The APS Alpha Fund (click here to read the factsheet) was launched in August year, and is Singapore's first and only zero expense ratio fund. Since launch, the fund has underperformed its peer Asia ex-Japan funds. In a recent meeting with fund holders, Chief Investment Officer Wong Kok Hoi explained the underperformance was a result of core positions in Korea and Taiwan that have suffered due to market volatility. In this email interview, the fund house goes into further detail about the fund's performance, and explain changes to the performance fee structure.

Q: Why has the performance of the fund fallen behind that of its peers in the last year?

A: A large part of the underperformance can be attributed to the non-performance of the Korean and Taiwan stocks which account for above 45% of the portfolio value. Despite their very cheap valuations, the markets have continued to ignore some of these stocks. Their earnings year to date have increased more than 35% in some cases, ROEs are between 25%-35% and they are trading at below 10x PER. Cash dividend yields are also high. On top of that these companies have solid and honest management. We believe that investors will have to recognize and allocate money into some of these stocks eventually when their profitability and value become more obvious.

We are also not invested in Indonesia, which happened to be one of the best performing market in the region this year. As long term investors, we tend to want to avoid companies with corporate governance issues and there are a lot of them in Indonesia, despite the fact that they may appear cheap on paper. It is like holding on to a bomb that may blow up in your face any time. It is the same argument we all had during the internet bubble. Warren Buffett looked very stupid when the internet bubble kept going up but he stuck to what he knew instead of trying to go in and out of a hot sector/country du jour. That saved investors a lot of pain in the end.

Q: The fund appears to have suffered as a result of its investment in LG Card (South Korea's largest credit card issuer). Why did this stock under perform? Are you still holding onto this stock? Why?

A: We certainly learnt a very valuable lesson from this one. It just goes to show that no matter how careful or experienced you are, there will always be very bad investments. It happens every year. This is why it is important to diversify our investments. In the case of LG Card, we have certainly underestimated the extent of the bad debt problem in the company. We should have been more cautious about investing in a financial company that has grown very quickly in the previous 2 years. Our investment rationale at that time was that because of the huge spreads that it earns (the company was borrowing at 6% and lending it out at above 20% on average) it would be very hard, even for a dumb management, to lose money. Our investment thesis was based on this and on some very conservative assumptions on bad debts and declining margins going forward. On top of that, we bought it at around 6x PER.

But even this is not enough as a margin of safety as we soon found out. The government started slamming the brakes on credit card loan growth in a series of severe and sudden changes in regulations without giving the card companies time to adjust. This caused many borrowers to default because they were overleveraged. Then the SK Corp crisis happened at about the same time, causing fears of default in the corporate bond markets. This effectively meant that funding for LG Card, which had issued a lot of corporate bonds for its capital, dried up in a matter of days. The company was then became technically insolvent and had to be bailed out. The bail-out itself raised another corporate governance issue where the creditor banks issued themselves a lot of shares at very low prices to the detriment of minority shareholders. You may wish to know that we wrote to the company and the Minister of Finance protesting against such blatant abuse of minority shareholders but to no avail. We finally decided that we should exit the stock given the high probability that the creditor banks and the government might still repeat this corporate governance abuse. We believe that both Capital Group and Templeton were also big shareholders until they got out at close to the bottom.

Q: Why does the fund have over 20% in Korea (as at 14 Sept 2004)? Considering that exports have slowed, consumer demand remains weak, and earnings growth estimates are forecast to slow, will the fund reduce this weighting in the near future? Why?

A: We are a bottom-up stock picker which means we go where the opportunities are regardless of where the stock is listed. We do not start from a macro perspective and decide beforehand where we are going to buy the cheapest and best stocks. So to answer your question, we have over 20% exposure to Korea because there is where a lot of good stocks trading at low valuations are. It is likely to remain this way as long as the company fundamentals stay the same or better and if the valuations remain attractive. Yes, exports have slowed and consumer demand remains weak but that doesn't mean that no one in Korea is making money or it certainly doesn't say anything about whether the stocks there are cheap or not.

We can also look at the situation in another way. Many stocks in Korea are cheap currently because many people are saying what you are saying and are avoiding Korea. The only time you can buy cheap is when no one is looking at it. By definition, the peak of the market is when all things are going well and that you cannot possibly imagine a situation in which next year is going to be a bad year. (Remember the technology bubble?). Investing is hard for this reason. It is hard to justify to your clients when you are buying something that no one sees a potential in because all the charts and numbers will prove you wrong and the good numbers are yet to appear. On the other hand, no one gets sacked for buying Chartered Semiconductor or Datacraft at the top of the market because everyone thinks that it is a no-brainer to pick those "winners".

Q: Which stocks were the best and worst performers within the fund? What was the profit/loss like for each of these stocks?

A: The best performer in the fund since inception in Sep 03 is definitely Hi-P International which was up close to 200%. This company is a contract manufacturer of your Braun toothbrushes and your Gillette electric shavers. The other top performer in the fund is Kingboard Chemicals listed in HK, a maker of PCB laminates, which registered a 92% increase as at end Sep 04. We are very excited about the prospects of these 2 companies and they are likely to grow at very high rates in the next few years, given their robust business models and excellent management.

Amongst the worst performers are Powercom, a maker of Uninterruptible Power Supply (UPS) equipment, which was down 48% and KH Vatec, a handset component supplier to Samsung, down 44%. They are both relatively small positions in the portfolio (started out with 1%) and so the impact is not huge. The only one that really hurt the portfolio was Pihsiang Machinery which started out at more than 7% and lost 34%. The company, and indeed the entire electric wheelchair/scooter industry, faced an unexpectedly decline in the US market because of a Medicare subsidy scam there. The subsidies have been restored but we believe it will take some time before the market returns to normal.

Q: The fund has more than 25% in Taiwan. What proportion of this is in IT and financials? Do you specifically like this type of stocks? Why?

A: That is a very good question and an interesting one! That is because many fund managers investing in Taiwan tend to focus a lot on technology companies. And maybe recently they are looking at some companies that may benefit from the short term domestic reflation theme and M&A activities in the financial sector. APS, on the other hand, is still focused on some old economy stocks making "boring" things like car lamps, golf club heads, pneumatic tools and bathroom ware. Make no mistake, though, these are world class manufacturing companies in their own industries. They may or may not be in vogue all the time but this does not bother us. We are looking for stocks that will do well over long periods of time not for those that do well for a couple of months.

We are not very keen on the tech sector in Taiwan in general because of the serious corporate governance issues there. The companies could be doing very well on paper but most of the benefits have accrued to the employees through stock bonuses (issued at par value) and not to shareholders. In fact, in many cases, if you expense the employee bonuses into the profit and loss statement, you will realize that these companies are not as profitable as you think they are. A lot of companies are paying more than 50% of their profits to their employees (thanks to shareholders). Some companies have paid out more than their profits as bonuses or huge bonuses to their employees in years where they are making losses. We find it hard to be enthusiastic about companies doing that.

We do not like financials in general because of their business model. Competition is very intense in this industry in general and there is very little to differentiate one bank from another. Everyone is selling more or less the same products and the only way to compete is in price. ROEs are generally low, reflecting such an industry structure. If you can find more exciting and profitable companies where you can hold for the long term, why pick a bank? The only time when we would own a bank (and we have in the past in Indonesia and Thailand) is when the entity is selling at bargain basement valuations. We do not think this is the case at present in most countries.

Q: With the exception of Singapore, the fund appears skewed towards stocks in North Asia (Hong Kong, Taiwan & Korea). Why?

A: We do not have a special bias for or against the other countries in the investment universe. It just so happens that we can find some really good companies selling at very cheap valuations in North Asia at this point in time. In other words, we have a bottom up approach when we pick stocks. We don't care where it is listed as long as it meets our stringent investment criteria. To be sure, there are some very good companies listed in the other countries but they are not selling cheap enough. We will go where the opportunities are. We think that is a more pragmatic approach.

Q: Considering that the fund has more than half its holdings in consumer stocks (consumer staples and consumer discretionary), why aren't there more Southeast Asian stocks that tap consumer demand?

A: The answer to the question is that the MSCI classifications are indeed misleading at times. For instance, a lot of manufacturing stocks are actually classified under consumer stocks when it is strictly speaking not a direct exposure to Asia consumption. Meiloon, a manufacturer of high end speakers based in Taiwan is one good example. It makes and exports most of its speakers to the US and Europe. Same thing with Pihsiang Machinery (electric wheelchair and medical use scooters), Grandhall (BBQ equipment) and Basso Industries (pneumatic power tools). In fact, we have very little direct exposure to the domestic consumption theme in Asia at the moment. One of the more prominent exception is Want Want which sells most of its rice crackers and gummy sweets in China. That is because we see a lot of opportunities in the long term outsourcing trend from US and Europe. Manufacturing is definitely the strength of Asian companies, especially those that are producing in China.

Q: Recently there have been changes to fund's performance fee. How is this beneficial for investors?

A: APS has decided to lower the level of performance fee from 30% to 25% of performance, while keeping the hurdle rate at 6% p.a. The advantage for investors is obvious - they will have to pay less fees for the same performance. An additional improvement for investors is that we have now introduced a high watermark, which means that the investor does not pay twice for the same performance. For example, if an investor enjoys positive performance in year 1 and pays a performance fee, followed by a negative return in year 2, the fund's performance in year 3 needs to take the fund beyond the level at the end of year 1 before performance fee is payable again.

APS continues to absorb all other expenses, i.e. the fund continues to carry a zero expense ratio. This is much better than what some other fund managers in Singapore offer, who have come with performance fee schemes - these fees tend to be in addition to a fixed management fee as well as charges for other expenses.

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