Portfolio Performance
The performance of the company's portfolio in the first six months was, on a pre-tax basis, 2.3% which translates into an increase in net asset value (after allowance for tax on realised gains and losses) of 1.3%. In absolute terms, this is a modest performance. In comparison to a basket of international stock markets, such as the Morgan Stanley Capital International World Index, which returned a negative 4.6% over the same period, the performance is reasonable. However, six months is a very short period to measure the quality of an investment manager.

Investment Scene
It was hard work in 1994 for those trying to win against the markets by playing a conventional game. The large stock markets (New York, London, Paris, Frankfurt) moved sideways at best and most were down from their February highs, though Tokyo showed an upward tendency. Most of the emerging markets were hardly any more sympathetic, as most declined with the notable exceptions of Brazil and Peru. To remind investors of the dangers of so-called emerging markets, the recently elected Mexican government chose to float the Peso in December, only to find that this shattered foreign investor confidence with a resulting slide of over 40% against the US$.

Having participated in emerging markets of Asia and Latin America since the mid-eighties, we are not particularly surprised by those setbacks. In our view, most have well and truly emerged. This is evident from the significant coverage they now get from the international broking community. There are very few markets which are not covered by at least six to eight international broking firms. Moreover, in the good old days, (mid-1980's), the companies in these markets traded on earnings yields of 14% to 20%, now it is more common for these companies to trade on earnings yields of only 4% or 5%.

In most cases, this rise in valuations reflects the expectation that the developing economies will achieve superior growth rates than the industrialised economies. This expectation is clearly widely held judging by the head-long charge of pension fund money out of the USA and the alacrity with which private investors have acquired region-specific mutual funds.

Our concern is that these valuations build in little for the attendant risks. In many cases the institutions of developing economies are less robust than in the traditional markets and financial reporting standards are sometimes of dubious quality. At the same time, the local owners of these businesses have responded swiftly to foreigners' fantasy of distant lands and have been only too glad to sell part of their highly priced companies to these eager buyers. (Boring as it is to receive visiting analysts, they make far better company than disgruntled bank managers who offer funding at a much higher cost!)

The January 1995 mini-crash in emerging markets highlighted the risks of dependability and liquidity. Notwithstanding some subsequent sharp rebounds, we suspect that the allure of some of these markets will diminish as short term interest rates creep upwards over the next year or so and the "riskless" virtues of cash deposits are rediscovered.

As for the developed markets, we are somewhat more optimistic, if still a little guarded. Many have corrected a fair deal from their peaks of February 1994 or have seen considerable inter-market price adjustments. Profit growth is bringing valuations more in line with historic norms, even though there is concern about the high share of profits (when expressed as a percentage of GNP). This, however, seems likely to persist for a while yet as we do not expect inflation to lift sharply in the foreseeable future, though it may blip up in 1995/96. Long dated government bonds in most markets are giving investors "prospective" real (pre-tax) returns well above their historic norms, so we do not expect bonds to undermine equity valuations.

Some of our readers will be surprised to find us writing about markets, so-called top down analysis, rather than companies, but given the sort of disparity we see between the valuation of quality, dependable businesses in Europe and America and those available in the developing markets, we're simply cautioning our readers that a high growth economy does not in itself guarantee good investment returns. In our search for good investments around the world, we are in most cases more comfortable with the traditional markets than the emerging markets.

There are several themes that we are playing in both the traditional and the emerging markets.

The first is the likelihood of a prolonged economic cycle which will allow capital intensive companies producing commodity products (so-called cyclicals) to earn high returns for a longer period than usual. In newsprint and paper, these companies are Abitibi and Quno (Canada); Champion (USA); Klabin (Brazil). In metals, Cominco (zinc in Canada); Milpo (zinc in Peru); Minsur (tin in Peru), Buenaventura (gold and silver in Peru).

The intriguing thing is that while in general these industries have lost money for the last 3-4 years, industry commentators continue to fret over the possibility of recently closed capacity coming back on stream. This and other factors indicates to us that the market is misreading the likely level of demand and the desire by most companies to rebuild their balance sheets. (Some of the closed capacity has been dismantled and much of the balance is high cost in nature). We would note also that in the newsprint and paper industry, it is still far cheaper to acquire existing capacity than to build new tonnage.

Our second theme is the continuing boom in personal computers (PCs) and information technology. (In 1994 deliveries of PCs to US households exceeded that of deliveries for business use). While much of the "information superhighway" discussion focuses on software, there will in parallel be a huge need for companies with strong technology to lay the foundations of computing power and systems to support this. With its vast effort in research and development, and an improving execution in transferring its technology to the marketplace, we think IBM will show wonderful profit growth from these developments (as well as from its wide-ranging restructuring efforts).

Apple computer has a terrific franchise built on the ease of use of its operating system and hardware; this has given the company dominant positions in the education, graphics art, home and small business markets - positions which have held up well in recent years in the face of very aggressive competition. The negative sentiment affecting the share price mainly concerned the predominance of IBM compatible machines and their use of a different operating system owned by Microsoft. While the gap between the two principal operating systems is narrowing as Microsoft adapts its offering, Apple is continuing to lead with innovative upgrades to the Macintosh operating system such as support for multi-media. Most importantly of all, Apple will licence its operating system to a number of partners this year, which will make the Apple operating system more widely available, encourage greater support from software developers, and generate significant fee income.

Looking out to next year, Apple, IBM and Motorola will offer Power PCs which will be able to operate on several operating systems and hence reintroduce Apple PCs to the mainstream. This will dramatically alter users' perception of IBM compatible PCs versus Apple MacIntosh. As these developments gradually unfold, it is likely that the market will reassess the company and emphasise its extraordinary record of innovation. (It is interesting to note that Apple spends between 6-8% of its sales on research and development compared with 2.3% spent by the present market darling, Compaq).

A third theme is the anticipated turnaround in Airline companies, particularly in the USA. The industry is presently under a cloud because of cut-throat competition from new start-up and low cost providers. However, the industry is at the end of its financial tether and even the low cost providers are in trouble. While the major companies are finding ways to cut costs, low cost producers are tending to raise their prices which suggests to us that the industry is at a cyclical turning point, notwithstanding the late phase of the US economic cycle.

Our holdings in Europe and elsewhere lack these themes and the companies have been selected on the basis of their individual merits. As you will see from the geographic distribution of the portfolio these are quite dispersed and vary from a tobacco company in Spain, to property developers in Asia (notwithstanding rising interest rates), and to several investments in Australia.

Our investment in Russia has done a full circle, having appreciated enormously in the first two months, it has now returned to close to our entry price. Notwithstanding the political risks, we believe this pooled investment makes sense in terms of exposing us to a potentially vast and resource rich market.

New ideas will be financed out of our cash balances and to the extent we are concerned about market risks we will continue to short stock market indices or sell heavily overpriced companies which we do not own, with the intention of buying them back at a lower price (short selling). We remain of the view that the A$ will be strong in a trade-weighted sense and we will continue to hedge most of our assets into A$.

In conclusion, we think the portfolio is reasonably balanced for the type of choppy markets we foresee. We are very excited about some of our new ideas and believe they should bring good returns.

Upside/Downside Table
The above table categorises the portfolio in the same way that we do for our day to day management. The "physical" column simply shows the location of the fund's investments.

The "upside" column is an approximation of the portfolio's exposure to upward movements in a market. This approximation is calculated by making two main adjustments to the "physical" position. The first is to subtract (from the physical position) any short positions in shares or share index futures. For example, if 5% of the portfolio was invested in Japan but there was a 2% short position in Nikkei futures, then the upside column would show 3%. Conceivably, the figure could show a negative exposure which would indicate the portfolio was (net) short the Japanese market. The second adjustment is for options held to buy shares. A call option with the premium representing 0.5% of the portfolio to buy shares in Toyota worth, say, 3% of the portfolio would require an additional 2.5% to be added to the Japanese exposure (thus determining so-called underlying exposure).

The "downside" column is an approximation of the portfolio's exposure to downward moves in the market. It is calculated by adjusting the "physical" position for any short positions in shares or share index futures. It is not necessary to adjust it for call options as only the option premium (already included in "physical") is at risk, not the underlying holding callable by the option.

Back to the top