Monday, October 11, 2010

More bull: Apollo Asia Fund - the manager's report for 3Q2010

At the time of writing, modern retail accounts for 30% of the securities held. The shops operated by our companies comprise supermarkets, hypermarkets, general merchandise stores, pharmacies, health food and convenience stores, and are broadly spread from greater China through Southeast Asia to India. These businesses have long-term pricing power (margins in any given quarter may be squeezed), and they are typically supplier-funded, so that rising inflation requires no new capital. A fair percentage of their sales are staples, so footfall is resilient. One pays for such merits: the current-year PE for the portfolio is 13.8, and for our retailers ranges to almost twice that. At present we hold no fashion or luxury-goods retailers.

Low-end consumer finance represents another 9%. Like the retailers, these benefit from supportive demographics and urbanisation trends throughout Southeast Asia - but they are much more vulnerable to changes in government policy. Looking at the mess caused by excessive debt and bank failures in the west, it is understandable that Asian central banks should consider preemptive braking. The lack of current growth makes these stocks unfashionable: current-year PEs range from 8 to 11 on our estimates (although earnings could of course be battered by NPLs in the event of renewed recession), and net dividend yields are 5-6%.

Given the concerns we expressed earlier in the year on the importance of energy, we now have no airline exposure, and no companies whose own operations seem particularly energy-intensive. However, the portfolio does have significant exposure to automobiles (parts manufacture, distribution, testing), and a high general dependence on the continuation of business as usual. (We'd be happy to reduce that dependence if we could, as the risks for the global economy seem extremely high.)

Meanwhile, with interest rates trivial globally, it is easy to make the case that the earnings yields on equities are attractive, and that equities may hold their value in case of inflation, while real returns on cash would be indisputably negative. Against this stands the voice of experience (and statistical analysis), that when equities have had such a strong bull run, and are as highly valued as they are now, the subsequent returns are usually disappointing. But the party can go on for a long time.

The reported comments of Messrs. Buffett, Munger and Gates on their short China trip were doubtless intended mainly for their domestic hosts, but brought to mind those of Barton Biggs in late 1993 ('tuned in, overfed, and maximum bullish'). Then, just as we thought a crazy market could not get much sillier, American asset allocators supercharged the punch. Now, quantitative easing by developed nations is causing new waves of funds to flow to Asia, and doubtless a new generation to fall for the sirens' tales. There are sound stories too: of secular progress, and the absence of certain problems prevalent in the west - overindebtedness, excessive pension liabilities, etc. These merits are striking, and well articulated by brokers. But Asia's internal problems (inflation, energy security, water security, pollution, overdependence on construction...) are also becoming more significant.

These are not the sort of markets in which we excel - indeed we frequently underperform, having a tendency to worry too early about the risks, while lacking the confidence or imagination to find ways of profiting when they crystallise. Suggestions are very welcome. However, investors wishing to participate fully may prefer to switch horses.