Apollo Investment Management

Coal-fired growth
Apollo Asia Fund: the manager's report for 2Q2014

The Apollo Asia Fund's NAV rose 4.2% in the second quarter, to a new high of US$2,098.23.

Geographical breakdown
by listing; 30 Jun14
% of assets
Hong Kong
Net cash & receivables

The international backdrop remained distracting, and tensions in our region have risen significantly. China's aggressive move into Vietnam's waters, Malaysia's willingness to abandon ASEAN solidarity and kowtow, the Thai coup, the Modi landslide, a jump in pirate attacks, and a resurgence of majoritarianism, have been among the more disconcerting events of the quarter, set against a backdrop of the rapid border changes in Ukraine and Iraq, and the consequent realignments of alliances.

Oil & gas resources lie behind some of these issues. The numbers in BP's annual statistical review of world energy offer useful insights. Over the sixteen years from 1997 to 2013 (since Hong Kong handover, and approximately the life of the fund), primary energy consumption in Asia-ex-Japan has risen 2.5 times, which represents compound annual growth of 5.9% - roughly in line with real GDP growth. In China, primary energy consumption is up 3 times, and in Vietnam 4 times. Even the city states are using much more energy than they were at the start of the period: 78% more in Hong Kong, 107% more in Singapore.

With oil and gas windfalls dwindling, coal consumption has risen even more rapidly: in Asia-ex-Japan it is up 2.8 times over the sixteen year period. Usage of coal in the Philippines is up 4.4 times, in Indonesia up 6.6 times, and in Malaysia up 10.5 times. (Air pollution, recently severe, is not only due to the peat fires and the loss of trees.)

Many economic forecasters in Asia continue to extrapolate the trends of the recent past, failing to recognise the past contribution of resource windfalls which are dwindling, vanished, or overtaken by domestic consumption. Some of these trends are clearly unsustainable. If coal usage in Malaysia were to rise at its present rate for another 16 years, it would have risen 109 times since the start of the fund, and the consequences for the environment are important to contemplate. In practice it seems likely that coal will continue to increase as a proportion of the Southeast Asian energy mix; growth in energy use will moderate as costs rise and some subsidies are withdrawn; and GDP growth will be less than before.

Moreover, a higher proportion of economic activity will relate to resource extraction and the costs of environmental change (from water procurement through flood mitigation to health impacts). Anecdotally, we have also noticed a number of cases of forced investment in replacement systems due to individual unobtainable parts, without any of the productivity benefits experienced at the time of the original expenditure. Maintenance and replacement expenditure, along with debt service, may thus consume a rising percentage of income. Exports, the traditional growth driver, have faltered since the global financial crisis erupted in 2008. In several countries it now seems appropriate to focus on companies supplying the goods and services that will be prioritised if disposable income is squeezed.

Now for an administrative announcement. HSBC, the Fund's administrator, wishes us to draw the attention of our investors to the provisions on redemption in the Explanatory Memorandum, although these are unchanged since inception. The standard notice period is a full calendar quarter, to protect the fund from sudden withdrawals. (There are also provisions for pro-rata and in-specie redemption, as-yet-unused.) The fund manager has the discretion to waive or reduce the notice period, and declare additional redemption days, when this can be done without disadvantaging the ongoing investors. Thus, the redemption form has for some years invited redeeming investors to express a date preference. HSBC has asked us to inform you that we have exercised our discretion to reduce and waive notice periods in the past, and may well do so in future.

Since HSBC has asked us to write here on administrative matters, and not just to focus on investment as we would prefer, I will continue from the unchanged to an aspect in which change may be necessary. HSBC has been running multi-month backlogs on transfers, and occasionally on redemptions, as their overloaded staff attempt to apply new regulations. Our shareholders sometimes struggle to comply with the new complexity of their processes. While regulatory requirements have been increasing, we would not wish our investors to bear any unnecessary burden, and are considering changes, so would welcome views from investors with experience or insights relating to the various providers of custody and administration services in Asia.

Claire Barnes, 3 July 2014

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