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Arisaig Asia Diary November 2008    
Performance
The NAV fell 4.2% in November giving up much of the late October bounce. It was at least encouraging that markets tested the low without breaking down further. From a chart perspective, the next major support level, the March 2003 SARS low, lies a vertiginous 30% further down.

With dividend yields in many Asian markets now at over twice ten year government bond yields (the ratio is 1:1 in the USA) there is no doubting the value in equities. That said, if the world does slip into a prolonged deflationary spiral, as some commentators predict, then all bets are off.

Certainly the pace and magnitude of wealth destruction have been breathtaking. Whether the trillions of dollars being thrown at banks and economies stop the rot remains to be seen. Unlike governments in the West, the Chinese at least, own the dollars that they are throwing, which presumably has implications for the relative value of currencies going forward.

The end game in the West must, in our view, be full scale nationalisation of banking systems as being the only way to cancel out the myriad derivative obligations that are said to account for 1000% of global GDP (traditional bank loans measure only about 80%). If this is the final outcome, the mandarins in Beijing may start to think that the West has finally come to accept the case for “capitalism with Chinese characteristics”.
 
The role of China
Just as, arguably, this global crisis began in China, it will, in our view, find its ultimate resolution there too. We trace the origins of the successive bubbles of the last fifteen years to the decision by the Chinese to devalue their currency in 1994 by 50% and then to run an artificially depressed exchange rate ever since.

This, coupled with the never-ending supply of cheap labour migrating to tax-incentivised coastal cities, resulted in an export boom and the accumulation of huge trade surpluses in both China and the neighbouring countries that supply the raw materials and components to its manufacturing sector.

Hot money, betting on “inevitable” Renminbi appreciation, augmented the monetary aggregates in China. Indeed we understand that 75% of all savings since time began have been accumulated in the past decade - mostly in Asia.

The recycling of these savings back into the developed world resulted in low inflation and very low interest rates. During such disinflationary periods investors tend to end up chasing higher returns on the periphery, usually in so-called “emerging markets”.

Hence the bubbles (followed inevitably by busts) that have occurred initially in Asia in the late 1990s, followed by dotcom exuberance at the turn of the millennium, property throughout the period and more recently commodities.

The largest bubble of all, of course, took place in the developed world’s own emerging market back-yard, the sub-prime sector, with its impact, tragically, both concealed and magnified many times over by the ingenuity of investment banks.

China has the economic fire power, and just as importantly, the political desire, given Communist Party insecurities, to keep growth bowling along. Hence the dramatic interest rates cuts and assorted fiscal measures that have been announced of late with accelerating intensity.

The most significant measure, however, in our view, largely overlooked in the West, has been the announcement in October of land reform, allowing the country’s rural population the right to buy, sell and rent etc. their allotments.

Just as the decision to distribute state-owned apartments to factory workers for nominal sums from the late 1990s spawned a property-owning middle class with all the obvious mortgage multipliers, the new rules on farmland will have the same impact on the rural community and on the pace of urbanisation to the advantage of domestic consumption and therefore our portfolio.

The ultimate test for the Chinese, however, will come, when, as we anticipate, huge fiscal deficits in the West, put downward pressure on the US Dollar and Euro. We will then see whether the Chinese are willing to countenance an appreciation of the Renminbi in keeping with their goal of boosting domestic consumption and higher value-added manufacturing.

Longer term we must all hope that China’s political structures evolve sufficiently to relinquish the imperative of growth at all costs, the cost this time round being extreme pain in the West.
 
Our Portfolios

We have continued to rationalise our portfolios removing holdings that are now too small. This process is more or less complete in all funds bar India where chronic illiquidity is making this a challenge.

We expect to be allocating cash mainly to China and ASEAN. Our dilemma remains that the top quality mid cap consumer names are not yet that cheap. Like us, investors seem reluctant to sell businesses that have emerged as long term sector winners.

That said, we have no doubt that this difficult period will separate the boys from the goats. Take for example the decision by the founders of Natural Beauty, a chain of cosmetic clinics across China, to try, with the help of private equity backers, to privatise the company at a price below the current market value. Whilst we are fairly confident of being able to block this initiative, the company’s reputation is now tarnished.

 
Korea - The Sick Man

Lindsay spent a week in Seoul with Shi Young. Korea is the one country in Asia suffering from western style debt problems. Bank loan-to-deposit ratios are at 140% (compare to India where that number is about 60%). Household debt is now equivalent to 75% of GDP, up from 35% a few years ago, and pre Asian crisis savings rates of 16% have fallen to Anglo-Saxon levels of 2.5%.

As we often say, Koreans are incapable of doing anything by half. For example, the deregulation of corporate pension scheme rules in 2007 resulted in a wholesale shift of money from bank deposits into the stockmarket – just at the wrong time.

And then, to add insult to injury, Korean corporates punted private pension schemes in weirdly named currency derivatives (“KIKOs”, “Pivots” and “Snowballs”) with the inevitable disastrous consequences. Worse still, Korean banks (who acted as agents for the foreign banks selling these derivatives) have, apparently, guaranteed the liabilities of their end customers.

With Korea now representing only 6.9% of the Asia Fund, our decision to de-emphasise this market appears to have been the correct one. Our core holdings, AmorePacific, LGH&H, Woongjin and Ottogi continue to stand out in terms of business quality, albeit the first two are still not as cheap as we would like. Meanwhile we are completing due diligence on a couple of new ideas.

 
Redemption Update
Following one-on-one meetings with our US Endowment and Foundation clients in New York in November (these account for about 60% of our invested capital) we wish to update all investors on the issue of redemption flows and notice terms.

There is no doubt that the Endowments are, as has been much publicised, facing a degree of liquidity pressure. Gifts from alumni, which have helped to fund annual commitments to pay for research, bursaries and new building projects, appear to have dried up. Meanwhile cash calls from private equity portfolio managers are no longer being met by cash distributions from more mature funds.

The reaction to these liquidity constraints has been, for the most part, to raise cash from holdings in hedge funds, particularly those with onerous lock-ups.

We came away with the impression that, unless global markets ratchet significantly downwards again, our US investors are more inclined to add to their holdings in emerging markets which have, due to market action, fallen well below target levels.

The fact that many of our competitors are withdrawing from the small cap space, resulting in ever more pricing anomalies, supports the case. Increasingly we find ourselves as being the first port of call and, invariably, the only bidders for blocks of stocks that come out of the woodwork.

With respect to redemption notice terms, it would seem that our relatively “open” redemption provisions (28 days notice on a daily dealing basis) have, counter-intuitively, helped. The fact that our investors know that they can file a redemption instruction on any day of the month has meant that they have not felt the need to file precautionary redemptions. We have no plans to change our current provisions.

Therefore, although the global outlook remains uncertain, we are minded, following feedback from our meetings in New York, to slide some of our cash holdings of about USD 90 million back into the markets given the very attractive prices now available, especially in the small cap space.
 
ARISAIG PARTNERS
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November 2008