Apollo Investment Management

Dangerous times
Apollo Asia Fund: the manager's report for 4Q2009

The Apollo Asia Fund's NAV rose 3.6% in the fourth quarter, to US$918.61 - up 49% for the year, and 62% from the February low, but less than 2% above the previous peak of May 2008: charts.

In the fourth quarter, the Fund experienced its first writeoffs. So much for our assertion in October that we owned resilient businesses. The only comfort to be drawn is that the two writeoffs had already been identified as (by far) the highest risks: our mistake was to consider that those risks were appropriately priced, and worth carrying, albeit in less-than-average size (the two combined represented 3.5% of end-Sept NAV).

Aero Inventory, listed on AIM and in the process of upgrading to the London main board, went suddenly into administration, with the directors suspending the whole top management team and referring the case to the Serious Fraud Office. As noted on our news pages, information flow has been sparse (fortunately journalists have continued to ask questions, and occasionally get a response, while others are stonewalled), and the LSE's only public response has been to delist the company and all online documents. Better communications, an official communications channel, and a full archive of past announcements would surely be in the public interest. (What happened, and when? What signs of trouble might have been noted and at what stage? Accountants, bankers, investors, and directors of other companies, might all be interested in learning from corporate casualties.)

We also took a full provision against CHT Holdings, a Chinese manufacturer of adhesive tape for the auto industry etc, which remains listed (in Singapore) but has now been suspended for six months. Its major US customer, Plymouth Rubber, a former supplier to the troubled Delphi Corporation, defaulted in 2008 on payments due, and the company was unable to meet debt obligations unfortunately bunched from May 2009. The company remains a going concern, and the last traded price is a mere 14% of the Sep09 book value (which is eroding, down 28% yoy), but its inability to reach a timely restructuring agreement for the syndicated loans and convertible notes, together with uncertainties over the export revenue to repay offshore liabilities, make it hard to value the equity, while the long suspension may cause further problems.

Actual turnover in the fourth quarter was limited. We trimmed or slashed four positions, in two cases mainly on a risk reappraisal, and in two others because of steep price increases; we added to one existing holding; and added one new position - so far very small, due to liquidity constraints. Portfolio turnover for the year was a low 16%.

Geographical breakdown
by listing; 31 Dec 09
% of assets
Hong Kong
Other equities
Net cash & receivables

At the end of December, the portfolio's historic EPS (based on the last full financial year to be reported) was down 20% from its peak last December (the last figure to reflect pre-crisis conditions), and we expect a further 6% decline in the current year, taking the current-year portfolio EPS estimate to 27% below its peak. About half of this 27% decline reflects the wipeout of earnings from our two writeoffs, Aero Inventory and CHT, which were among our lowest-PE holdings; the rest seems fairly representative of a tough year.

The historic PE of the portfolio at the year-end was 14.8, and the prospective for the current year 15.8: taken together these are comparable to the past highs of October 2007. As noted in the last report, our company mix currently includes some with temporarily-depressed earnings and losses (with the potential to recover, but no certainty as to timing), and some with high long-term growth potential (economic conditions permitting). The two writeoffs were the only two holdings for which the debt burden had seemed to pose a major risk (which we had wrongly decided to accept); less than a third of the portfolio is in companies with any significant borrowings at all. Despite our recent war-wounds, we still consider our company portfolio, as a whole, to be relatively resilient - and resilience is a quality to be prized.

Portfolio BVPS has risen 15% yoy. Book value used to be a useful yardstick, but its value under IFRS is limited. On an aggregate basis, we would not place much confidence in this measure. P/B is now 1.6: it has been much higher in the past, but portfolio ROE was then higher than the current 10%.

The current-year dividend yield is estimated at 3.1% after local taxes. The current-year estimate for portfolio DPS is 15% below its peak of March 2008. Since business conditions have rarely been tougher, this seems somewhat reassuring.

The regional MSCI index peaked in October 2007, lost 63% by November 2008, and had by Dec 2009 recovered 56% of those losses. This still looks consistent with a rally in a bear market, and a rally which could falter at any time. The world is in a mess, and while 'growth' headlines will be temporarily facilitated by the depressed comparative figures of 1H09, we are far from convinced that this growth will be sustained, or that Asian economies can make a swift and smooth transition from the export model. Since all of the world's fundamental problems have been papered over and compounded, rather than addressed, we fear that major turbulence will recur. So, apparently, do Asian companies, obliging as ever in accelerating the supply of new shares to meet demand.

However, an esteemed former colleague, now one of our valued brokers, believes we are in a new HK/China bull market. He reviews the psychological stages: "disbelief, resistance, acceptance, consensus, enthusiasm, momentum, naked 'n' crazy" - and considers that we are only on the cusp on a transition from consensus to enthusiasm, with the fireworks yet to come. Given derisory rates on bank deposits (1-10 basis points at many of the safer regional banks), the relative attractions of emerging markets to a host of newly-converted investors from the eyeball-indebted OECD, and the notorious zeal of new converts (cannon-fodder for the corporate issuers), he may well be right that there is much further to go. Doug Noland supports the possibility in his latest 'Credit Bubble Bulletin' entitled 'Issues 2010':

"The world is operating without a stable monetary regime. There is no gold standard. There is no functioning Bretton Woods currency stability regime. There is no longer even an ad hoc dollar reserve 'system' that tended – at least on occasion - to discipline foreign Credit systems and restrain excesses. Like never before, Credit systems around the world operate unrestrained. It is my long-held view that pricing mechanisms – and Capitalism generally – function poorly in a backdrop of unrestrained (inherently mis-priced) Credit.

"Most importantly, there is today no common understanding that stable international finance is wholly dependent upon individual Credit systems being operated with discipline and restraint. Quite the contrary, as the universal policymaking view these days is that aggressive stimulus and monetary looseness are essential for supporting financial and economic recoveries. The world is devoid of a monetary anchor and operating in a unique monetary environment that foments speculation, financial excess, imbalances, economic maladjustment, and potent bubble dynamics. As we begin 2010, inflationism is still seen as the solution instead of the problem.

"The year 2008 marked the collapse of the Wall Street/mortgage finance Bubble. It specifically did not mark the end of the Chinese Bubble, the global Credit Bubble, or even the greater U.S. Credit Bubble. Last year saw the emergence of the Global Government Finance Bubble – quite possibly a monumental development. Accordingly, 2010 should be viewed as a Bubble Year. This implies a bipolar perspective when contemplating probable outcomes: On one end, the Bubble expands and makes it through the year. Or, on the other, the Bubble bursts and financial systems and economies sink right back into crisis. As a long-time analyst of Bubbles, I caution against predicting the timing of their demise.

"Last year saw intense speculation reemerge in US and global financial markets. It is the nature of speculation to intensify as long as it is accommodated by loose financial conditions. Similarly, it is the nature of Bubbles to expand and become more robust unless inflation dynamics are quashed through some type of monetary tightening. Excess begets excess… And the more protracted – hence powerful – the Bubble the greater the degree of tightening necessary to eventually rein it in. The more heated and expansive the Bubble the greater the dislocation associated with its bursting. I see no appetite anywhere in the world this year to aggressively suppress Bubbles."

We request investors to review their own capital allocation. It may be appropriate to take some profits. Alternatively, if taking the view that Asian markets will see further prolonged strength, other managers might do better riding that wave: this Fund has often underperformed markets with strong momentum. Redemption requests will be met sympathetically. Our current cash balance is the result of recent decisions to sell individual stocks, and of indecision on the relative merits of possible additions. The portfolio earnings yield is 6.3%: unexciting, but enough to justify a move back towards fully invested.

We continue to ponder inconclusively the valuation methods appropriate to different types of businesses in different monetary environments. If any of our readers has a view on the appropriate multiples one should pay for Japanese companies and their Indian or Indonesian counterparts, we'd be keen to discuss. Another major area of uncertainty is how to respond to long-term environmental and resource risks (especially the latter, which receive much less press coverage, but both would be cause for a more comprehensive rethink of socio-economic goals). Identifying some risks is easy: minimising the number we miss would help with our first priority, avoiding permanent loss of purchasing power. Identifying winners seems harder: helpful ideas from our readers would, as ever, be appreciated.

Claire Barnes, 11 January 2010

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