Apollo Investment Management

Tidal waves forecast, two stocks revisited
Apollo Asia Fund: the manager's report for 3Q2000

The NAV of the Apollo Asia Fund fell 4.1% in the third quarter, so we are now down 5.6% year-to-date. NAV was US$98.09 at the end of September 2000, after all deductions. Meanwhile our companies have been doing reasonably well, so this dull performance has been caused by de-rating, and is more than explained by the dismal performance of Asian market indices and currencies, as the absolute and relative charts here will show.

The big risk in my view emanates from the US, where financial market excess has in recent years gone off the scale even by emerging market standards. Financial engineering and creative accounting have been among the notable features of the last years of this extraordinary bull market. The Microsoft story mentioned today is just one amongst a number of indicators that a precarious edifice is beginning to crumble. The zaitech content of earnings will not be news to those who read the sceptics' publications regularly recommended here, such as Fred Hickey's High-Tech Strategist, Bill Fleckenstein's daily column, and prudentbear.com, but in the past most US analysts and market commentators glossed over such details. Now newspapers are beginning to run more and more such stories, as fear begins to triumph over greed, and in Bill's expression people start to "join the dots". The general complacency about equities is only just beginning to be dented in the US. Richard Russell has been looking and listening for the phrase "bear market", still very rarely mentioned in the media. The main US indices have fallen surprisingly little, given the carnage in an ever-growing number of US stocks. Newsflow and psychology now appear to be developing ominously - prudentbear wrote last week that the music is building up dramatically, as if a trapdoor is about to give way with a climactic curtain fall for the end of the act. Others believe that the market is now oversold and due for a rally. Both could be correct, but as regards the US market, and the knock-on consequences, I'm personally in the nervous camp.

A hard landing or crash landing in the US would be unlikely to inspire Mr Market to bid up the quoted price of our shares in the short term, even though in Asia he is more used to roller-coaster cycles than his American cousins, some of whom are too young to have experienced a bear market. However, the Apollo Asia Fund is in the unusual position, compared to most institutional investors, of being able to take a long view based on fundamental value - not on guesswork as to what other punters may be prepared to pay in the next few months. Our companies are underpinned by relatively solid earnings and cashflows, assets and dividends, and the relationship of these to current prices is so many multiples better than cash in the bank (or investment property, straight or index-linked bonds, or other asset classes I can think of) that even your wary fund manager considers the long-term risk-reward ratio highly attractive. Moreover, while general market declines are often indiscriminate in the short term, a flight to quality can result in absolute performance. The S&P utilities index is up 48% year-to-date, and the dividend yield on these companies is good only by US standards (2.9% according to Bloomberg, and even that is probably before tax). On the AAF's ordinary shares, the after-tax dividend yield is now estimated at 7.8%,and the current year earnings yield at 17.4%.

Just over a year ago, I wrote about two companies with strong ROE's and track records but very different valuations. It now seems appropriate to revisit those companies and reassess the comparison.

Venture Manufacturing at the time of our last note (based on closing prices of Friday 3 Sept 1999) was S$15.90. I noted that my caution had already proved premature, but the shares then doubled again, peaking at S$32.00 in February before plunging earthwards again to the present $14.40. Cafe de Coral by contrast started at HK$3.80 and rose only 3% before falling back to the present HK$3.00. However, the prices need to be adjusted for the dividends during the period: Venture has paid out a total of S$0.04, tax-exempt for the moment due to "pioneer status"; Cafe de Coral has gone ex two final dividends and one interim totalling HK$0.269, untaxed because Hong Kong has an investor-friendly tax regime. This leaves little to choose between the two performances to date, and adjusting for the unforeseen weakness of the Singapore dollar brings them neck and neck.

Venture exceeded expectations for 1999 earnings, so its historic PE has come down from 54  when we last wrote (and obviously much more at the peak) to 39. Price to book has come down from more than ten, when we last wrote, to a little over seven. The prospective dividend yield remains unchanged - like the absolute payout - at 0.3%. Broker forecasts still indicate strong growth, with a forward PE of 31. However, there is a lot which could go wrong, transparency is poor, and even the historic numbers indicate some cause for concern. Trading profits (before non-operating income and FX gains) fell year-on-year in the first half, net profit margins have fallen for the last three six-month periods, inventory ratios have been rising over the same time frame, and free cashflow has shown no uptrend over the last four years. The price is almost 80 times a 4-year average of free cashflow, and it is not clear how much if any of the expenditure for expansion is discretionary. After looking at these numbers we can also factor in intangible worries about how the probable disappointments in global PC and handphone sales, probable over-capacity in recently high-growth industries, and possible knock-on effects on business and consumer spending, may begin to impact the future prospects. We should also remember that the company's historic ability to issue shares at high multiples of book has contributed some of the past EPS growth. I have asked for a meeting next week, and would be very interested to hear the thoughts of Venture's management on the present business environment. Meanwhile I am unconvinced that the shares are attractive, notwithstanding broker representations that they are cheap after falling so far, or by reference to other securities.

Cafe de Coral meanwhile lived up to expectations for the year to March 2000, so after EPS growth and a price decline the PE has fallen from 12 to 7.5 historic and from "under 10" to 6.4 prospective. The price-to-book has fallen from 2.3 to 1.6, and the prospective dividend yield has risen from 4.4% to 6.6%. Growth prospects meanwhile have brightened. The consensus is again very positive on China; Guangdong province is the fastest growing area therein, and we would assume that in the medium to long term, as living standards converge, this "immediate backyard" offers Cafe de Coral the chance to clone its existing operations in a market ten times the size of Hong Kong, before thinking about other more alien parts of the country. The relatively new businesses of school lunchboxes, institutional catering and food processing are growing strongly, and tough business conditions coupled with frequent health scares play to the strengths of a good operator and enable it to grow by acquisition. This has all been profoundly unexciting to the TMT-crazed investor, and the news pages devoted to Cafe de Coral on Bloomberg over the last year number only one-fifth those for Venture - even though a quarter of Cafe de Coral's are the obligatory daily announcements to the stock exchange about share buybacks.

Meanwhile, an unexpected opportunity has arisen. The breakup of a distressed North American conglomerate caused Cafe de Coral to be invited in as manager, and while details remain scanty, it will have 48% of a chain with about the same number of outlets as its entire present operation for an equity outlay of US$3m. This LBO - leveraged for our player, at least - highlights the high barrier to entry in this down-to-earth business: greater perhaps than in the ostensibly-more-daunting business of contract-manufacturing electronic components. A Chinese fast food operation is very much more complicated than a hamburger or fried-chicken operation, and while many an immigrant will start a restaurant or two for lack of other options (hence in part the lack of "investment chic"?), very few companies have the expertise and discipline (dull!) to manage a chain of any scale. Certainly the scale and geographic spread cause one to gulp at the management challenge, and at the temporary diversion of effort from the Asian markets where one had previously assumed the growth opportunities to lie, but while equity accounting would show up a share of any losses, the available financial details already show that Cafe de Coral has secured substantial upside (both in profits, and in future businesss opportunities should it prove successful) in exchange for minimal financial downside, the temporary diversion of management effort, and some risk to morale.

It now probably goes without saying that we stick with, and strongly reaffirm, our preference of a year ago. Investor obsession with the "new economy" has led to extreme over-valuation in that sector and extraordinary neglect (indeed contempt) of "old economy" companies, even those which are of high integrity and earnings quality, and very cash-generative. (I have heard the latter quality spat out as an insult, which to me suggested some foolishness on the part of the speaker).

The increase in intrinsic value to the investor may fairly be measured by adding after-tax dividends to the increase in net tangible assets per share, assuming one is happy with accounting policies. Over the last twelve months of reported results this increase represents 3% of Venture's present share price, and 13% of Cafe de Coral's. (This should not be construed as a comment on the relative quality of business or management; it is mainly a function of the respective share prices.) We also have greater confidence in the direction and growth prospects for CdeC going forward.

Our comments on Venture Manufacturing have some implications for our only two electronics-sector manufacturers, Varitronix and Kingboard Copper Foil (which together now represent 7% of NAV - we cannot see anything else in the portfolio which can be construed as TMT). We consider both of these cheaper and more attractive, but welcome feedback and argument in relation to these - as to any of our holdings, but both the risks and the potential rewards appear here to be relatively high. Our top ten holdings are mentioned below: others worth mentioning are BAT Indonesia, United Tractors, and Jusco (HK). It is conventional after a decline in NAV (modest to date, but it may yet look worse) to thank investors for their patience and understanding. I hope that in our case I have given enough information for this to be mixed with some excitement as to the opportunities.
Geographical breakdown % of  securities  
Hong Kong 38  
Indonesia 4  
Malaysia 16  
Singapore 7  
Thailand 12  
Bonds & other  20  
Net cash     3  
  Top ten equity holdings (>3%)
  Aeon Credit (HK)
  Bumi Armada
  Cafe de Coral
  China Hong Kong Photo
  Land & General bond
  MBK Properties
  Singapore Bus
Wiik & Hoeglund

Claire Barnes, 10 Oct 2000

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