The Scott Letter: Closed-End Fund Report©
Published by Closed-End Fund Advisors, Inc.
20th Floor, 707 East Main Street, Richmond, Virginia 23219
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THE ASIA PACIFIC FUND
July/August, 2003 – Volume III, Issue 6
George Cole Scott, Editor
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We currently have back issues of The Scott Letter Online. They include interviews with Adams Express (2),
General American Investors, Ellsworth & Bancroft Convertible Funds, The Royce Funds, The Templeton
Funds(2), Renaissance Capital, Tri-Continental Corp, Allied Capital, Pan Pacific Reality and Central
European Equity Fund.
The investment objective of The Asia Pacific Fund (APB-NYSE), a US-registered 1940 Act closed-end
investment company, is to achieve long-term capital appreciation through investment in equity securities
in the Asia Pacific countries (excluding Japan and Australia). Managed by Baring Asset Management
Limited from its office in Hong Kong, APB has faced challenging stock markets for the last several
years: the net asset value for the fiscal year ended March 31, 2003 declined –22% in US dollar
performance while its benchmark, the MSCI All Countries Combined Far East ex-Japan index declined
–25.2%.
The 2003 annual report dated March 31 states:
“The Manager’s optimism on the Asian markets last year did not come to fruition. The region neither
generated positive returns, nor significantly outperformed the major regional markets (see table 1 below)
... The geopolitical backdrop of the last twelve months – events in Iraq, high oil prices, faltering global
economic growth and growing deflation concerns – has been a hostile environment for equities …
nevertheless economic growth and corporate earnings news for the region remained robust, growing
+6% and 30% respectively. This good news, however, was not reflected in the local bourses, and they
continued to be de-rated, despite their improved fundamentals.”
The report goes on to say that the management continues to have confidence in the Asia Pacific region
and “the rich seam of investment opportunity which is Asia … the region’s strong fundamentals –
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manifested by high earnings growth, strong corporate balance sheets, low debts and improving domestic
consumption, combined with low valuations – are likely to make it a compelling proposition when
equity risk appetite returns.”
James Squire was appointed portfolio manager of the Asia Pacific Fund in September 1997. Based in
Hong Kong, he is responsible for managing equities on a pan Asian basis. Mr. Squire began his career as
a graduate trainee for Rothschild Asset Management and later managed the UK equity portion of UK
pension funds. He relocated to Tokyo in 1991 to cover Japanese equities and then to Hong Kong in 1992
to cover the Asian markets. Most recently, Mr. Squire worked for Citibank Global Asset Management
where he managed country specific Asian and global funds. During his ten years in Hong Kong, he has
specialized in the South Korean, Taiwanese and ASEAN markets.
We interviewed Mr. Squire by telephone on June 25 in Seoul, Korea:
S. L.: How does the Asia region look now?
Squire: I think it is as attractive today as it has ever been since I have been investing in Asia. The region
has been significantly de-rated. Expectations are low. Lessons have been learned. By and large at the
private sector level there now is a greater appreciation for profitability as opposed to market share for
market share’s sake.
S.L.:
What is your investment style?
Squire: Baring follows growth at a reasonable price (GARP) philosophy. What is reasonable? Value
alone is not enough: it needs to be accompanied by growth. When I talk about value, I don’t necessarily
mean price to book. Cash flow accompanied by growth rather than hard assets is the heart of value.
What extra is required in Asia? I think there are several elements: management is critical and
you have to do your due diligence and reflect on their past actions. Also, transparency and disclosure are
real issues in Asia. Many managements are signed up members of a Hall of Shame. We refuse to invest
in such names because they neither respect nor protect minority shareholders. Finally, shareholding
structures, particularly inter-related party transactions, need to be analyzed. In many cases, the structures
are complicated and opaque making it impossible to analyze them.
In summary, we try to become comfortable with the above building blocks before trying to
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analyze companies in the traditional Anglo Saxon way.
S.L.:
What kinds of companies do you mean?
Squire: One example is holding companies, not all but many. These typically own big stakes in listed and
unlisted companies. With multiple holdings and listings often at an inter group level, the ability to sell
shares to each other and book trading gains making them appear more profitable than they really are is
high. This has been common practice in the recent past in places like South Korea, Malaysia and
Indonesia. Another example is a significant number of accounts in Asia are qualified by their auditors. If
the auditors don’t feel comfortable with them, we shouldn’t either.
S.L.:
What kind of companies do you like?
Squire: Baring is selective and quality stock investment focused. We believe it is easier to find a
company that has the potential to be re-rated from five to seven times than a company that is to be rerated twenty to twenty-eight times. The math is the same, but the likelihood is lower and the risk is
higher the more highly rated a company is. For a growth at a reasonable price investor, this is common
sense.
There are various key features to the kind of corporates Barings finds attractive. These include
companies with strong franchises and high barriers-to-entry. For those companies, which sell at a
premium to the market, we want earnings visibility and repeatability.
In the absence of pricing power, the lowest cost producer is the next best thing, particularly in
Asia where it is always easier to find low cost producers than it is to find companies with strong pricing
power.
In practice, perhaps the most suitable quote for the Baring Asian team is what Gary Player used
to say, “The harder I practice the luckier I seem to become.” You can never do enough research or visit
enough companies; that is what I am doing this week in Korea.
S.L:
What are the investment themes you look for before you invest?
Squire: They are broad: I am currently looking for the consumption-related companies, restructuring and
special situations. For consumption-related companies, we like a number of names in Korea here such as
Amore Pacific, a cosmetics company. For restructuring companies, we like Guangdong Investment, Ltd.,
a utilities company. We also like Lindeteves Jacoberg in Singapore. For consolidation plays, we hold
Fubon Financial in Taiwan. I try and avoid asset heavy, commodity type industries which are highly
operationally geared and generate low returns on invested capital. Hence the Fund’s limited exposure to
airlines and auto manufacturers.
S.L.: I notice that you have your largest holdings, 31.5%, invested in Hong Kong and China. What can
you tell us about this investment climate? How has the SARS epidemic affected these markets?
Squire: The recent economic performance of Hong Kong and China could hardly have been more
different. China has had GDP growth of 7-8%, whereas Hong Kong has effectively been flat. The Fund
does not split out the exposure to China and Hong Kong separately because the effective overlap
between the two in many cases makes it impossible, or meaningless, to do so at the corporate level.
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Fears that Shanghai is going to eat Hong Kong’s lunch, I believe are overstated. Hong Kong has
been a dynamic and resilient market since 1949. They have always been able to recreate themselves. The
biggest advantage Hong Kong has over China is its legal system. Contract law in China is deemed not to
be worth the paper it is written on whereas in Hong Kong it is based on English Law. Hong Kong is repositioning itself. For example, Hong Kong no longer has a significant manufacturing base which has
been forced to move to China to remain competitive. However, remember there are over 10 million
people employed by Hong Kong manufacturing companies on the mainland. Hong Kong itself has a
population of less than 8 million. In response to this and other changes, the nature of the Fund’s Hong
Kong China exposure has changed. Some of the older Hong Kong names have been replaced by
relatively unknown China plays such as Ngai Lik and Kingboard Chemical.
As for SARS, it has had an impact. First, when you have something like SARS, you have to satisfy the
basic human needs first: people need security and a feeling of well being. The authorities have tried to
focus on this before even thinking about making money. The impact of SARS shows in the passenger
through put levels at the Hong Kong airport, which fell as much as 80% below normal levels and today
are still significantly below normal capacity. Perhaps the psychological impact was overly inflated, for
instance in the U.S. last year 284 people had died from West Nile disease whereas by early June fewer
people in Hong Kong died from SARS. It is amazing how SARS captured the imagination; I think the
world media needed a story to replace Baghdad; it filled the spot beautifully.
S.L.:
Would you help us to understand the valuations in Asia versus other regions?
Squire: If you compare equity valuations in Asia versus other regions, you will note they appear less
demanding. Asia trades on 15X historic, 13X current earnings. This is approximately half the level of
the US. Such a situation has not always been the case. In the mid-nineties, Asian valuations were similar
or higher than those of the US market. Asia has been de-rated in the last six years despite the fact that
returns on equity, balance sheet strength, and corporate management in the region have been improving.
S.L.: Would you tell us if you use top-down or a bottom-up fundamental analysis in choosing your
portfolio companies?
Squire: Baring uses both a top-down and bottom-up approach. The macro is reviewed rigorously on a
monthly basis at our Pacific Policy Meeting. The micro and the core portfolio is formally reviewed at a
weekly basis at the Regional Stock Meeting. Through the investment cycle Baring expects to add value
50:50 from bottom-up and top-down. In the last six years, the bias has been for the bottom up to add
more value (80% of the Fund’s out-performance). At the end of the day I consider myself to be a stock
picker depending heavily on the Baring team. Nevertheless, I believe that one often does much better
being in a fair stock in a good market than being in a great stock in a struggling market.
S.L.: In analyzing foreign portfolios, we often find that portfolio managers start with telecom
industries. What are your thoughts about this?
Squire: This is not the industry I would start with in Asia. I believe banks and technology are more
important not just because they each account for over 20% of the benchmark index (almost double the
telecoms weighting) but also because they reflect the domestic (financials) and export (technology)
dynamics of the region. As for telecoms, we have been generally underweight over the last 2 years. We
do own Korea Telecom(KT) which is really a value play as free cash flow there is over 15% this year.
They are buying back shares, and we believe they will continue to do so. I also think they will be raising
their dividend pay-out ratio.
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S.L.: What about the tremendous potential for cell-phone growth in China, where it is so much cheaper
to sell these instruments than having to construct telephone poles?
Squire: You are absolutely correct, George. It is cheaper to build-out a cellular network than put it on a
fixed line. As a result, one would expect this to be a fruitful investment story for China. However, it
has been a huge disappointment for investors since the authorities have tinkered with the regulatory
framework and encouraged competition to such an extent that returns do not cover the cost-of-capital.
The net effect is that the consumer benefits from both low cost phones and low cost tariffs. As a result,
the Fund is underweight Chinese cellular companies.
S.L.: In the electronics sector, we have been impressed with the technology of the Korean company,
Samsung Electronics. What is your position on Samsung?
Squire: It has been our biggest holding for the last three or four years, and the Fund has over 600% gains
on its book cost, but I have recently started to reduce it. I like its competitiveness in three business
divisions: the telecommunications side (mobile phones) as it has been taking market share from Nokia,
Ericcsson and Motorola. I also like the D-Ram angle as they are the lowest–cost producer and the leaders
in this industry. Finally, its TFT-LCD division is growing fast; they are fast becoming the global leader
here also. Samsung Electronic valuation isn’t what it once was since it has significantly outperformed.
Previously, I believed that earnings growth would drive returns, now you have to believe in re-rating for
the company to provide similar returns to the recent past.
S.L.: Would you tell us how Taiwan is doing? I notice that you have invested 16.1% of your portfolio
there. Has Taiwan been able to get away from its high tech dependence?
Squire: I have been concerned about Taiwan tech for sometime. Their accounting practices are
questionable. The tech orientation in APB is very blue chip focused. Speculative names are avoided. I
have shifted some of our investments from the traditional names into the less well-known industrial
names. We also have investments in Fubon Financial Holding, a power tool company and Formosa
Chemical and Fibre. We are increasingly selective in Taiwan. This summer is likely to see a deluge of
equity-related paper in this market.
S.L.:
Tell us about your investments in Singapore?
Squire: The Singapore equity market is the only bond market that hasn’t rallied. What I mean is the
Singapore equity market yields about four percent, whereas local bonds yield a little over two percent.
Bond markets around the world have rallied yet this pseudo bond market hasn’t moved - perhaps
because investors have been so risk-averse. Three of the stocks we hold yield over five percent, one
around ten percent, so your being paid to wait. We think they are showing very good value for their
growth and franchise characteristics.
S.L:
Tell us how you play dividends on high-yielding stocks such as these?
Squire: First, dividend payout ratios in the region have been rising significantly in the last nine months.
In some countries (Korea, Singapore, Taiwan, for example, the Fund receives only approximately 80%
percent of the dividend due to withholding tax regulations. It is sometimes possible to sell the shares just
before they go ex-dividend and then look to buy them back again if they adjust badly. Overall, we like
stocks that provide dividends. Long term investors will know that approximately one third of total
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returns are derived from dividends.
S.L :
What about Malaysia?
Squire: In Malaysia, for the first time in many years, the valuations look sensible, but I just can’t get
very excited about the stocks. We have 6% of the portfolio there, steady-eddy companies like banking
and tobacco, but I find it difficult to be constructive about Malaysia.
S.L.:
And Thailand…
Squire: In Thailand, we have been quite successful, but my problem is I should have owned much more.
I have been too cautious. We have recently taken some big profits in various companies that have risen
60-80 percent in the last year or so.
S.L.:
I notice that you have only a small investment, 2.5%, in India. What is your strategy here?
Squire: I like India, particularly the Indian banks; it is an active bet, since India is not in our benchmark.
The consumer credit cycle has just started in India. This is one of the few areas where I clearly see a
three or four year investment story. We invested in the Morgan Stanley India Investment Fund, which is
well managed. I like the investment style of this closed-end fund we purchased at a nice discount to its
net asset value. For a high quality fund in a market I like, it has been a good investment.
S.L.:
Do you invest very often in closed-end funds in your region?
Squire: Sometimes. In the past I have invested in the Taiwan Fund and others, and I continue to look for
opportunities. These vehicles are a great way to get into areas where I am less comfortable or
knowledgeable about investing in individual stocks. Also, closed-end funds can be a very cheap way to
enter a market. For instance, if I like the Singapore small-cap companies and I saw a fund there at a 20 to
25 percent discount, I would look closely at it. Nevertheless, this is the exception rather then the rule.
S.L.: At Closed-End Fund Advisors, we, of course, like the fact that you use some closed-end funds as
we also see them as a cheap way to invest in countries. We encourage institutional investors to take
advantage of closed-end funds, particularly in the foreign markets. It is time to wrap this up. Do you
have any concluding comments?
Squire: In the short term, Asia is going to remain largely US dependent. So long as Wall Street behaves
well, I believe sentiment in Asia will remain firm. However, I am wary of the rally in the US since an
economic recovery does not necessarily justify a richly valued market. If the US economy slows down
the region will be impacted economically – not that I am expecting this in the short term. However, as
time moves on, the close correlation between the US and Asian markets is likely to subside, while
growing inter regional trade will slowly wean the region off its dependence on the US. Valuations in
Asia are attractive in absolute terms as well as in relative and historic terms. As such, the Asia region is
an good investment and could quickly benefit from fund flows if regional sentiment and risk appetite
were to improve.
NOTE: The next Scott Letter will be published on or about September 15.
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The Scott Letter: Closed-End Fund Report©
Published by Closed-End Fund Advisors, Founded 1989
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