Seafarer Overseas Value Fund Portfolio Review – First Quarter 2017
During the first quarter of 2017, the Seafarer Overseas Value Fund returned 8.86%.1 The Fund’s benchmark, the MSCI Emerging Markets Total Return Index, rose 11.49%. By way of broader comparison, the S&P 500 Index gained 6.07%.
The Fund began the quarter with a net asset value of $10.16 per share. The Fund paid no distributions during the quarter, and it finished the period with a value of $11.06 per share.2
The first quarter of 2017 marked a point of departure for the Value Fund’s performance relative to its short history. Since inception until the end of 2016, the net asset value (NAV) had proven remarkably stable, both at the time of the Fund’s inception in the middle of a strong emerging market (EM) rally, and through the EM sell-off at the time of President Trump’s election. A “step-function” may best describe the Fund’s subsequent performance during the first quarter of 2017. The Fund appreciated strongly throughout the quarter until early March, when the NAV stabilized again.
In examining the drivers of performance for the quarter, I do not discern any sector or country patterns. The top contributors are an eclectic group operating in real estate, advertising, shipping, and leisure. Stock price appreciation was satisfyingly distributed among most Fund holdings, with approximately one third of portfolio securities appreciating in excess of 10%. However, I do detect a reflection at the stock level of what my colleague, Andrew Foster, has described as an earnings acceleration at the EM universe level (please refer to the Growth and Income Fund’s third quarter 2016 portfolio review). Indeed, while the top and bottom contributors to performance during the quarter both share a history of negative earnings momentum up to the first half of 2016, in most cases, the quarter’s top performers did report earnings growth in the second half of 2016.
I would take the argument one step further by noting that as it concerns holdings in the Value Fund only, the acceleration in earnings was limited to that: earnings. Revenue has shown limited signs of acceleration thus far. Furthermore, the primary basis of differentiation between the top and bottom contributors to performance is one of revenue exposure. The top performers share a regional base of operations, while the bottom contributors have country-specific revenue bases.
Analyzing the portfolio through this dimension proves insightful in that I interpret the appreciation of emerging market stocks as not only a reflection of improved earnings momentum, but an anticipation of an expected revenue acceleration. Perhaps unsurprisingly, and equally illuminating, the stocks with the worst performance have their revenue bases confined to China and Mexico, two countries singled out by the Trump administration. I think this observation is simply a coincidence, albeit an interesting one, in that the two worst performers, AMVIG Holdings and Xtep International, do have stock-specific drivers of negative revenue momentum. In the case of the Fund’s only holding in Mexico, Crédito Real, the stock actually contributed positively to the quarter’s performance. Nonetheless, I place it in this negative category because the stock sold off significantly since the election of President Trump and the company earns revenue primarily in Mexico. These factors represent part of the reason that I find value in the stock and purchased it for the Fund by the end of the first quarter.
Indeed, in addition to the strong appreciation of the Fund, the other salient factor for the portfolio during the quarter was the addition of three new holdings. All three are stocks that I have been tracking for some time, and I discuss them further in the Allocation section below.
The final point to make with regard to performance is that, as was the case in the fourth quarter of 2016, emerging market currencies continue to account for a significant proportion of overall returns in the universe. A representative basket of EM currencies appreciated 4.76% against the U.S. dollar during the first quarter of 2017, accounting for 42% of the MSCI Emerging Markets Index’s total return of 11.49%.3
I added three new holdings to the Fund during the quarter. All three are companies I have been tracking for some time. The reason for adding them this quarter and not earlier is a combination of price action and new information.
The impetus for adding Crédito Real to the portfolio by the end of the first quarter was price action. The stock price depreciated 26.18% from the U.S. presidential election on November 8, 2016 through March 31, 2017.4 The risks for this payroll lender are largely known by now: more expensive costs of Mexican and U.S. corporate bonds, which the company uses to fund its payroll lending; and a slowdown in the demand for credit. What the valuation at a 1.2 price to book value ratio fails to properly account for is the high return of the business coupled with the low level of risk assumed, as well as the cash that will accumulate on the balance sheet as growth slows down. In essence, the company is too profitable for the level of growth expected for the next year, which is why I place it under the Asset Productivity category of value, within Seafarer’s framework of the seven sources of value in emerging markets. In other words, the market is focused on revenue growth prospects, ignoring that the company’s lending capacity and value actually grow as cash accumulates on the balance sheet during a slow period.
Further to the East, another portfolio addition is Tabreed, headquartered in Abu Dhabi, and listed in Dubai. The company designs, builds, and operates central cooling facilities, which pump chilled water to buildings via its pipeline network for the purpose of air conditioning. This technology is both more efficient (greener) and more economical than distributed cooling technology. I place this company within the Deleveraging category of value. Tabreed is growing cash flows to existing shareholders as it partially repurchases mandatory convertible bonds, and the remaining debt amortizes faster than the service contracts that provide 30-year revenue visibility. Furthermore, the company continues to build capacity in lock-step with concession growth.
Rounding out our global tour by going even further to the East, the Fund added China Yangtze Power to its holdings. It is worth highlighting that this security is a Chinese A-share. In other words, the company is listed in Shanghai and trades in renminbi, which means that foreign investors have traditionally lacked unfettered access to this security until the establishment of the Shanghai-Hong Kong Stock Connect in November of 2014. Seafarer has tracked this company since before the establishment of the Stock Connect. However, only recently has Seafarer become sufficiently comfortable with the inner-workings of the Stock Connect to purchase a Chinese A-share security via the program.
Comfort with market access is one of the reasons for adding China Yangtze Power to the portfolio now. The other reason is new information concerning a major acquisition, which the company finalized during 2016. Now that consolidated financial and operating details are available, I have determined that the free cash flow yield this company generates is not only attractive, but enjoys high visibility. The company presents an attractive combination of sharing this cash flow with investors (5% dividend yield), deleveraging over the next few years, and pursuing growth in the long term with significant capacity additions currently gestating at the parent level. I classify the company under the Structural Shift category of value due to the uncommonly competent nature of management in this state-owned enterprise, China’s push for green energy, and the expected partial liberalization of electricity prices in China over the coming years.
Allocation among existing holdings in the Fund has been a balancing act between Fund inflows and appreciating holdings. The Value Fund has received steady inflows throughout the quarter. These inflows have kept the weight of appreciating securities in check, obviating the need to sell down the quarter’s strongest performers for risk control purposes. Given the more cyclical nature of the best performing securities in the portfolio, I have intentionally favored the steadier, more income generating businesses in the allocation of Fund inflows. The purpose of this allocation choice is to safeguard as much of the Fund’s NAV as possible in the event of market drawdown. As I discussed above, my read of market action during the first quarter of 2017, both for EM as a whole and for the top performing names in the portfolio, is that there is a degree of speculation on a potential revenue acceleration. I am not judging whether this estimation is correct. The Fund does not own the names in the portfolio for this reason. My tactical allocation simply aims to maintain a balance within the overall portfolio with the objective of safeguarding against a reversal of what has proven to be a very strong quarter, while maintaining the portfolio’s overall character.
In the portfolio review for the previous quarter I noted that, beyond the vagaries of policy changes in China or the election of President Trump, the core underlying issue facing both the U.S. and China is the ever-declining ability of new debt issuance to generate gross domestic product (GDP) growth. The table below illustrates this concept. The table tracks changes in public debt and nonfinancial debt by decade for each country and compares it to GDP. While this basic exercise is not intended to be an exhaustive study of the subject, the conclusion is clear. On a crude basis, each new dollar of debt in the U.S. and China produces approximately 30 cents of additional GDP. This trend – the rapidly declining productivity of deployments of debt capital – is not sustainable, prima facie; and it is even less so in the context of a rising cost of servicing that debt.
|Public + Nonfinancial Debt Change||4,732||7,846||15,789|
|Marginal GDP / Debt||0.74||0.73||0.30|
|Public + Nonfinancial Debt Change||2,794||26,690|
|Marginal GDP / Debt||0.57||0.31|
Sources: Federal Reserve of St.Louis FRED Economic Data, Bloomberg, Seafarer.
I published this table because I’d like to focus our collective attention on what really matters. A strong stock market appreciation in the U.S. and emerging markets has followed the U.S. presidential election. There is endless speculation about various Trump policies, both the helpful (less regulation and lower taxes), and the misguided (imposition of additional trade barriers and a rise in deficit spending).
Instead of debating each policy ad nauseam, it is important at times of swift change, such as the present one, to focus on a few core drivers and dismiss the rest as more likely to be noise than information.
The point of the preamble above is this: U.S. banks have $2 trillion of excess reserves that could be deployed to finance either a larger U.S. government deficit directed at infrastructure, or corporate capital expenditures presumably incentivized by lower tax rates. This factor probably lies at the core of the U.S. stock market reaction to the election. While the deployment of these reserves would flow to corporate earnings and probably translate to higher stock valuations, the long-term and ultimate determinant of asset values (i.e. a Fund’s NAV) is less whether these reserves are deployed, and more whether this additional credit goes to enduring productive use. The table above suggests that from an historical perspective, there is little ground for optimism.
What does this mean for the Seafarer Overseas Value Fund? In terms of the immediate future, and to the extent that a portion of a potential new cycle of credit and spending growth in the U.S. flows overseas and affects emerging market asset prices, there is potential for the Value Fund to lag markets or other funds with a more growth-driven focus.
In terms of my own actions, I intend to continue searching for new value ideas wherever they may present themselves. Sometimes they show up in countries that have gone through macroeconomic adjustment, such as this quarter’s new portfolio addition in Mexico. On other occasions, value does not show up even where one expects it to do so, such as my inability to see value in a subset of Egyptian stocks before and after the country’s currency devaluation. And yet in other instances, one finds value in stable economies such as the portfolio additions in the United Arab Emirates and China this quarter.
The point is that almost regardless of the overall economic environment, companies still go through their own natural dynamics, yielding potential opportunities for the Value Fund. One prediction I would make about the future is that I expect this natural process to continue.
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 March 31, 2017, AMVIG Holdings, Ltd. comprised 2.7% of the Seafarer Overseas Value Fund, Xtep International Holdings, Ltd. comprised 2.8% of the Fund, Credito Real SAB de CV comprised 2.7% of the Fund, Tabreed (National Central Cooling Co. PJSC) comprised 2.6% of the Fund, and China Yangtze Power Co Ltd. comprised 2.5% 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) returned 8.74% during the quarter.
- The Fund’s Investor share class began the quarter with a net asset value of $10.18 per share; it finished the quarter with a value of $11.07 per share.
- Source: Bloomberg.
- Source: Bloomberg.