The next three decades may be different
Apollo Asia Fund: the manager's report for 4Q2013

The Apollo Asia Fund's NAV rose 5.6% in the fourth quarter, to a fractional new high of US$2,003.60. Over the year it was up by 11%. Portfolio turnover in 2013 was 25%.

A recent FT article by Gillian Tett contained the curious comment that "Most of the time, investors do not ponder the nature of conventional wisdom, or their unstated assumptions; after all, nobody wants to admit they are a creature of their cognitive environment." As recommended there, it seems useful to do all three.

Investors will be familiar with the adage that the most dangerous phrase in investing is that "this time is different". When it comes to excitement over new technologies, fads, and bubbles, the sceptics are generally (in the end) proved correct. Yet today it seems appropriate to examine several potential cracks in the foundations of conventional thinking on economics and investment. I have been fortunate enough to spend my working life in Asia during a period of peace, prosperity, and globalisation, and to have witnessed tremendous growth, with a few major bear markets along the way. I am accustomed to cycles, but currently more interested in secular trends. It seems to me that the next three decades may be very different from the last three, and from the last century or so on which most investment thinking is based. A number of my assumptions have changed significantly in the last five years, with more focus on the following:

Energy

• Not just a small fraction of GDP: the enabler of all the rest.
• Steady economic growth for the world is a phenomenon of the last 250 years, coinciding with mass exploitation of fossil fuels. We have used more and more of these each year. In the 'progress' now assumed to be normal, we exaggerate the role of human ingenuity, and understate the importance of the windfall.
• Extracting more and more each year, at an affordable total cost, is becoming harder. We should focus on what we can do with less and less, but collectively have not done so.
• Energy is often a key factor in the fortunes of nations. Dwindling windfalls often lead to trouble. For many of the countries now struggling, the energy situation is relevant, but popular awareness remains curiously low.
• Many energy producing countries have rapid population growth. If more energy is required for local consumption, surpluses may dwindle and distribution tensions rise, even while production is still growing.
• Slow declines in production may cause rapid deterioration in a trade balance (the Export Land Model) and in government finances.
• Many Asian countries used to be self-sufficient in energy, but now rely on imports. More and more importers are dependent on fewer and fewer net exporters.
• Few countries have a coherent energy policy.¹ Most seem nervous of open discussion.
• "The tight oil 'revolution' has provided some short-term relief, but seems unlikely to make a significant difference in the longer term."
• The judgment above is from the latest Theme Issue of the Philosophical Transactions of the Royal Society, which provides an excellent overview of energy issues, and concludes that "adapting rapidly and peacefully to oil scarcity in a manner that does not destroy the global environment provides humanity with a formidable challenge".²

Resource limits, more broadly

• The easiest iron ore, coal, copper etc was extracted first: over time we have to dig deeper and use lower grades. This uses more energy. Similarly, to extract energy from deep ocean fields or tight formations tends to use more and more steel, copper, and other materials. The history of mankind is a history of gradual adaptation, but thought experiments with simple models of interconnected resource networks suggest that viability can deteriorate suddenly to the point of collapse. Warning signals might be limited to slower growth, diminishing affordability, poor profits, funding difficulties... not uncommon, and thus ambiguous. Real networks are too complex for the models to predict timing, but simple experiments should suffice to warn against complacency.³

Environmental damage

• Big environmental shifts once seemed likely to be noticed over generations, rather than decades. The timescales are compressing. How many of us expected such rapid loss of Arctic ice, of bee populations, or of wild fish stocks?
• The oceans are so big that many generations assumed they could absorb everything dumped therein. News of the last five years should erode such complacency.
• Abrupt climate changes are now considered possible, "within a few decades or even years", according to a new report from the National Academies of the US. We are warned to consider tipping points, and "the potential for such changes to happen faster than society or ecosystems could adapt".
• Costs of routine environmental damage are mounting fast enough that larger challenges, once on the far horizon, are from some locations now clearly visible. Meanwhile, many of us pay more for fresh water, fresh air, and remedial healthcare.
• Costs of more dramatic environmental damage are rising too. Typhoons in the Philippines may be no more frequent than before, but are causing greater disruption as the growing population has moved into areas previously considered too dangerous, with more floods and landslides due to loss of trees and topsoil.⁴

Growth

• Looking back over thirty years in Asia, the scale of landscape transformation is extraordinary.⁵ How much is too much? How many more doublings of the footprint are possible? Would more make us happier? The limits used to seem far off in a distant future. Now, not so far.
• When this fund was started, it seemed that world growth would continue, and that growth was A Good Thing. Now, indefinite economic growth seems an inappropriate goal⁶, and for the world as a whole, it seems far from clear that it will remain attainable. Possibly GDP could be decoupled from resource use, but the old model was closely correlated with the use of more and more commodities each year, and our governments continue to promote growth on the old model - more property development, more cars, more consumption. Since GDP measures economic activity, regardless of its contribution to wellbeing, it is possible that the former may grow while the latter contracts.⁷
• Personally I would prefer governments to pursue quality of life, with development goals, and some policies for a steady-state economy⁸ - but no change of course seems likely for now. We are therefore committed to the inappropriate goals, with little contingency planning in case they prove out of reach.
• Profit growth has in recent decades been boosted by steady improvements in efficiency. It is now clear that some of this was at the expense of resilience. We may need to redress the balance.
• Our current financial system has developed in a period when growth was 'normal', and rising levels of debt may have helped to defuse distributive tensions. I no longer have much confidence that current debt levels are sustainable, that the financial system is stable, or that regulators will act in a predictable manner to uphold the public good.
• For decades, Asia has been able to leverage global growth. During a period of rapid growth, investment and knowhow spread easily through Asia, and economies followed one another to prosperity like flying geese. If there is no global growth...
• Asian countries may still have more flexibility than the west, as governments have made fewer explicit unfunded promises, and the successful are less encumbered with red tape. However, many have ageing populations, rising maintenance bills, daft subsidies, high consumer debt, low trust, weak institutions and scary lobbies. In practice, few have strong leaders (and we should be careful what we wish for).

Psychology and denial

• "We... expect the combination of oil depletion and environmental constraints to have far-reaching implications... most governments and electorates remain either unaware of these implications or reluctant to face up to them."²
• The inadequate discussion of these issues baffled me for some time. It now seems to me that people are indeed reluctant to think about them, and prefer to assume they can muddle through. Contributory factors may include: 1. Awkward timescales. The situation has developed over a long period, and should perhaps have been considered before; better not to acknowledge that. It may not become critical immediately; so rather than engage a thorny issue now, why not hope it blows up on someone else's watch? 2. The new analysis may not fit into the conventional models and narratives, such as progress, growth, human ingenuity and the Ascent of Man; many feel impelled to defend the old models rather than look at new evidence. 3. Failure to follow the accepted narratives can trigger curiously hostile emotional responses. 4. Several of our major challenges are predicaments with no easy answers, no clear route to consensus, and a choice of responses which would all be unpopular. 5. The topic itself therefore makes people uncomfortable. 6. Other alarms have proved false, such as Y2K. If we ignore this issue, it may blow over. 7. As individual executives, officials, responsible parents, or fund managers, if we acknowledge such issues, we will be expected to have a coherent response. Most of us don't. Better keep quiet.

Government

• Hopes of leadership have dwindled since the 'wasted' opportunity of the 2008 financial crisis: given regulatory capture by lobby groups, the complexity of regulation, and global lock-in to complex international conventions, reform seems too difficult.⁹
• Expectations of independent thinking have dwindled too. Officials are more often expected to self-censor, to publish only along conventional lines, to duck difficult issues rather than initiate discussion, and not to highlight risks. Pockets of independence remain in academia, but threatened by funding constraints.
• I thought I was appropriately sceptical about the integrity of governments, but now realise that I was not nearly cynical enough.

Economies and sectors

• The growing cost of extraction of energy and resources, and of dealing with environmental damage, seems likely to consume a growing proportion of incomes, leaving less for other sectors. However, the investment needs of the growth sectors may make it hard to secure adequate returns even there, affecting possibilities of funding the requisite investments. Many sectors seem more risky than before; uncertainties abound.
• For example: aviation, shipping, freight, and our current passenger transport systems depend on liquid fuels. The Royal Society's editors recommend "serious efforts to restrict the overall growth in mobility and to promote the most efficient modes", consider the energy situation "unlikely to allow the majority of the world's population to achieve the levels of mobility currently enjoyed in the West", and note that "lower mobility, in turn, implies a very different direction for future economic development".
• Interconnecting everything may reduce small risks initially, while setting up the risk of bigger and less manageable failures later.¹⁰ It makes systems harder to understand, and consequences harder to foresee.
• Government finances in Western countries are a mess: opportunistic tax grabs and fines-as-income will continue.¹¹
• Confidence that Western government will follow a predictable rule-based framework has eroded. With monetary policies from Wonderland, and bail-outs and bail-ins case by case, confidence that any institution will honour its promises, or be around to do so, is now less than absolute.
• With traditional role models tarnished, it is becoming harder to persuade governments and companies elsewhere to uphold standards of governance.

Investments

• Since starting to invest in late 1997, in the wake of that year's currency turbulence, we have generally been happy to hold Asian currencies, which seemed likely to appreciate relative to western currencies. In our brave new monetary world, no fiat currency is likely to be a reliable store of value, and relative winners and losers are harder to call.
• The disappearance of risk-free real returns on deposit has turned many people into reluctant speculators, who may be unprepared for the likely volatility.
• Investment theory is based on the last hundred-plus years, during which economic growth was the norm. At some stage we will face a future without general growth, and have to reconsider expectations that all can achieve real returns on capital. Preservation of purchasing power will become significantly more challenging.
• Naturally rational investors would always have acknowledged the impossibility of infinite growth on a finite planet, but the limits seemed far enough away, beyond the few decades of our usual maximum planning horizon, far enough to be ignored in our models. This no longer seems prudent. Limits, however difficult to measure, are becoming relevant to our investment timescales.

Given the above, rational investment allocation seems more challenging than in the past. Change always presents new opportunities, but they may arise in new sectors, rather than those in which our skills have been honed. Caution as to future growth leads us to see fewer opportunities among the 'inevitables', riding predictable trends of demographics and income growth: some are priced for rates of growth that may become hard to deliver.

Valuations of Apollo Asia Fund's holdings are as high as they have ever been. Fifteen years ago, in December 1998, the current-year earnings yield of the portfolio was estimated at 16%, and the net dividend yield at 6%. Five years ago, in December 2008, the figures were 13% and 5% respectively. Both were years of crisis, which presented opportunities, and set us up for good gains. Now the earnings yield is 6% and the dividend yield 3%: still worth playing, but promising less. On a range of valuation parameters, our portfolio is now 25-30% more expensive than averaged over the last ten years. Cheaper stocks can be found, but they are often cheap for good reason. Many small companies have attracted new attention, as often happens when bull markets mature, and we treat lobster pots with caution.

All this should demonstrate that past performance is no guide to the future. Given the higher starting valuations, return expectations from here should be appropriately subdued. With business risks higher, rational investment allocation currently seems difficult. In a changing world, fresh thinking and skills may be required. Investors may wish to seek fund managers better equipped for the future: redemption requests remain welcome.

Charles Hugh Smith has provided a timely reminder that wealth is not just financial. Those of us with access to libraries and gardens should, like Cicero, count our blessings. He goes further: "What if our commoditized, financialized definition of wealth reflects a staggering poverty of culture, spirit, wisdom, practicality and common sense? What if we defined wealth more by what cannot be bought...?"

May we all enjoy our libraries and gardens¹², appreciate our privileged view of unfolding developments, and return refreshed to the world we are making.

Claire Barnes, 10 Jan 2014

•  3 Oct 13  Overcomplexity to dysfunctionality: 3Q13 report for Apollo Asia Fund
•  7 Jul 13  Ominous tremours: 2Q13 report for Apollo Asia Fund
•  6 Apr 13  Good governance is vital: 1Q13 report for Apollo Asia Fund
• 22 Jan 13  Gaps in the canopy: suggestions for HSBC's forest policy
• 16 Jan 13  Markets expensive, complacency dangerous: 4Q12 report for Apollo Asia Fund
• 12 Oct 12  Cognitive dissonance: 3Q12 report for Apollo Asia Fund
• 16 Jul 12  The imprecision of vital statistics: 2Q12 report for Apollo Asia Fund
•  4 Apr 12  Nifty valuations: 1Q12 report for Apollo Asia Fund
•  8 Jan 12  The primacy of resilience: 4Q11 report for Apollo Asia Fund
• 16 Oct 11  Not a normal cycle: 3Q11 report for Apollo Asia Fund
• 26 Jul 11  Open letter to Securities Commission Malaysia: feedback on Corporate Governance Blueprint 2011
• 22 Jul 11  Bureaucracy and overcomplexity: 2Q11 report for Apollo Asia Fund
•  8 Apr 11  World in upheaval: 1Q11 report for Apollo Asia Fund
•  8 Jan 11  Unsustainable growth: 4Q10 report for Apollo Asia Fund
•  8 Oct 10  More bull: 3Q10 report for Apollo Asia Fund
•  4 Jul 10  Real-world turbulence, market lull: 2Q10 report for Apollo Asia Fund
•  5 Apr 10  Limits to growth: 1Q10 report for Apollo Asia Fund
• 23 Mar 10  Energy for Asia: an overview
• 11 Jan 10  Dangerous times: 4Q09 report for Apollo Asia Fund
•  5 Oct 09  Vertigo again: 3Q09 report for Apollo Asia Fund
•  6 Jul 09  A major bounce: 2Q09 report for Apollo Asia Fund
•  7 Apr 09  Falling prices, long-term value: 1Q09 report for Apollo Asia Fund
•  6 Jan 09  Tortoise still crawling: 4Q08 report for Apollo Asia Fund
•  6 Oct 08  Crisis and opportunity: 3Q08 report for Apollo Asia Fund
•  7 Aug 08  Thai dividend taxation and NVDRs
• 13 Jul 08  Tectonic shifts: 2Q08 report for Apollo Asia Fund
• 10 Apr 08  The turn of the stockpicker: 1Q08 report for Apollo Asia Fund
• 11 Jan 08  More interesting times: 4Q07 report for Apollo Asia Fund
•  8 Oct 07  Complacency and euphoria: 3Q07 report for Apollo Asia Fund
•  6 Jul 07  The fully-invested bear: 2Q07 report for Apollo Asia Fund
• 13 Apr 07  The case for long holidays: 1Q07 report for Apollo Asia Fund
•  6 Jan 07  Thai-phoon battered: 4Q06 report for Apollo Asia Fund
•  6 Oct 06  Snakes and ladders: 3Q06 report for Apollo Asia Fund
•  5 Jul 06  To the top and down: 2Q06 report for Apollo Asia Fund
•  7 Apr 06  Climbing a wall of irritations: 1Q06 report for Apollo Asia Fund
•  7 Jan 06  Slower growth, relative value: 4Q05 report for Apollo Asia Fund
•  4 Oct 05  Liquidity and haze: 3Q05 report for Apollo Asia Fund
•  5 Jul 05  Calm before the storm?: 2Q05 report for Apollo Asia Fund
•  4 Apr 05  Limitations in a growing investible universe: 1Q05 report for Apollo Asia Fund
•  7 Jan 05  A time to recognise good fortune: 4Q04 report for Apollo Asia Fund
• 10 Oct 04  North-east monsoon approaching: 3Q04 report for Apollo Asia Fund
•  9 Oct 04  Accounting & disclosure issues in Asia
•  6 Jul 04  Relative calm: 2Q04 report for Apollo Asia Fund
•  4 Apr 04  Risk warnings still in force: 1Q04 report for Apollo Asia Fund
•  7 Jan 04  Fun while it lasts: 4Q03 report for Apollo Asia Fund
•  4 Oct 03  Rise extended: 3Q03 report for Apollo Asia Fund
•  4 Jul 03  Apollo in wonderland: 2Q03 report for Apollo Asia Fund
•  6 Apr 03  Turbulent times, but underlying growth continued: 1Q03 report for Apollo Asia Fund
• 10 Mar 03  Pirates attempt to seize whole Armada: pitfalls of investing in Malaysia
•  3 Jan 03  A new high & cautious optimism: 4Q02 report for Apollo Asia Fund
• 17 Oct 02  Relative resilience: 3Q02 report for Apollo Asia Fund
•  8 Jul 02  A good harbour: 2Q02 report for Apollo Asia Fund
•  4 Apr 02  Awash with liquidity: 1Q02 report for Apollo Asia Fund
•  4 Jan 02  Steady as she goes: 4Q01 report for Apollo Asia Fund
• 10 Oct 01  Resilience in adversity: 3Q01 report for Apollo Asia Fund
•  5 Jul 01  Prices more volatile, value still compelling:  2Q01 report for Apollo Asia Fund
•  3 May 01  Opportunities for selective investors in Asia:  article for the Gloom, Boom & Doom Report
• 13 Apr 01  Earnings yield 19%; some risk discounted:  1Q01 report for Apollo Asia Fund
•  5 Jan 01  High seas now evident - how we navigate:  4Q00 report for Apollo Asia Fund
• 10 Oct 00  Tidal waves forecast, two stocks revisited:  3Q00 report for Apollo Asia Fund
•  6 Jul 00  Price stagnation, sensational valuation:  2Q00 report for Apollo Asia Fund
•  9 Apr 00  A Pacific Century - if not for Cyberworks:  1Q00 report for Apollo Asia Fund
•  9 Jan 00  Excellent values for interesting times:  4Q99 report for Apollo Asia Fund
• 11 Dec 99  Angel of mercy, or falling angel? Strange happenings at Quality HealthCare
• 14 Nov 99  Apollo Asia Fund:  key terms & summary of features (updated 21 Oct 02)
• 18 Oct 99  Interesting times ahead! & hence, opportunity:  3Q99 report for the Apollo 001 Fund
• 16 Sep 99  Opacity, the Asian way?  Stock exchange responsibilities on disclosure
•  6 Sep 99  The all-way case for Asian investment
•  5 Sep 99  Our type of company - and our type of valuation. A two-stock comparison
•  5 Sep 99  UAF & Euroclear:  lessons and issues
•  4 Sep 99  More on dollar cost averaging
• 27 Jul 99  After gains, value persists:  2Q99 report for the Apollo 001 Fund
•  6 May 99  Portfolio value:  an update
• 30 Apr 99  Investment grade markets, and the imperatives of the herd
• 18 Apr 99  Value, not momentum:  extracts of 1Q99 report for the Apollo 001 Fund
•  3 Mar 99  Perfidious Thais
• 16 Jan 99  The benefits of dollar cost averaging
• 16 Jan 99  How good is the investment case for Asia now?
• 31 Dec 98  Extracts of manager's 4Q98 report for the Apollo 001 Fund
• 27 Dec 98  Nuggets on rereading my book, Asia's Investment Prophets