At the end of August the fund had cash of about 5% (we don’t trust the banks), with the investments being split approximately as follows:

Indonesia - 50%
Malaysia - 34%
Singapore -16%

Details of the individual holdings are available to investors on request.

Overview

The fund has a November year end, explaining the third quarter report at end of August.

Every time I check Indonesia seems to have dropped another 4%. The JCI has now fallen by about 20% in the past two weeks alone. Indonesia’s stock market had been driven by the commodities boom and many resource based stocks had risen to ridiculously optimistic valuations. There is still plenty to unwind in this sector I suspect. The fund’s Indonesian holdings are in the consumer sector.

No market has been spared the effects of the global liquidity contraction. Generally the first half results of the companies we are holding have been fine, as expected, (in fact in Indonesia they’ve really been pretty good) but this hasn’t been enough to prevent their share prices from falling. We also have a situation in which the regional currencies have been dropping against the U$, further lowering the fund’s NAV in the short term.

Over the long term FX moves tend to even themselves out (excepting catastrophic collapses like that of the Rupiah in 1997). As a currency falls the exports rise thus boosting the economy. For managers of businesses, exchange rate moves are normal, it is how they deal with them that matters. We hope that the companies in which we are invested are able to cope with change and to make correct choices most of the time. We tend to invest with companies that have been around for a while and whose managements have a record of not getting it wrong too often (while keeping our fingers firmly crossed).

The last part of the global liquidity bubble, the commodities market, looks as if it is finally unwinding. This will be good news for those not holding resources and their derivatives. Oil bulls expect a bounce, pointing to all the new consumers in India, China and elsewhere. What may happen is that the price falls further as Venezuela and other oil producing basket cases quickly see budget surpluses turn to deficits as the price falls below U$100; and the only way to stay ahead is to open the spigots and cheat on their OPEC quotas.

I keep seeing an advert on the internet which tells me that the US alone has reserves of 200 zillion barrels of oil under Milwaukee or somewhere, and that the oil price boom is a conspiracy. Unfortunately to read more I have to pay U$4.99 which I can’t spare just now, but if the price does continue to fall I’ll probably wish I had, as such wild theories become the consensus.

Being a fund manager at the moment is a bit like being a pirate in the Asterix books, which I hope is a terrible analogy given that those poor chaps get a thumping every time and never come out on top.

Politics

If anyone needs a lesson on emerging market risk, current events in Thailand, Indonesia and Malaysia provide a pretty good one. In Thailand we have the same old situation in which the middle class minority will not accept the majority’s decision to keep re-electing Thaksin in one shape or another. They were not satisfied when Thaksin’s buddy Samak took over, so I can’t imagine they’ll be popping the champagne now that the ruling PPP is planning to replace him with Thaksin’s brother in law.

The Thais and others are going to have to learn that living under crap governments and having a go at voting them out every few years is what democracy is all about, and that this is better than changing them with tanks. It would help if the PPP could choose someone slightly less controversial (unlikely) or if the constitution had a few more checks and balances (unfortunately the PPP has enough votes to change the constitution) but in the end Thailand would be much better served if a bit of political patience were to creep into the national psyche.

The Thai economy seems to be in reasonable shape. Foreigners are investing in manufacturing, the farmers are getting richer on the back of higher prices and consumption is growing. A recent visit (our third in the past few months) has shown that many Thai companies are selling too cheaply. We are not invested there at present although that may change.

The authorities in Indonesia, in the shape of the capital markets regulator, have brought in rules making it virtually impossible to take over a listed company. These rules, I am told by those who should know, are there so certain politicians can get their hands on certain assets. It does of course mean that companies will not trade at their full values as the chance to realise that value is now not there.

They are now exempting Malaysia’s Maybank from the new rules in its attempted acquisition of Bank International. Part of the problem is not only are the rules stupid but there is no certainty as to how they will be enforced. Unfortunately muddled regulation isn’t only confined to capital markets, as any miner or oil driller will tell you.

Meanwhile the Indonesian government has expressed surprise that the country has slipped from 127th to 129th in the IFC’s Doing Business Report, describing the result as “odd”, especially as measures have been implemented in order to make things easier. I believe they were rather hoping for 125th this year. Singapore came first as usual, those patient Thais were 13th and Malaysia 20th (even PNG came 95th). As you will have seen above we have been increasing our exposure to Indonesian companies, just not government linked ones.

The latest from Malaysia is that Anwar Ibrahim claims to have enough MPs crossing over from the ruling coalition to form a new government. Many doubt him, and the present incumbents are fighting tooth and nail, by means fair and other, to stay in place. Like the rest of us, Malaysians prefer political news to last for a few weeks before an election every few years and then for it to slip into the middle pages where it belongs. However, there is a definite excitement around the intriguing possibility of the first change of government since the top-hatted British left in ’57. A change might stabilise things, no change probably won’t. There is some speculation that emergency rule or suchlike will be imposed which would not be good news. We’ll have to wait and see.

As Thailand has shown us, bad politics doesn’t have to mean a bad economy. Malaysia’s economy, however, is not in great shape. The government is acting like a populist rabbit caught in the headlights. Inflation is now at 8.5% but interest rates have not been raised (it wouldn’t be popular with either the electorate or politically connected businessmen).

More worrying is the forecast budget deficit of 4.8% this year. How can that happen? Malaysia is an oil exporting country with tax rates of up to 26%. The country should be an enjoying a Venezuelan style boom but the reality is that whoever is the next prime minister, he is going to have to spend a lot of time on the economy, especially if Milwaukee really does have all that oil.

The problem with deficits is that they need financing, easy last year but not so easy now. Indonesia pulled its bond issue last week due to lack of demand and will have to try again at a higher interest rate. The Malaysian government recently destroyed its domestic bond market by changing the terms of private sector concession agreements. It has now reversed this position, probably not coincidentally given its borrowing requirement, but to a certain extent the damage has been done.

Poor politics lead to corruption, cronyism, underinvestment and capital flight. Does this matter? Yes because these economic terms result in poverty, lack of educational opportunity, higher infant mortality and lower life expectancy. And lower returns for investors.

Outlook

One of our stocks in Indonesia fell 15% over the first two days of this week and we were able to buy some more. Another fell 18% in an afternoon last week but there was no volume. At some point this volatility will settle down and we shall probably enter a period of disinterest in emerging Asian stock markets. The retail investors will have been too badly burned to want to go back in and the volumes will be too low for most institutions.

If the above is correct then the conditions will be close to ideal for value investing. The number of eyeballs searching for opportunities will be reduced, but not the number of opportunities. Stocks will be trading at lower valuations and expectations will be pessimistic rather than optimistic.

As I have mentioned, the fund has been increasing its exposure to the Indonesian consumer sector as these stocks have fallen in line with the general market panic in that country. What we used to pay 6x for we have been able to get for 3x recently. With the exception of financials and concession holders, all of the fund’s investments have net cash balance sheets, generally something we prefer.

Consumption growth has been exceedingly strong in Indonesia this year. For example, car sales are up 49% YOY for the first eight months. This has been driven by the increase in rural incomes on the back of higher commodity prices, so obviously some, but not all, of this rise is at risk as these prices fall. However, the half of the population living in Java not benefiting from the boom, will be better off as food inflation falls, bringing with it lower interest rates, despite liquidity being tighter, so overall the country is nicely cushioned.

We own a warrant in a power company. An adjustment in its conversion terms should have added 8% to its price at the beginning of the week. It already trades at a discount. Did it go up? Did it monkeys. These opportunities do not exist in good times.

The medium term should provide rewarding times for the patient investor. The current debacle in the West will provide a reminder to the well-learned lessons of the Asian financial crisis of the importance of sensible balance sheets. Asians will continue to work harder for less money than Westerners and their economies, despite the best efforts of their politicians, will continue to grow at a rate that uplifts millions from near subsistence to trendy consumers.

For those with any cash left this is a good time to be buying stocks. Simplistically, a company trading on 5x provides an earnings yield of 20%. If its cash flow broadly matches its profits and the management has a history of making good decisions with the company’s cash, and if you can add in a bit of growth, you are probably looking at a bargain. When market conditions make analysis this simple it is the time to be getting excited. When analysts start using gobbledegook such as the Gordon Growth Model and CAPM, the converse is true.

I’m not trying to call the bottom of the market but an observation I read a few years ago (at similarly depressed times) might help. Go and ask your bank manager for a loan to go on holiday. He’ll probably say yes, even now. Ask him for a similar loan to buy stocks. If he says no, as he will, then the bottom can’t be too far away.

James Hay
18th September 2008.

Ps. Ten years ago all the clever economists were highly critical of Asian governments’ bail-outs of failed companies. They were right but why can’t we hear them now?

More details concerning the fund’s investments are always available to shareholders in the fund on request.