Sidebar:A recent refinement
In an article that I wrote for the April 2010 issue of Cayman Financial Review, I set out the reasons why I share Buffett’s view, except that I explained why it applies to the broader Asia ex Japan region that comprises nearly half the world’s population. In this article, I will explain how our firm invested in Asia during the past 20 years.
Twenty plus years of investing in Asia
In the late 1980’s, I worked for one of the early European hedge funds. Amongst other asset classes, the fund invested in privatised telephone companies in emerging markets, small-cap companies listed in Hong Kong which were doing business in Guangdong province, and rapidly growing companies listed in South East Asia. We were one of the early investors in emerging markets and bargains abounded. Single digit Price/Earnings (P/E) ratios were common, and in some cases, P/Es were low single digits.
Twenty one years ago, I formed Overseas Asset Management. For the first nine years, we only managed segregated client accounts. One of the areas in which we earned attractive returns was buying offshore-incorporated, closed-end country and regional funds. In those days, this was a fairly obscure corner of the market where we were able to buy closed-end funds with liquid assets at discounts as high as 50 per cent to net asset value (NAV).
In some cases, these funds had upcoming continuation votes or open-ending dates, while in other instances we wrote letters to the directors of these funds urging them to open-end or wind up the fund. These large discounts were a result of the funds either not being listed, in which case they were traded through market makers or being listed on exchanges like Osaka, Seoul, or Bangkok where investors were less familiar with opportunities in closed-end funds. The wide discounts to NAV skewed risk/return in our favour. However, the opportunities were relatively limited and diminished during the past 10 years.
In 1997/8, Asian equity markets and most currencies in the region fell sharply. In some markets like Thailand and Indonesia, stock markets in USD terms fell by about 90 per cent. Such deep declines were likely to create enormous investment opportunities so I travelled around Asia for nearly a month looking for investment opportunities. I discovered companies that were trading at P/Es less than 6 and dividend yields higher than 6 per cent, as well as profitable companies trading at less than net cash on their balance sheets. I could have put together a portfolio of these companies, just sat on them and waited for the inevitable recovery, and probably generated a very attractive return.
However, longer-term, I would have difficulty following these businesses from Cayman because we sleep when Asia is awake. To be successful in this new venture, I either needed to move my family to Asia or allocate money to managers in Asia who I trusted to invest our clients’ money sensibly. With a one-year old and a four-year old at the time, I dared not suggest the first option and risk revolt from my wife.
The second option had drawbacks. How would I know who to trust in Asia? I also had grave reservations about the layers of fees in fund-of-funds and questioned whether the managers we selected would be able to overcome these fees and beat the Asian equity benchmark indices net of fees and expenses. Indeed, over the years, Asian fund-of-funds have for the most part produced disappointing returns.
With the first option out of the question, I embarked on a second one-month trip to Asia in late 1998. Having already established that there were huge opportunities in Asian equities, my quest was to identify the up-and-coming Warren Buffett or Peter Lynch of Asia and set up a fund to allocate money to these managers. That was the genesis of OAM Asian Recovery Fund.
The Bamboo Network
In Asia, knowing the right people is more important than in the US or Europe. The main reason for this is that corporate governance in Asia, particularly at that time, was worse than in the West, so accessing the right network and finding out who to trust is imperative. Corporate governance is still a problem in Asia. One fund manager joked to me recently that in many instances in Asia, CFO stands for Chief Fundraising Officer.
There is a book named “The Bamboo Network” which is about the networks of wealthy Asian families whose business ties are often interlinked through marriage. Most of these families are part of the Chinese diaspora. Likewise, in investment management in Asia there is a fairly tight network. During my second trip to Asia, my contacts were initially limited to a few brokers, Dr Marc Faber who writes the Gloom Boom and Doom report, and Cheah Cheng Hye and V-Nee Yeh who founded Value Partners in 1993.
As a fund manager and stock-picker, I was interested in learning about the investment process of each manager I met. My typical interview entailed a review of the top 10 holdings in the fund.
This review would often last a few hours and it gave me insight into the manager’s process and the extent of the opportunities available based on the degree of undervaluation of their largest holdings. I still do this Top 10 review today.
At the time, Value Partners was only managing about US$100 million. However, it was clear from my meeting with Cheng Hye that he was both an exceptional fund manager and the opportunities available to him in Hong Kong were outstanding. The average P/E of his investments at the time was 6 and the average dividend yield was more than 6 per cent with no tax withheld on the dividends. In 1999, we invested about $2 million in what is now called the Value Partners Classic Fund.
That investment is now worth over $25 million. About three quarters of the compound annual return that Value Partners Classic Fund generated for its shareholders during the past 12 years came from outperformance that resulted from superior stock-picking rather than from tailwinds of Greater China indices outperforming Western equity index benchmarks. Today, Cheng Hye is referred to as the Warren Buffett of Asia.
Value Partners currently manages US$7.5 billion, making it the largest hedge fund manager in Asia, and the management company’s shares are listed on the Hong Kong Stock Exchange.
Although Cheng Hye is well on his way to becoming a billionaire, he remains as humble and passionate about what he does as when I first met him 15 years ago.
Cheng Hye introduced me to two superb fund managers in Singapore. One of these was N L Teng, a Malaysian Chinese like himself who also worked in smaller company research for Morgan Grenfell before starting his own firm. Like Cheng Hye, I found Teng to be a modest, hardworking man with tremendous investment acumen. As an aside, both men became my friends and I count them among the most engaging and honest people that I have met in my investing career.
A review of Teng’s portfolio in 1998 showed that the investment opportunities in Singapore and the surrounding ASEAN region were very attractive. Teng also satisfied a key criterion: he was a large investor in his fund. One thing I learned over the years is that it is imperative that a fund manager have a significant part of his net worth invested in the fund he manages – what I refer to as eating your own cooking. At the time, Teng’s Target Asia Fund had less than US$10 million in assets, of which about $2 million was his. In late July this year, Teng announced his retirement. His fund had grown to over US$2 billion. He said that he would liquidate the Fund and return cash to the Fund’s shareholders so that he could devote the next stage of his life to philanthropic causes close to his heart.
In November, my wife and I along with John Dyke, one of our non-executive directors, and his wife had dinner with Mr Teng and his son, Matthew. I was curious as to why Mr Teng decided to retire. Target Asia Fund’s performance was superb – returning nearly 18 per cent per annum versus less than 8 per cent per annum for the MSCI Asia free ex Japan (US$) index and less than 1 per cent per annum for the S&P 500 index during the nearly 12 years during which we were invested in the Fund.
However, if this is split into two 6-year periods, the comparison is revealing. In the first six years that we owned shares, Target Asia Fund returned 23 per cent per annum compared to 6 per cent per annum for the index. In the second six years, the Fund returned about 12 per cent per annum, almost perfectly matching the index return. I suggested that the reason was that as the Fund became very large, it was difficult to buy shares in smaller and medium sized companies that were most likely to be mispriced. Mr Teng agreed with this assessment but felt that a more important factor was that many of the more recent investors in his Fund had shorter investment horizons which meant that he had to restrict his investments to highly liquid stocks, thereby resulting in his performance mimicking the index much more closely.
This is a key point to which I will return shortly – managing large amounts of money is usually an impediment to superb investment performance, no matter how good the manager.
Interestingly, because the challenge of managing money and winning still captivates him, he is considering launching a smaller fund with a “soft lock-up”. This fund would manage a significant portion of his wealth and he would invite some of Target Asia Fund’s shareholders to subscribe to the new fund. He will return to his investing roots with a focus on deep value. I told Mr Teng that we would very much like to invest in his new fund.
For the first five years or so of OAM Asian Recovery Fund’s existence, we invested all the Fund’s cash equally in funds managed by five managers who I selected as those most likely to become the Warren Buffett of Asia. Apart from Value Partners and Target, the other three managers were recommended by Philip Gray who was a very good broker at James Capel, Marc Faber and Cheng Hye. Target Asia Fund just liquidated and returned capital to its shareholders, but the remaining four managers still manage nearly US$100 million for us or about 40 per cent of the assets of OAM Asian Recovery Fund.
The next stage
When we selected these five boutique fund managers in Asia, they each managed a total of $10-200 million. In every case but one, their assets under management ballooned to well over $1 billion through a combination of compounding and the stronger inflows of cash which accompanied their increasing profiles. In several cases this effect resulted in their investment performance reverting closer to the index. This pattern is also evident from a close examination of Buffett’s record.
This led me to search for the next group of up-and-coming managers. By this stage, our network in the Asian fund management community had broadened. We found about half a dozen such new managers during the past seven years, and in many cases, we were one of their early seeding investors. In seeding these new managers, we urged them to cap the size of their funds and in some cases, managers have heeded our request.
Experience suggests that the real sweet spot for finding mispriced assets is companies with a market capitalisation of less than about US$1 billion. Such companies typically have little or no following from brokers. As a rough rule of thumb, I reckon that a fund needs to manage less than about US$200 million to invest in this sweet spot. That equates to 20 investments of about $10 million. Our managers who manage less than $200 million and are able to invest in equities capitalised at less than $1 billion have provided OAM Asian Recovery Fund with its best returns during the past 5-7 years.
When I was in Asia in November with John Dyke, we had lunch with Anthony Bolton and Cheng Hye. This came about because John Owen, a past Governor of Cayman is Chairman of Fidelity China Special Situations plc, Anthony Bolton’s most recent fund. He suggested that I meet Anthony Bolton when I next visited Hong Kong. I read Bolton’s book and was keen to meet him.
For those who do not know Anthony Bolton’s history, he is perhaps Britain’s best known fund manager. He generated a compound annual return of nearly 20 per cent per annum when managing Fidelity Special Situations Fund in the UK from 1979-2007. Early this year, he came out of retirement to launch Fidelity China Special Situations plc, a new investment trust that raised nearly £500 million. He has committed to manage the trust for at least the first three years. The trust has already returned more than 25 per cent since its launch and in contrast to most investment trusts it trades at a premium to its NAV.
When I invited Anthony Bolton for lunch, I also invited Cheng Hye as I thought it would be interesting to listen to a discussion between these two masters. Cheng Hye offered to host the lunch.
We were not disappointed. For me, the most interesting remark that Anthony Bolton made during our lunch was that investing in Chinese stocks today reminds him of investing in Europe in the early 1980’s: the market pricing inefficiencies are as large today in Greater China as they were back then in Europe. Interestingly, a large part of Bolton’s fund is invested in the sweet spot of smaller companies with limited broker coverage. He has the added advantage of managing a closed-end fund so he does not need to worry about shareholders’ liquidity requirements or time horizons.
The record so far
On 31st December 1998, we launched OAM Asian Recovery Fund at $10 per share and listed it on the Cayman Islands Stock Exchange. Nearly 12 years later, the Fund’s NAV per share is about $75. The Fund has generated a compound annual return of 18.5 per cent since launch versus 8.5 per cent for the index. This return was achieved without using any leverage. It was also achieved with considerably lower risk than the index – draw-downs during bear markets have been smaller than the index and volatility has been about 25 per cent less than the index as measured by the standard deviation of returns. Selection of great managers has been the main reason for the Fund’s success.
The other ingredients have been a sophisticated group of investors who have generally added money when markets are cheap, and to a lesser extent taken out money when they are expensive, and a desire on our part not to allow the Fund to grow too large. We have refused to take money from people we do not know, particularly those who have seen our Fund’s statistical record appear on their database.
With our mix of managers and the recent refinement of our approach to managing cash levels, we remain optimistic about the Fund’s future prospects. However, some caution is in order as Asian markets are already trading slightly above fair value even though we are only 22 months into the current bull market.