During the fourth quarter of 2016, the Seafarer Overseas Value Fund returned -0.34%.1 The Fund’s benchmark, the MSCI Emerging Markets Total Return Index, fell -4.08%. By way of broader comparison, the S&P 500 Index rose 3.82%.
The Fund began the quarter with a net asset value of $10.32 per share. During the quarter, the Fund paid an annual distribution of approximately $0.125 per share. The Fund then finished the quarter with a value of $10.16 per share.2
Since the Fund’s inception on May 31, 2016, it returned 2.85%, and the benchmark gained 8.98%.3
[Please note: this portfolio review encompasses only the fourth quarter of 2016, and does not offer a thorough discussion of the entire calendar year. The Fund operates on a fiscal year that concludes April 30; as such, Seafarer offers comprehensive performance reviews for the Fund’s annual and semi-annual periods, which are published in the Fund’s Shareholder Reports in late June and December, respectively. Previous Shareholder Reports are available in the Archives.]
The defining moment for emerging markets during the fourth quarter of 2016 was less the U.S. election, and more who won: Donald Trump. Mr. Trump’s victory coincided with a 2.58% depreciation of a representative basket of emerging market currencies from November 8 to the end of the year, accounting for the largest contribution to the MSCI Emerging Markets Index’s total return of -4.08% during the quarter.4
For the time being, politics appear to have halted the first annual rise in the MSCI Emerging Markets Index since 2012. I ended the Fund’s third quarter 2016 portfolio review by discussing how the world economy is likely undergoing a period of adjustment that is manifesting itself primarily through currency movements. It is interesting to note that this dynamic continued during the fourth quarter for reasons that were unforeseen during the prior period. I attribute the reaction by emerging market currencies to Mr. Trump’s stated intentions regarding the free movement of goods and services, as well as his desire for larger government deficits coupled with the expectation of a rising cost to fund those deficits. The former factor implies a slowdown of U.S. dollar inflows to emerging markets in the form of smaller current account surpluses, and the latter implies an outflow of U.S. dollars from emerging markets to fund deeper U.S. deficits going forward. Both forces tend to be associated with weaker emerging market currencies.
It is therefore ironic that the top two contributors to the performance of the Value Fund during the fourth quarter were holdings directly involved in the global trade of goods: Global Ports and Pacific Basin. Global Ports, a Russian port owner and operator, made tangible progress in the refinancing of its U.S. dollar-denominated debt, and Pacific Basin’s share price reacted to the rise in daily spot dry bulk freight rates. Note that while I expected Global Ports to make progress in refinancing its debt, I did not rely on a turnaround in freight rates to invest in Pacific Basin. The company’s low valuation, combined with my estimation that cash flow generation was sufficient to maintain Pacific Basin as a going concern, drove my investment decision.
I added a new position to the portfolio during the fourth quarter: Samsung SDI. While I discuss the investment merit of the company in the Allocation section below, it is relevant to point out here that this investment made the fourth largest positive contribution to Fund performance this quarter. I consider the Fund fortunate to have made the investment just prior to the stock price appreciating 16% by the end of the fourth quarter. This is a case of timing luck, as I obviously did not know when the stock price would begin to reflect some of the investment merits of the security.
The largest detractors to performance during the quarter were the Fund’s two Vietnamese holdings. Both companies suffer from negative earnings momentum, and their stock prices apparently reacted to shrinking quarterly earnings, even though this did not constitute news. I hold these positions because they continue to generate free cash flow that the market values cheaply, both are expanding capacity for the long term, they have very liquid balance sheets, and their sustainable dividend yields are 6% and 10%, respectively.
The first point to make regarding portfolio allocation is that the high cash balance of 22% as of December 31, 2016 reflects a substantial cash inflow just prior to the end of the quarter, and is not representative of the average cash level throughout the period. The inflow is being deployed gradually.
One use of the Fund’s cash balance during the quarter was the purchase of a new security: Samsung SDI. This Samsung Electronics affiliate specializes in manufacturing lithium ion batteries. The investment case for this security can be viewed within the framework of the seven sources of value in emerging markets that Seafarer defined in the white paper On Value in the Emerging Markets. Samsung SDI represents a mix of two sources of value: Breakup Value and Structural Shift. The company’s balance sheet holds stakes in several Samsung-related companies, some of which are publicly listed. At the time I initiated the investment, Samsung SDI’s enterprise value was significantly lower than the combined enterprise value (for the listed stakes) and book value (for the interest in unlisted companies) of the assets on its balance sheet. Furthermore, the company is in the process of making a structural shift into battery manufacturing for electric vehicles and energy storage systems. The investment required is likely to result in the liquidation of some of the company’s stakes in Samsung affiliates, in effect substituting what will probably be higher return capital in a core business for “dead assets” on its balance sheet.
Additionally, this holding brings a new and welcome dimension to the portfolio. Battery manufacturing for electric vehicles and energy storage systems appears to be a growing business that is likely to transform established patterns of mobility and energy distribution. In contrast, many of the constituents of the Structural Shift category of value tend to represent mature businesses whose growth has seemingly plateaued. While the Value Fund contends that these businesses can be priced and are therefore capable of generating attractive investment returns, the addition of a company in the early stage of the growth curve to this sleeve of value provides a new dimension of diversification within the category.
I remain focused on adding new holdings to the portfolio, and have already identified a number of securities in the Middle East and Latin America that will likely make it to the portfolio at the right price.
Emerging market developments during the fourth quarter of 2016 read like a horror novel. Egypt devalued its currency on November 3. On November 8, India announced that Indian rupee 500 and 1,000 notes will no longer be legal tender. These notes constituted more than 80% of the currency value in circulation. In late November, China began flirting with various new forms of unofficial (verbal guidance) and official capital controls: requiring approval for international mergers and acquisitions transactions in excess of $10 billion, real estate purchases abroad exceeding $1 billion, and international money transfers above $5 million; taxing Macau cash inflows in excess of $15,000 brought by visitors, and reducing the per-transaction limit of Macau ATM withdrawals (for more information, view Seafarer’s Changes to Chinese Currency Policy – Update video). These events made for a rough quarter in addition to the post-election selloff.
China’s actions are symptomatic of a larger dynamic taking place at a global scale. In my opinion, the underlying issue is that China is approaching the natural limit to credit expansion. By that I mean that each additional renminbi of credit generates an ever-diminishing renminbi of Gross Domestic Product (GDP). Arguably, the same dynamic is taking place in the developed world, explaining tepid economic growth despite starting from a lower GDP base level post the 2008 recession, and despite what is probably the largest credit expansion in history.
Whether Chinese citizens are conscious of it or not, they are instinctively aware of the deleterious effect of continued rapid credit expansion in the country, and are thus seeking to substitute circulation currency (renminbi) for money (U.S. dollars and real assets). This dynamic manifests itself in the form of depleting reserves, a weaker exchange ratio of the renminbi against the U.S. dollar, and tightening capital controls. Evidently, the inclusion of the renminbi by the International Monetary Fund in the Special Drawing Rights (SDR) currency basket effective October 1, 2016 has failed to convince Chinese citizens that the renminbi is money as it concerns its function as a store of value.
Concurrent with China’s still rapid credit growth, the U.S. dollar has progressively become “harder money” through the end of quantitative easing in October 2014, and most recently the jump in the 10-year Treasury yield.
In my opinion, the most natural way for China to find a way out of its predicament is for the State to slow down credit expansion and accept slower GDP growth. I would venture a guess that this action would ease the pressure on the renminbi and obviate the need for stricter capital controls.
The events cited above constitute the salient developments for emerging markets during the quarter. While seemingly diverse in nature, they do share a common thread: credit is becoming scarcer and more expensive than in the most recent past. From a U.S. dollar perspective, one could say that the risk-free rate is rising.
The implication for emerging markets overall is that, as the cost of capital rises, stock selection will probably become a more important determinant of investment returns going forward. The implications for the Value Fund include the importance of being keenly aware of holdings in the Deleveraging category of value. While I am as susceptible to error as anyone else, I will say that, for the Fund’s holdings in this category, I have discussed with each company’s respective management its refinancing and deleveraging plans and deem them credible.
No discussion of the risks surrounding the Value Fund as a result of my global outlook would be complete without also considering the opportunities. I ended my third quarter 2016 portfolio review stating that “I am optimistic that the process of adjustment the world economy is undergoing will yield opportunities for the Value Fund.”
I am happy to say that I have identified strong candidates for the Fund in countries that have made tangible progress in the process of adjustment. Contrast the above discussion of China’s predicament against the action already taken by Egyptian authorities to finally abandon capital controls and allow the Egyptian pound to float, which led to a 51% devaluation between November 3 and December 31, 2016.4 Consider as well Brazilian credit growth, which is now contracting in nominal terms and where private banks are recapitalizing themselves through wider spreads. Are Chinese banks capable of such a feat? Finally, consider the 12% depreciation of the Mexican peso from November 8 to the end of the calendar year.
I would contend that one is likely to find value in the developing world, and that any potential investments there would carry less risk precisely because of the sharp adjustments that have taken place already. Note that I may or may not add securities from these countries to the Value Fund. As is usually the case, this type of outlook discussion does not necessarily mean that the prices for specific securities I am interested in are attractive. These are interesting times for the Seafarer Overseas Value Fund.
Thank you for entrusting us with your capital. We are honored to serve as your investment adviser in the developing world.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 December 31, 2016, Global Ports Investments PLC comprised 3.8% of the Seafarer Overseas Value Fund, Pacific Basin Shipping, Ltd. comprised 3.1% of the Fund, and Samsung SDI Co. Ltd. comprised 2.9% 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) declined -0.36% during the quarter.
- The Fund’s Investor share class began the quarter with a net asset value of $10.32 per share; it paid an annual distribution of approximately $0.104 per share during the quarter; and it finished the quarter with a value of $10.18 per share.
- Since the Fund’s inception on May 31, 2016, the Investor share class returned 2.83%.
- Source: Bloomberg.