Apollo Investment Management

Unsustainable growth
Apollo Asia Fund: the manager's report for 4Q2010

The Apollo Asia Fund's NAV rose 11.0% in the fourth quarter, to a new high of US$1,270.51: over the year 2010 it rose 38.3%. Charts.

Geographical breakdown
by listing; 31 Dec 10
% of assets
Hong Kong
Net cash & receivables

During the quarter, we added two new names - both in Japan, where we now have stakes in four companies - and added modestly to three of our holdings elsewhere. Valuations in Asia-ex-Japan appear rich by historic standards, and the few companies where we have been comfortable to add are very small and illiquid. We have however done relatively little trimming on valuation grounds (so our investors may wish to take their own decisions in this regard). We focussed instead on business risks, and the adequacy of incumbent management teams to tackle current challenges, which in some cases are much greater than envisaged at the time of our initial investment. We completely sold out of three holdings, and lightened our stakes in five.

At the end of December, our portfolio was on an estimated current-year PE of 14.7. By current-year, we mean the next full financial year to be reported: over half of these earnings relate to companies for which the year just ended in December. For the next year, we estimate the portfolio PE to be 13.1, reflecting 11% EPS growth; coincidentally this is about what has been achieved over the last three and five years, after the dive and recovery. The net dividend yield for the current year is estimated at 2.8%. Price to book is about 2.3; ROE is around 16%. Although the valuations may sound reasonable in relation to those cited by other managers or as market averages, these figures are at the expensive end of the range for our portfolio since inception. We have quite a few small-cap stocks, which are normally and deservedly cheaper than average.

However, we would generally consider the "quality" of our portfolio earnings to be better than market average, in that they are relatively robust recurrent earnings, from businesses which we think are braced for survival in tougher times. (We also strip out exceptional gains on stockmarket or property, which are nowadays included in reported earnings and distort comparisons of current and historic market valuations. And as noted on the performance page, we are conservative in our calculations on dilution.) Given our assessment of much greater-than-usual business risks and challenges ahead, we are even more selective than usual about the sectors and the specific businesses in which we invest.

Interest rates available from Asian banks remain negative in real terms, with rising inflation. At the end of the quarter, seven individual positions exceed 5% of NAV, and the top ten holdings account for 63%. Portfolio turnover for the year remained low, at 19%.

One pleasant surprise was the resumption of trading in CHT Holdings, after almost eighteen months of suspension. We had taken a full provision on this holding in November 2009, but the shares' recent trading has been at double the pre-suspension price. The company has now restructured its debts, taken full control of its modern subsidiary in exchange for a writeoff of US receivables, sold its older factory, and signed a new supply agreement with Delphi Automotive. Current market capitalisation represents only one year of past peak earnings/cashflows, so it could fare well from here, but we nevertheless took the opportunity to exit.

No such writeback is expected on Aero Inventory, the larger holding which we wrote off in the same month of 2009. The reports of the administrators (KPMG) suggest that the systems for inventory management were extraordinarily lacking for a business premised on this one activity. Their latest progress report says only that they "are investigating the failure of the business and will make an assessment as to whether a claim can be brought against any third parties. These investigations are ongoing..." - and nothing has been heard from the Serious Fraud Office, reported to have started formal investigation in February. Unsecured creditors are expected to receive only 1.1p in the pound, so there will clearly be nothing left for ordinary shareholders, but we remain curious as to exactly what happened.

When the time comes to write each quarterly report, I frequently start by listing all the developments which have most struck me during the quarter, and all of the issues which I consider most important. The latter list is increasingly dominated by big global issues - limits to growth, the disconnect between growth and welfare, environmental destruction, and the revenge of Gaia, to take a few which range beyond the unmended cracks in the financial system and the many vulnerabilities of stockmarkets.

None of this usually helps me to write the report, because the subjects are too big, the timetables too vague, and the implications for pricing of the Fund's securities relative to alternatives hard to determine. Yet the evidence of approaching limits, and of the ill-heeded consequences of past development, is coming closer and closer to home.

Much of the current Indonesian boom comprises the burnup of irreplaceable resources: unsustainable development without heed to externalities. And the same is true in too much of Asia. When I first came to Malaysia, jungle reserves seemed huge relative to the population and to the level of exploitation. How quickly that changes: from the air one now sees extraordinary urban sprawl, and heartbreaking devastation. It used to be a joy of life in the tropics that ugly development eyesores were quickly greened over, or even reclaimed by the jungle: now I am told that the topsoil is completely gone in many areas.

The video to the right is one which I considered mentioning on this site when it was first published, but hesitated to do so, in case my sophisticated readers thought it too simple. The power of compounding is very well understood by value investors, and bullish Asian analysts, yet not fully appreciated by all. The limits to exponential growth are well understood by another group, which includes indigenous tribes and others who are close to nature. The two groups do not necessarily overlap. Yet compound growth of financial assets may only be possible in a world experiencing economic growth. We have lived through a period when this has been unusually rapid and smooth, and arguably attributable to the discovery and exploitation of fossil fuels. This simple animation illustrates the limits to growth, and Liebig's law of the minimum. It comes to my mind repeatedly, in varying contexts, which are no longer distant and abstract - I commend it to you.

Claire Barnes, 8 Jan 2011

Previous reports:
Home Investment philosophy Fund performance Reports & articles *What's new?*
Why Apollo? Who's Claire Barnes? Fund structure Poetry & doggerel Contacts