Three Kingdoms Korea and Yellow Tiger Greater China Funds: Fabien Pictet and Partners (FPP)

Good returns in small packages

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Jonathan Neill, investment manager of both funds, is out of sync with his industry peers when it comes to investment decisions. Most long/short equity managers agree that rooting around in a company’s every nook and cranny is crucial for deciding whether or not to invest.

But Neill does not carry out detective work either at the company under consideration nor its country of residence. He would like to visit Korea one day, “but not to visit any Korean companies,” he says.

“Our process is entirely quantitative and based on evaluations and we follow exactly the same system for China and Taiwan. I have been to Taiwan many times but I don’t believe in any of the visits I have learnt anything from a company that has helped me make a better or worse investment decision,” he claims.

“I’ve made lots of good and bad investment decisions in my life but they were never the result of meeting a company. They are a result of sitting here, looking at the valuations, discussing with a colleague and deciding what to do. Other people like visiting companies, knowing everything about them and think that gives them an advantage. I say good luck to them,” notes Neill.

Some of Neill’s bad investment decisions were made in 2008. Neill readily admits both funds’ performances were disappointing relative to the rest of the industry’s performance.

In 2008 the Three Kingdoms Korea Fund was down 53% and the Yellow Tiger Greater China Fund rell over 64%. In contrast the HFRI Fund Weighted Composite Index was down only 19% and the HFRI Emerging Markets: Asia ex-Japan Index fell just over 33%.

“I was very proud of our performance. We did very well, growing a company from nothing to running nearly $1 billion dollars. Then 2008 came and I am ashamed to say we didn’t see the full extent of what was happening and all the funds got murdered, down 55%-60%,” Neill acknowledges.

Neill says 2008 and 2009 was the most difficult period he has ever had to manage. “From the valuation point of view, there were no signs markets were about to fall to pieces, so I could see no reason to change the funds’ exposure,” he says.

Coming out of the financial crisis, both funds have made amends. Neill is particularly proud of having recognised the potential for investment in emerging markets and both funds’ subsequent recoveries. “Obviously some people sold out [of the funds] and booked those losses. Some of them remained. Those who remained got the full extent of the recovery. So although we were wrong going into [2008], we were absolutely right coming out of it,” he asserts.

Three Kingdoms and Yellow Tiger predominantly invest long-only but if markets fall by a specified percentage chosen by Neill at any point in a month, a hedge is placed on the whole portfolio and short positions taken. This typically takes place a third to a quarter of the time.

This system has been developed over the last 12 years and, according to Neill, is simple but effective. Although this means that performance is sometimes spent, Neill’s faith in it is unswerving.

The long positions are usually held for over a year, although they are constantly being reassessed and altered. Neill compares the funds to submarines, “chugging along slowly” and only occasionally implementing change.

“We trim stocks that get more expensive and increase stocks that get cheaper. We rarely dispose of any of the shares at the top of our list in their entirety. Stocks that perform extremely well but become very expensive may be entirely disposed of, but they would have to become extremely expensive for that to happen,” Neill comments.

Neill is a founding director of FPP, having previously worked at Pictet & Cie from 1990 to 1998. He has managed the Yellow Tiger fund since inception in March 2005. In mid-2009 he took over the Three Kingdoms fund, launched in April 2004.

The Three Kingdoms fund’s dismal performance coupled with staff cuts and performance issues with Yellow Tiger presented Neill with ­several challenges.

The change of management seems to have paid off. In 2009 Three Kingdoms returned 34% and a healthy 29.6% in 2010, outperforming the 25.3% of the MSCI Korean Index in 2010.

Yellow Tiger more than reached its high water mark in 2009 with a stunning 148.9% return followed by a tamer 17.8% in 2010. This still considerably outperformed the MSCI China Index’s 2.3% returns in 2010.

The funds focus on Korea, China and Taiwan. These countries have “broadly undervalued currencies, low inflation profiles and consumers are not loaded with debt in the style of the Western world,” says Neill.

Neill is unflustered by political and economic issues. For example, of the recent heated military drama between South and North Korea he calmly explains “the Korean situation has been like that since the 1950s. Occasionally it flares up and they lob a bomb somewhere, everyone gets excited and the markets go down.

“Some people use it to explain the chronic discount they think Korea sells at relative to other markets. All we can say is that Korean shares from the valuation perspective from the time we launched the fund to today remain inexpensive relative to other assets both in the region and in the world.”

His pragmatism largely stems from the confidence he has in FPP’s “price/appraised value model”, developed by the company in the early 1990s. Stocks are chosen using data from a system called Factset.

Several databases are fed into Factset, including data from MSCI and Thomson Reuters. Factset then creates spreadsheets on individual stock markets, including the spreadsheets FPP has used to run its emerging markets funds since 1993.

Stocks are then analysed in terms of both growth and returns enabling Neill to select the lowest price stocks relative to fixed-income investments. Chris Edwards, FPP’s director of global markets, says this is not a “forensic” investment approach.

“We don’t say we can find the cheapest shares in Korea. We say we can work out how much to put into each share if we’re going to outperform the Korean market. Then we have a hedge in place to stop it losing too much, which is what happened in 2008,” Neill explains.

The fund expanded to include China in 2009 following its rapprocehment with Taiwan After the two signed an economic co-operation framework agreement in June 2010, Neill believed further investment opportunities would be created.

He also saw a commercial reason to expand into another country as “single-country funds were difficult things to encourage people into during the financial crisis and they still are difficult vehicles to promote to people”.

In mid-February Yellow Tiger held 157 long positions, the majority of which were divided between technology (22%), finance (19%) and energy minerals (11%).

Likewise Three Kingdoms, with 82 long positions, concentrates on technology (23%), finance (15%) and consumer durables and producer manufacturing (13% each).

Some of the winning investments for Three Kingdoms include Samsung Electronics, the iron and steel company Posco and Hyundai Motor Corporation. “We see the large companies in Korea being extremely attractive in price. Here you don’t need to be scrambling about looking at small and mid-size companies as the bigger shares are so inexpensive. These are the shares that will drive the Korean market,” he states.

Neill believes their capacity to trim and adjust these holdings stems from the independence gained by operating in a small team. “We can do whatever we want. We’re extremely nimble. We’re not burdened by bureaucracy and investment committee meetings and so on,” he says.

The Three Kingdoms originally only invested in small and mid-cap companies. “I didn’t see any reason to retain that focus when the bigger companies look much more appealing,” Neill explains. “One day that will change and we have to be pragmatic. There is no point remaining stuck in a rut when you see a better path elsewhere. I changed the focus and we will change it back again if for some reason the bigger companies become extremely expensive compared to the smaller ones and we can find better opportunities there.”

Although the funds’ largest weightings are at present in the technology sector, Neill acknowledges the risk of a “technology buzz”, particularly in Taiwan and Korea. He believes technology cycles are different to economic ones. There can also be periods when there is little innovation and no “winning” product. Such a situation can lead to earnings depression. “These can depress prices even when the world is ticking along nicely,” he says.

However, Neill does not view this as a high risk at the moment and considers the technology sector particularly cheap at present.

Neill is content with the price/appraised value system although he concedes it has its flaws. “The cheapest shares don’t always go up the most and that’s a difficult thing to deal with,” he says.

To cope with this Neill has adopted the technique of tennis number one Roger Federer: “Federer does exactly the same thing over and over again whereas other players are much more volatile. So I think if we do exactly the same thing based on a commonsensical evaluation approach, in the end that will work well,” he says.

In the past two years this approach has served both funds well and returns have been exemplary although investors continue to stay away.

Currently, AUM of Yellow Tiger is $14.5 million and Three Kingdoms is $10.4 million. At their peaks, the funds reached $214 million and $120 million respectively.

“Over past two years, the Yellow Tiger Greater China Fund has been one of the top-performing Chinese funds out there, so I don’t know why it isn’t 10 times the size,” he exclaims.

The funds are predominantly marketed to fund of hedge funds in the UK, private banks in Switzerland and institutional investors in Europe and in North America, or as Neill puts it, “anyone who will listen really. We aren’t fussy.”

“Before the financial crisis people believed in us and believed what we were saying. There are a lot more sceptics out there now,” notes Neill. Convincing the sceptics is like “banging your head against a wall,” he says.

However, he is confident the “inclement” investment climate will not last forever. “We still have the same people and the same processes in place. I believe the investment will come back,” he confirms.

Fund facts

Full name:

Three Kingdoms Korea Fund

Yellow Tiger Greater China Fund

Fund manager:

Jonathan Neill

Jonathan Neill and Vanessa Lui

Investment management company:

FPP Asset Management

Contact information:

FPP Asset Management, 34 Brook Street, Mayfair, London WIK 5DN

Launch date:

March 5, 2004

March 10, 2005

Assets under management:

$10.4 million

$14.5 million

Net cumulative performance since inception:

44.07% through January 2011

21.82% through January 2011

Annualised return:

29.6% (December 2009 to December 2010)

17.8% (December 2009 to December 2010)

Annualised volatility:

24.89 (January 2010 to December 2010)

19.64 (January 2010 to December 2010)

Sharpe ratio:

1.72

1.46

Strategy:

equity long/short, Korea

equity long/short, China, Hong Kong and Taiwan

Prime broker/custodian:

JP Morgan

Morgan Stanley

Administrator:

Daiwa Europe Fund Managers Ireland

Auditor:

Ernst & Young

Share classes:

US dollar, euro

Legal counsel:

Dechert

Domicile:

Cayman Islands

Listing:

Irish Stock Exchange

Management fee:

1.75%

Performance fee:

10%

Minimum investment:

$100,000

Redemption/liquidity terms:

10 business days’ notice

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