Apollo Investment Management 

After some gains, value persists
Apollo 001 Fund:  the manager's 2Q99 report

After falling by 7% in the first quarter of the calendar year, the net asset value rose 62% in the second. The combined gain for the first half of calendar 1999 was just over 50% before fees, taking the NAV to US$19.75.

Values continued to surge in the first few weeks of July, but as of the close on 26 July the fund's NAV had fallen back to US$19.55. Panic is back, and a very convenient environment it is too for level-headed bargain-hunting. The rest of my comments will be based on the latest data, as of 26 July - I cannot see any reason to give you information which is less than current just for the sake of administrative tidiness, particularly since I have new information (from results and visits) on companies representing large proportions of our portfolio.

First the updated NAV chart, as of 26 July:

Roller coaster rides are the norm in financial markets, and investors should be prepared for major setbacks, as this chart will remind. The prospects of rising US interest rates and a setback in US financial markets are currently causing nervousness in Asian markets, as well they should; inevitably that bubble will eventually burst, and the possible repercussions for global financial markets and for Asian exporters are indeed frightening to contemplate. This is, I believe, the major risk to your fund's short term valuation, but I have learnt by experience both the unpredictability of market triggers and the near-impossibility of market timing.

Portfolio value, and elements of the philosophy

Asian markets had again become extremely frothy, but it has remained possible to find outstanding individual investments, and I personally remain comfortable investing new money in our portfolio. The prospective PE for the current financial year is 7.6; investors may prefer to think in terms of the inverse, the earnings yield, which is 13.2%. The after-tax dividend yield on our ordinary share portfolio is expected to be 7.6%, both this year and next - actually there will be some growth in the underlying dividends declared, but this will be disguised by the one-year tax break on 1999 profits and dividends of Malaysian companies. These numbers are based on sustainable dividends; some of our companies have declared special dividends in the last eighteen months, and may do so in future, as several of our holdings are characterised by remarkable cash generation.

I must stress again that the investments we seek to make are in quality companies, with good growth prospects, and management of integrity - and we then like to make such investments at a reasonable price, considered as if one were buying a private company. This implies looking well beyond the headline reported figures, and we do not buy companies solely on the basis of "cheap" ratings. Nor, conversely, would we necessarily be deterred by the absence of short-term earnings; we are however very reluctant to overpay for fashionable names. This directs us to hunt in two categories: amongst the unfashionable (we are happy to be contrarian, but not for the sake of it), and amongst lesser-known companies.

Everywhere in the world, it seems, small companies are much more lowly rated than medium companies, which are more lowly rated than big companies. This does not necessarily make the share prices any safer in a downturn, although the modern-day equivalents of the Nifty Fifty evidently have tremendous downside, but the "intrinsic value" one can buy with each dollar is very different. We try to choose businesses which are robust and cash-generative, and which can withstand a wide range of business conditions. Many of our companies came through the Asian financial turmoil of the last two years with flying colours, with their businesses little-dented or enhanced, but this stability in their "intrinsic values" was in marked contrast to the gyrations of share prices. We try to spend our time assessing trends in the intrinsic value of our holdings and target companies, while watching for opportunities which may arise when market prices deviate substantially. There will be nothing new here to readers of the US investment classics, who will spot the influence of Graham, Fisher, and Buffett; I find it astonishing how the investment principles of the latter are ignored by an adoring public and self-serving financiers, and try to adopt the investment approach rather than just borrowing (or twisting) the words.

Incidentally, I regard "intrinsic value" as a qualitative concept with numbers attached and prevailing interest rates compared:  a more quantitative approach sounds fine conceptually, but tends to become nonsensical when applied. (Maybe I have the germ of a Barnes Law here, the Uncertainty Principle of financial markets. Following on:  the higher the paper qualifications of the analyst... I shall think about this further.)

Back to small companies, as our portfolio is currently concentrated therein. I do not contend that small companies are necessarily an attractive asset class; especially in Asia, this is probably incorrect. However, they offer an attractive field for stock-picking, because they are less well covered. Given the present magnitude of the valuation differentials, several other attractions are worth noting:

Generally, companies which set out to take advantage of this financial alchemy come unstuck in the end, and we prefer companies which concentrate on more mundane activity, specifically their core business. However, we find that an awareness of the possibilities helps to save one from unpleasant derating surprises, and to spot solid shares with a possible rerating windfall.

While our holdings tend more to "predictable compounders" than to "whizzo growth", a habit of taking profits on those which become expensive and reinvesting in shares which appear cheap may enable us to achieve growth in portfolio earnings which is even higher than that of the underlying shares. The concept of "look-through" earnings and dividends makes sense to us. On a monthly or quarterly basis the figures will be unstable because of changes in portfolio composition, and potentially misleading, but I expect to return to this subject once the trends can be measured in years.

Enough waffle, what about the securities?

Several of our largest holdings have reported annual results in recent weeks. Two more have released annual reports. There have been few surprises, and the few have been positive, taking the shape of positive long-term operational developments (nothing sensational, but solid and encouraging) and special dividend payments (in one case sensational - this company in twelve months will have paid out 45% of our original purchase price). Results reported have been broadly in line with my expectations, and valuations of all our major holdings remain very attractive.

Valuations of all our holdings remain attractive, or they would no longer be in the portfolio. Two stocks were eliminated during the second quarter; both had performed well (the better of the two was up 3.5 times since purchase), eliminating the margin of safety, and making them less attractive than other opportunities in the market. In July, less happily, I sold our loss-making position in the Union Asia Finance bonds, ahead of the proposed restructuring. This was a tougher decision, as even on the terms offered by the Thai authorities it was on a 22% baht yield to maturity (before taxes, to which the new instrument would be subject), and all logic would point both to mutually advantageous improvements in the terms and to a current valuation much higher than our exit price. However, because of the deficiencies which had become evident in Euroclear structures, the Thai legal system, and the Thai financial system, the possibilities of further defaults or outright dispossession could not be dismissed. On balance I decided that a poorly-documented untradable ten-year zero-coupon obligation on the unimpressive BankThai was not the most attractive investment we could own, and that even at this price our cash should be redeployed elsewhere.

The portfolio now has fifteen holdings, with between 10% and 13% in each of the top six. While I would not be unhappy to make further purchases of any of our holdings, my top choices actually coincide with the top six, and this is forcing me to review the appropriate level of concentration. In the recent past I have in practice limited investments in any company to 10% at the time of purchase, but I now propose to increase this to 15%, which I believe will still ensure adequate diversification.

We have 8% of the fund in three plantation shares, all in Malaysia. Plantation shares have been suffering in recent weeks due to a dramatic slump in the palm oil price, but this is (a) off an unsustainably high base, (b) due in part to a strong recovery in production. Our shares are all comfortably above cost, but remain very attractive on valuations (even plugging lower numbers than previously imagined into our models), partly because they are somewhat illiquid and under-researched. Valuations are comfortably below replacement cost and we are inclined to hold on to these.

Having previously expressed the view that Malaysia is no longer investment-grade, I find to my embarrassment that I must alter my stance, as I have no wish to sell the remaining Malaysian shares in the portfolio. In all cases I remain comfortable with the specific companies in which we are invested, and with the management of those companies. The concern has been top-down, and our greatest fears relate to damaging taxes or confiscation rather than the economic consequences of reduced growth. Policy instability, the erosion of public confidence in the legal system, and indications of government indifference to minority investors in general, with active hostility to foreign investors in particular, have all caused a significant reassessment of the country risks. CLOB investors remain dispossessed, and suspicions linger that policy may be determined by individual rather than national interests. However, new attacks on the interests of investors have eased - arguably only because they were so obviously counter-productive, and it will take a long time for confidence to be restored in full, but nevertheless an improvement from when almost every day brought rule changes from Bank Negara, and the bad days three. Existing or potential investors with any thoughts on this subject are requested to call.

The portfolio mix is as follows:  as always, we'd emphasise that it has arisen from bottom-up stock selection, not from any pre-conceived ideas of asset allocation.
Apollo 001 Fund portfolio by class of security:         by geography     % of total portfolio  
Ordinary shares     83.1%   Hong Kong     43.2%  
Closed end fund     0.5%   Malaysia     23.8%  
Warrants     4.1%   Singapore     7.4%  
Bonds     9.2%   Thailand     13.3%  
Cash & net receivables     3.1%   Other     12.3%  
      100.0%         100.0%  

Notes: the warrants are 2-3x geared (purchased at 5-6x) at modest premia on respectable growth companies, and provide a way of participating in the upside while limiting downside. The two warrants give a combined "effective" equity exposure of 8%.  The closed end fund stands at a shrinking discount of 26% to NAV, and will vote on opening at end-99. We currently own no convertible bonds. The straight bond yields 30% in US$ to maturity and has a 15% running yield, at present valuation. We believe default risk is low.
In our quest for absolute returns, currently pursued through a long-only strategy, we take no account of benchmark indices or peer group activity, so the fund's performance may deviate dramatically from both. The overall stockmarket direction will however account for much of the volatility in valuation, and hence our regular chart of relative performance against a regional index. The marked underperformance of the first quarter has been made up more recently, so the long term picture looks respectable for now:

Claire Barnes, 27 July 1999

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