During the third quarter of 2016, the Seafarer Overseas Value Fund gained 3.93%.1 The Fund’s benchmark, the MSCI Emerging Markets Total Return Index, rose 9.15%. By way of broader comparison, the S&P 500 Index gained 3.85%.
The Fund began the quarter with a net asset value of $9.93 per share. The Fund paid no distributions during the quarter, and it finished the period with a value of $10.32 per share.2
Your fund took its first breath of life on May 31, 2016 with a net asset value of $10.00 per share. It launched with $2.8 million in assets under management, and ended the third quarter with $4.8 million.
I purposefully deployed the Fund’s cash on a gradual basis throughout the quarter, preferring an average price of entry for each holding over the arbitrariness of prices on launch date. The difficulty with this approach was lowering the average cost of entry for each position in a quarter when the emerging markets as a whole were appreciating considerably. That said, there was sufficient price volatility for individual securities within the quarter that I believe the portfolio was well served by this approach.
The primary difficulty of launching the Fund during a quarter of significant market appreciation was effectively implementing the portfolio I had intended to construct pre-launch. In fact, I did exclude several securities from the actual portfolio due to meaningful price appreciation prior to and during the launch period. By way of example, a potential holding located in Latin America more than doubled in price between the beginning of the year and the Fund’s launch, while another one in the same region appreciated by 66%. While not an ideal circumstance, I viewed this complication as a test and opportunity to practice what I preach as a value investor. The key tenet of the Seafarer Overseas Value Fund is to maintain discipline with regard to the price paid for securities.
On the other hand, there are a number of potential holdings on our watch list, which I expect to incorporate in the portfolio funded by its liquid resources.
The Fund appreciated 3.93% during the quarter. While the Fund does not seek to track a benchmark, it is worth noting that performance during its first quarter of life was distinctly more stable than that of the MSCI Emerging Markets Total Return Index. In other words, the Fund tended to underperform on days of strong index appreciation, and tended to outperform during negative performance days for the index. While not an a priori objective of the Fund, this behavior makes sense in hindsight as the third quarter’s benchmark performance was heavily concentrated in the Technology and Financials sectors, which together accounted for 65% of the index appreciation, and to which the Fund has little exposure. Furthermore, the technology sector recorded very strong year-over-year earnings growth of 69% during the quarter. As a result, I can identify two characteristics that drove the Fund’s idiosyncratic performance relative to the index during this particular quarter. First, the Fund tends to shy away from momentum stocks, favoring instead companies going through their own individual earnings cycles, with time horizons measured in years, as opposed to quarters. Second, the Fund’s sectoral exposure is a function of stock selection and nothing more. Indeed, the Fund’s active share score was 92% as of the end of the quarter.
I cannot speculate with regard to how the Fund will perform relative to any emerging markets index in future quarters, as there are too many variables to consider. However, given the nature of the Fund, I would expect it to maintain a relatively high active share score.
I view the Fund’s holdings within the framework of the sources of value defined in our white paper, On Value in Emerging Markets. From this perspective, the third quarter saw strong appreciation of several holdings within the Asset Productivity category, where the source of value is a cyclical downturn following a period of asset expansion. The common denominator of these securities is that they operate in industries that have been in recession for several years now. Whether these share price gains prove sustainable remains to be seen, but at least the market has given some indication that these particular stocks may have been over-discounted in what was already known to be difficult trading conditions.
At a security level, it is worth noting that three Fund holdings announced meaningful profit warnings during the quarter. Yet, the resulting pullback in two of the three holdings was relatively muted and short-lived. I interpret this stock performance in the face of negative earnings surprises as validation that valuations are already supportive of our original entry points.
Specifically, Shangri-La Asia, an owner-operator of luxury hotels and mixed-use properties throughout Asia, reported a meaningful asset impairment charge related to weak performance at some of its Mainland China properties. Wilmar International, a vertically-integrated agribusiness company, pre-announced a quarterly earnings loss primarily due to untimely purchases of soya. These stocks are currently trading close to or at a higher price than they did prior to releasing their negative earnings surprise, suggesting valuation support for the share price in the face of earnings losses. The third holding to report a negative earnings surprise was AMVIG Holdings. Second quarter earnings for this manufacturer of tobacco packaging declined 47% due to clients drawing down their existing packaging inventory in anticipation of changes to the rules governing the advertisement of health risks. Given the high dividend payout ratio, the company lowered the dividend in-line with earnings. The stock is down approximately 9% since the earnings announcement. Among the reasons I continue to hold this stock is the idea that I expect packaging volume to fully recover for this inelastic product, and pegging the corresponding future dividend to the current share price results in an expected dividend yield of close to 9%.
Emerging market equities and currencies distinguished themselves during the third quarter of 2016 by appreciating meaningfully (the MSCI Emerging Markets Total Return Index rose 9.15% in U.S. dollars) after struggling since the second half of 2014.
While it is tempting to attribute the most recent performance to the relative cheapness of emerging market valuations vs. developed markets, I remain concerned that the foundation of this appreciation is weak given that most, if not all, other asset classes appreciated concurrently; thus leaving open the possibility that there may be a larger driver, exogenous to emerging market equities, at work.
I am less concerned by the fact that virtually all asset classes have appreciated, than by the inherent contradictions in these indicators. Indeed, negative yields in fixed income on a global scale point to extreme market risk, while very low price to book value multiples for banks in developed markets implicitly recognize the malinvestment that public non-performing loan statistics for those same banks do not. In other words, the market has a very different view of banks than that portrayed by publicly available financial statistics. And yet equity valuations in developed markets seem to discount future growth that is incompatible with an eventual denouement of bank balance sheets.
Additionally, the third quarter of 2016 witnessed two seemingly contradictory and momentous events: the United Kingdom’s June 23 decision to leave the European Union and the inclusion by the International Monetary Fund (IMF) of the Chinese renminbi in the Special Drawing Rights (SDR) currency basket effective October 1, 2016. How should one interpret an economic divorce and a currency marriage of such magnitude all within one calendar quarter?
Perhaps it would be more useful to interpret these historic decisions not as contradictory events but as the breakdown of long-standing relationships. The United Kingdom chose to regain its sovereignty from Brussels, and China took yet another step to regain sovereignty from the U.S. dollar.
This breakdown of long established relationships as reflected in currencies may explain one of the most significant yet least appreciated idiosyncrasies of our times: the unnatural standstill in world trade. The natural state of a free market is the continuous reorganization of production processes. World trade should generally grow as a result of these adjustments more or less irrespective of whether gross domestic product (GDP) is shrinking in some countries and growing in others. In my view, the standstill in world trade since 2011 is more indicative of uncertainty on the supply side of the world economy, than the vicissitudes of economic output. The large currency movements both in emerging markets and developed economies since 2014 also constitute expressions of this breakdown in long established relationships. I view this process of adjustment as likely to generate cheap prices for companies that are perceived to be negatively affected by these changes. This should be a good time to hunt for value.
While I am concerned about the global economy, I would caution against interpreting these views as a negative for emerging markets. For every break with the past is also the birth of a new future. Looking beyond the period of global adjustment we are likely undergoing at present, I would point to the inclusion of the renminbi in the SDR basket as a potentially defining moment for emerging markets.
The reason for such a bold claim is that it is difficult to overstate the salutary impact of a sound currency on an economy and the well-being of a nation. Inclusion of the renminbi in the SDR does not make the renminbi a sound currency. China still must make the renminbi a hard currency (i.e. a currency that is not likely to depreciate suddenly or to fluctuate greatly in value) through its own actions. However, there is strong signaling value in the IMF’s decision. A potential transition of the renminbi from a U.S. dollar peg underpinned by capital controls, to a free floating currency underpinned by an open capital account, could pave the way for the use of Chinese securities denominated in renminbi as vehicles for long-term global savings. Such a transition would probably increase the demand for Chinese equity and debt instruments and would likely dampen their price volatility.
Furthermore, there could potentially be implications for the rest of Asia, and even emerging markets as a whole, to the extent that the renminbi could increase its role as a monetary anchor for the region. Whether the renminbi eventually fulfils this role remains to be seen. I am simply calling attention to the long-range possibilities of making the renminbi a “harder” currency that it has been historically.
Indeed, my colleague Andrew Foster’s study of the long-term impact of emerging markets currencies on U.S. dollar-denominated returns for the MSCI Emerging Market Index concludes that the net impact over the past ten years approximates -2% per annum. The result of this study is indicative of the general “softness” of emerging market currencies and partially explains higher discount rates for securities with cash flows denominated in these currencies. A successful transition of the Chinese renminbi to a reserve currency in the SDR underpinned by an open capital account would have a tremendous salutary impact on capital allocation in the country and the long-term return potential of China, and emerging markets by extension.
The Seafarer Overseas Value Fund remains focused on finding what it deems to be undervalued securities. The primary influence of the above discussion on the Fund’s research process is simply to be conscious of the possibility that historic rates of return and growth patterns may prove less useful in navigating an always uncertain future than has been the case in the recent past. I am optimistic that the process of adjustment the world economy is likely undergoing will yield opportunities for the Value Fund. For now, I plan to maintain a healthy level of liquidity to both invest in new opportunities and partially guard against potential market drawdowns resulting from currency rearrangements.Paul Espinosa Seafarer Capital Partners, LLC
- The performance data quoted represents past performance and does not guarantee future results. Future returns may be lower or higher. The investment return and principal value will fluctuate so that an investor's shares, when redeemed, may be worth more or less than the original cost. View the Fund’s most recent month-end performance.
- The MSCI Emerging Markets Total Return Index, Standard (Large+Mid Cap) Core, Gross (dividends reinvested), USD is a free float-adjusted market capitalization index designed to measure equity market performance of emerging markets. Index code: GDUEEGF. It is not possible to invest directly in this or any index.
- The S&P 500 Total Return Index is a stock market index based on the market capitalizations of 500 large companies with common stock listed on the NYSE or NASDAQ. It is not possible to invest directly in this or any index.
- The views and information discussed in this commentary are as of the date of publication, are subject to change, and may not reflect the writer's current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. It should not be assumed that any investment will be profitable or will equal the performance of the portfolios or any securities or any sectors mentioned herein. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Seafarer does not accept any liability for losses either direct or consequential caused by the use of this information.
- As of September 30, 2016, Shangri-La Asia Ltd comprised 3.6% of the Seafarer Overseas Value Fund, Wilmar International Ltd comprised 3.4% of the Fund, and AMVIG Holdings Ltd comprised 3.7% of the Fund. View the Fund’s Top 10 Holdings. Holdings are subject to change.
- References to the “Fund” pertain to the Fund’s Institutional share class (ticker: SIVLX). The Investor share class (ticker: SFVLX) gained 3.93% during the quarter.
- The Fund’s Investor share class began the quarter with a net asset value of $9.93 per share; it finished the quarter with a value of $10.32 per share.