The performance of the Floreat Fund since the end of 1995 can only be described as "disastrous". The disaster has been all the more difficult to swallow because the markets, with one or two painful exceptions, have largely performed as I had anticipated. So how do I explain that the Floreat NAV is today 75% below its high? (A high at which, incidentally, I confidently subscribed US$5 million.)

What went wrong ?

My stubborn conviction that gold is more than a relic of the past, and even my hopeless timing on short sales in Thailand, Malaysia and the semiconductor manufacturers, or the tragic stop-loss in the Hang Seng Futures short position cannot explain a loss of such magnitude. Alas, the real villains of the piece have been the value stocks! Since early 1994, when I became convinced that Asian markets had no where to go but down, I adopted the strategy of holding long positions in small developing companies which were not owned by the mutual funds and which would not, therefore, be subjected to forced selling, while holding short positions in the expensive companies held by every fund manager with an Asian brief. Throughout 1994, 95 and 96, the short positions continued to lose money until, alas, I cut my losses and reduced the short positions to insignificant levels. Although these losses were minor, they were enough to induce redemptions in the Floreat Fund, which forced me to sell the small companies from my long positions. My strategy was effectively working in reverse for I found myself the forced seller of stocks where there were virtually no bids at all. In some instances buyers could not be found even at 50% of the last traded price and I was obliged to sell stocks down to levels where substantial buyers showed themselves. When the dust settled, as it seems to have done, Floreat was faced with different problems:  whether to seek new subscriptions and restore a better balance to what has become a very concentrated portfolio, or to refuse new subscriptions in the belief that many of the holdings are quite likely to rebound on volume as slim as that on which they fell. As I am now the beneficial owner of more than 50% of the units and more intent on repairing capital than on income, I am refusing further subscriptions for the time being.

Outstanding value in our remaining holdings

To enable you to form your own judgement on this strategy, perhaps it will be worthwhile describing a few of the stocks which contributed the most to our losses and where I expect a strong recovery.

• Anzoil NL: this is an Australian company which acquired a Soviet-era oil and gas concession at Haiphong in Vietnam. We purchased our shares at the relaunch of the company, at an adjusted price of A$0.60. The shares rose more than sixfold to over A$4.00 when the company successfully delineated a gas field of 1 trillion cubic feet and had good oil shows in another field. However, the drilling caused considerable formation damage as a result of the extreme temperature and pressure encountered at depth, requiring additional funding. This coincided with dwindling investor confidence in the concept of Vietnam as the next tiger economy, and the company's only recourse was to bring in an industry partner. A French group invested US$16m for a 25% interest in the concession, but not before Anzoil shares had sunk to A$0.18. The farm-in effectively valued Anzoil shares at A$2.00 but, after a brief rally on the announcement to A$0.30, the shares settled back to A$0.17 where they now languish. It is a reasonable assumption that, if the present drilling overcomes the problems of formation damage and the gas flows properly, either this industry partner or another will wish to acquire the 75% of the concession held by Anzoil, and be willing to bid a higher price than the A$2.00 valuation accorded it prior to the present drilling.
• Asian Hotels Corporation: this Sri Lankan hotel and property development stock, like the country where it is located, has always impressed with its potential but has yet to deliver. For the last eighteen months the stock has been depressed by the fact that the company has been embroiled in a prolonged and very expensive arbitration with the Indian group which has a long term management contract for the company's flagship hotel. Although the group remains profitable, the arbitration has led to substantial legal costs and has absorbed an enormous amount of management time. The shares presently trade at 30% of book value and 20% of replacement cost. Results are expected to improve dramatically if the award is in favour of the owners and the Oberoi management can be ousted.
• Medical Corp of Australasia: this Australian listed company owns controlling interests in a pharmaceutical manufacturing company in China and a hospital in Hanoi. It also has developed several medical devices, one of which recently attracted bids of as much as US$20million for the patents. Since the IPO at A$0.30, the stock has collapsed to A$0.06, where the market capitalisation is US$3.5m. The group has no debt, so trade buyers are prepared to pay, for one asset, six times the price at which the market values the whole company.
• Vietnam Industrial Investments: this is another Australian listed company with operations in Vietnam. It owns controlling interests in a steel rolling mill making reinforcing bars for the construction industry, a manufacturer of roof trusses and beams, and a third plant producing wire mesh. We participated in this company at the start-up stage, but 20% of our holding was escrowed for a year at the time of the IPO. We were able to sell most of our holding quite profitably while Vietnam was popular, but buyers had evaporated by the time the remaining 20% was released from escrow. From a high of over A$0.40, the shares now languish at A$0.06, which is 25% of book value. The company remains profitable, earning more than A$0.02 per share in 1998 despite a cyclically difficult year.

Although these investments would be considered undervalued by most traditional yardsticks, they are small companies and, as such, may not find favour immediately in the stockmarkets. I am not content to sit and wait for a revaluation but, usually in conjunction with the majority shareholder, am seeking industry investors who will acquire the company or its assets at a price closer to book value.

It had never been my intention to hold a portfolio of small illiquid stocks at a time when I anticipated that the markets would be in decline. I have been in Asia long enough to know just how volumes can evaporate during downturns. However, at the time I made the investments Floreat was a $70million fund and each of these investments, except Asian Hotels, constituted less than 2% of the Fund. During the wave of redemptions, I perhaps showed too much compassion to those exiting, and not enough to those, like myself, who were remaining with the ship. I should certainly not have allowed liquidity to be reduced to the extent that I did, for it hampered my ability to maintain the large short position in Hong Kong which should have been so profitable.

Back to the future

However, this is all water under the bridge and it is more important that the way forward is clear. My primary task is to try to restore proper valuations to the stocks we hold. As soon as this can be achieved, I will reopen the fund to subscriptions, because I strongly believe that many of the Asian markets have seen the worst. Although, for most Asian economies, it is going to be a long struggle up the other side of the valley, with a few rockslides to contend with on the way, there are now some stocks offering outstanding value. There will certainly be other opportunities as companies restructure and begin to focus on shareholder value.

I share the sentiment of most value investors that the excesses of Wall Street are likely to end very badly. Indeed, it is not difficult to imagine the present virtuous circle rolling over into a vicious one where a steep fall in share prices leads to a sharp downturn in consumer spending, GDP and government revenue. Corporations have again increased their indebtedness to levels most unsuitable for a period of reduced consumer spending and margin squeeze. Nonetheless, the US economy has done a magnificent job as buyer of last resort, enabling the Asian exporting economies to rebuild their reserves and restore stability to their banking systems. The Japanese have had their heads in the sand for almost a decade now, but finally seem to have realised that this attitude leaves them prone to being kicked in the rear. There are signs that long-overdue restructuring is becoming fashionable in Japan: it is quite possible, and certainly desirable, that this economy can start to take up some of the slack left by a less robust US. This in turn will enable the Asian economies to continue their recoveries without further help from America.

Floreat has certainly not been an appropriate name for your fund during the last two years and for this I apologise. The horrible truth of allowing one's portfolio to decline by 75% is that one has to increase it by 300% simply to regain lost ground! This is difficult, but in Asia it has been possible before, I have achieved it personally before, and I will certainly be trying to achieve it again.