Apollo Asia Fund: the manager's report for 4Q2008

After observing in our last quarterly report that the Asian news for the third quarter had been benign, the climate worsened suddenly and dramatically in October. Asian exports fell precipitously, as did the revenue of many other businesses. Some orders will have been postponed due to inventory adjustments; some cancellations will have used trade finance as an excuse of convenience; but end-demand has clearly contracted in a wide range of industries, and in many cases the sustainable level of demand has yet to become clear. Trade finance remains a problem, according to recent comments by Victor Fung, who would have broad input. Whether this is because of capital constraints as the banks deleverage, or the usual cyclically indiscriminate tightening of lending criteria, credit is scarcer, and for many companies much more expensive - even as the returns on cash shrink.

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Assessing sustainable demand for many industries now seems difficult. When, if ever, will global construction activity regain the levels achieved in a worldwide synchronised boom, assisted by a credit bubble, coinciding with what may have been the most construction-intensive stage of China's recovery? Thinking of the excesses of the Middle East, and of the conviction with which many individuals around the world have accumulated multiple properties "for investment" without any regard to the rental yield and maintenance costs, I would guess this will not be for many years. This may be just as well for the planet, but I am not sure how one should currently evaluate the manufacturers of steel or construction machinery. Riding out a couple of bad years against a rising global demand trend is one thing: assessing the costs of adjustment to lower demand and the profitability thereafter seems more difficult. Of more immediate interest to us are those Japanese companies with world-leading technologies and reasonable 'normal' returns, for which valuations are cyclically depressed but with identifiable limits to how far a replacement cycle can be stretched and where it may therefore be possible to estimate sustainable demand with sufficient reliability to invest with a margin of safety. My sense is that there are significant opportunities here, and suggestions would be appreciated.

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At present, I am uncertain how to prioritise various different types of equity opportunity - for example the steady cashflow generators which may still command PEs in the high teens, versus capital goods makers which may be on fractions of book and less than 4 times historic earnings, but with no certainty as to when earnings, or in some cases even revenues, may resume.

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Despite the fall in market value of the portfolio during the year, intrinsic value (as measured by earnings, dividends, and book value) appears to have increased. Despite the evident risks, current valuations offer the possibility of compounding intrinsic value, our long term goal, at a reasonable pace. Errors are costly: a tortoise pace has caused us to miss many opportunities, but may be worthwhile if we can avoid most of the landmines.

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