Apollo Investment Management 

Value, not momentum
Apollo 001 Fund:  extracts from the manager's 1Q99 report

The fund lost 7% in the first quarter of 1999, although it has clawed back these losses in the first half of April; as of 16th April the NAV is unchanged for the year to date. Had we abjured stock-picking and bought the market leaders, we would have done much better: the most relevant MSCI index (the all-market Far-East-ex-Japan) was up 10% in the first quarter.

However, the fund's objective is to achieve long-term absolute returns, and as the largest investor I am personally very comfortable with the high quality of the businesses in which we own shares, their long-term business prospects, and their very attractive valuations.

Ordinary shares comprise 84% of securities held, as of 16th April, and their estimated PE for the current year is 6.0, falling to 5.0 one year out. Some of our companies recently reported significant exceptional profits (13-15% of market capitalisation), and these have been stripped out of the PE calculations, which are based on recurrent earnings only - ignoring the tendency in some companies for exceptional profits on a recurrent basis, for example due to the conservative statement of assets. By "current year", I mean the next to report: one result is still to come in for Dec 98, and one for Jan 99, with other year-ends spread fairly evenly between March, June and December 99. The forecast current-year dividends on the ordinary shares give an average yield of 7.0% after-tax. (Most brokers quote dividends on a gross basis, presumably because this sounds better.) The aggregate price-to-historic book, for what it is worth, is 78%.

More importantly, the market valuations are in many cases a fraction of what one would pay in a trade sale, or of replacement cost (for assets which yes, one would wish to replace). One of our shares is up 36% since December, but is still capitalised at less than its net current assets alone; for this company the prospective PE is 5 and the net dividend yield is in double digits. Long term growth prospects are outstanding, however, and best of all they can be achieved while the company continues to generate significant free cash flow and return this to shareholders through both dividends and share buybacks.

Such old-fashioned management integrity and shareholder rewards are of course deeply unfashionable, and contrast starkly with the US technology companies which make most of their profits from financial engineering (eg writing put options to gamble on the non-decline of their own inflated share prices - Intel), have never paid a dividend (Microsoft), and buy back their own stocks at extraordinary multiples of book value, inflated "earnings", and sales - but somehow the share capital never shrinks very much, because of all the employee options (Dell). I share an office with David Crichton-Watt; we dinosaurs share a conviction that all pyramid schemes eventually collapse, that litigation will be the boom industry of the turn in the millenium, and that real businesses generating real cash for shareholders are a safer home for investment.

Results reported by our companies have been in line with expectations - here we mean our long-term expectations at the time of purchase, avoiding the US game of analyst "guidance" and the management of expectations. One of the most important common factors is that our companies remain focussed on their core businesses. We buy only companies where we trust the management: so far this year there have been no major dents to such trust, and several positive surprises to reinforce our confidence at the company level.

Would that we could be so positive about the governments. Singapore's recent performance remains almost flawless, and China's restructuring efforts deserve better recognition, but Hong Kong's government has not been at its backseat best. Meanwhile, Malaysia's disrespect for the law (as seen, for example, in the confiscation of the shares formerly traded in Singapore) and its unstable policy environment as regards taxation, repatriation, trading and basic rights of ownership have in our view made it too risky for further portfolio investment at present. Meanwhile the Bank of Thailand continues to treat the bondholders of Union Asia Finance with contempt (see 3 March feature, "Perfidious Thais"), and so far to get away with this scot-free. We are still optimistic that the UAF bonds should be worth significantly more than their present valuation of 9 cents in the dollar. Even on the confiscatory terms offered by the authorities in January, yield to maturity would be 23% from this level, effectively in baht - but the terms should be improved and the documentation completed, enabling the intrinsic value to be realised. We are discussing action with other bondholders to expedite this process.

Going back to the overall parameters: our valuation calculations above excluded the UAF convertible, now in default. They also exclude warrants, a closed end fund, and one straight bond, on which I would like to elaborate.

The warrants (now 4.3% of the portfolio) were purchased at very modest premia when 5-6 times geared. This provided a way of participating in the upside while limiting downside - ie they were purchased in risk-limiting rather than leveraged quantities, on companies which we believed suitable for our core portfolios. One of these warrants, on Quality Healthcare, has risen more than threefold since purchase, reducing the gearing to only two, but the premium remains modest as the underlying share has also moved up, due to major progress towards the company's goal of being the leading integrated healthcare company in Hong Kong. I mention this company because I would like to avoid the impression that the fund invests only in "cheap" stocks - that we are inveterate Graham-and-Dodderers, to borrow Alan Abelson's expression. I believe that Quality Healthcare has the potential to be very profitable, although it is at a formative stage and a leap of faith is required. The book value is next to nothing, and the company has yet to pay a dividend. My guess for current-year earnings would put the ordinary shares on a prospective PE of 16, but I shall not be unduly disappointed if the short-term profits fall short, provided the management continues to move sensibly to maximise its emerging strategic franchise and develop an earnings base which is sustainable for the long term.

The closed end fund (0.5% of portfolio) stands at a 45% discount to NAV (over 50% adjusted for cash), and will vote on opening at end-99. We tried to buy more at lower levels but could not find stock to buy, so the position remains very small.

The straight bond (7% of portfolio) yields 44% in US$ to maturity and has a 19% running yield, at the present valuation. I believe the default risk to be low. This is an example where we do claim that the market is wrong - we just don't think there are many fund managers watching the particular segment. Those few passers-by who notice the $100 bill lying on the ground, to adapt the economics professor's analogy, may assume that it is booby-trapped, would require some expertise to form a judgment, and consider their time too valuable to stop and investigate.

The after-tax dividend / interest payment estimate for the current year on all securities (including the warrants and the defaulted bond, which generate no short term income) is 7.3%.

As before, I am refraining from giving too many specific stock names here, as many of our shares are illiquid and we may wish to buy more - but I am always happy to discuss the company selections in detail on a personal basis. 

Claire Barnes, 18 April 1999

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