already been reduced to 1x historic earnings and around 10% of book value (so there is upside, if it survives, and we have not at present considered it appropriate to write down further), and it represents only 0.6% of the Fund's net asset value. That is, we are happy with all our other holdings at current values - which may sound bland, but some funds may hold a higher percentage of dead assets. We try to maintain a selling discipline (and hence have tended to cap the size of the fund, rather than diluting the less favoured positions and excessively boosting the prices of the favoured). On occasion our initial confidence is dented, but not lost, in which case we may continue to hold if warranted by the revised price/value assessment: an example from earlier in 2008 involved unwise treasury decisions outweighed by the strength of operating cashflow.
To update the breakdown we gave in September: of our securities, companies manufacturing for export, and subject to demand, FX and input cost risks, make up 26% (increased a little in 4Q, perhaps prematurely). Of this, only 2% is China-based (down), and 25% is at world-leading standards (the company sold was not, although its products were suited to its domestic market). Modern retail is 31%, split between the same five companies; we still have no independent exposure to fashion or high-street chains. Consumer finance is 9%. The China manufacturer with a potential funding problem is the 0.6% discussed in the previous paragraph: bank funding for the other companies with significant balance sheet reliance appears stable, although this will for some time remain a factor to watch. Somewhat-essential services account for 12%; other Asian consumption plays another 17%.
Despite the fall in market value of the portfolio during the year, intrinsic value (as measured by earnings, dividends, and book value) appears to have increased. Despite the evident risks, current valuations offer the possibility of compounding intrinsic value, our long term goal, at a reasonable pace. Errors are costly: a tortoise pace has caused us to miss many opportunities, but may be worthwhile if we can avoid most of the landmines.
Claire Barnes, 6 Jan 2009
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