Letter to Shareholders – Annual Report
Period ended April 30, 2013
Dear Fellow Shareholders,
I am pleased to address you on behalf of the Seafarer Overseas Growth and Income Fund, which as of April 30 completed its first full fiscal year.1
During that year, the Fund’s Investor and Institutional share classes gained 18.24% and 18.33%, respectively. By comparison, the Fund’s benchmark, the MSCI Emerging Markets Total Return Index, rose 4.34%; and by way of broader comparison, the S&P 500 Index climbed 16.88%.
At the beginning of the fiscal year, the Fund had $2.8 million in assets under management; it finished with $37.8 million. The net asset value per share of the Investor class rose from $10.18 to $11.91, and during the year the class paid approximately $0.11 in distributions to shareholders.
At the Fund’s inception, Seafarer Capital Partners was pleased to provide a contractual obligation to the Fund that limited expenses on its Investor and Institutional share classes to 1.60% and 1.45%, respectively. The Fund’s subsequent growth allowed it to achieve some modest economies of scale; Seafarer was therefore pleased to offer in January an additional voluntary waiver that effectively capped expenses at 1.40% and 1.25%. Seafarer’s intention is to convert the voluntary waiver into a new contractual obligation that will commence in September, concurrent with the annual release of the Fund’s prospectus.
The team at Seafarer is proud to report this progress to you. Nonetheless, we are acutely aware that our work has only just begun. If the Fund is to achieve anything of lasting worth for its shareholders, its success or failure will be measured in terms of decades, not individual years.
Shareholder letters from fund companies typically discuss the state of affairs for financial markets, and they provide some sort of outlook for the future. My letters mostly follow convention – and this letter will conclude with the obligatory outlook. Yet I want to use most of the letter to do something different: I want to explain Seafarer’s investment approach, which is practiced “from the bottom up.”
If you finish this letter and you are still hungry for some practical details on the Fund, please see the Fund’s Portfolio Review for the first quarter of 2013. For insights on specific markets, see Seafarer’s Field Notes.
Investing “From the Bottom Up”
Seafarer invests “from the bottom up.” I will explain what that phrase means, and why I believe it is essential to invest that way. Before I do so, a caveat: please note the following remarks apply only to the process of selecting individual securities for the purpose of portfolio construction. My comments do not pertain to “asset allocation,” which is a distinct and complex topic, and one that I will not address here.
Investing “from the bottom up” means selecting individual securities for your portfolio based on their unique merits. It is the opposite of investing “from the top down,” in which security selection is determined via macro-economic analysis or broad secular themes. In the former approach, you select securities because you have researched each one individually, and you have come to the conclusion they meet your risk and reward criteria. In the latter process, you usually perform some basic research on securities, but your primary emphasis is on getting the “big picture” themes and trends correct, and then translating those ideas to a basket of securities that are likely to benefit.
Each approach has its merits and drawbacks. However, I believe “top down” is ultimately more fallible, mainly because it is so difficult to implement a successful strategy of this sort consistently, over time. “Bottom up” is not inherently superior; instead, “top down” is terribly problematic, and thus “bottom up” is the only game in town.
The Trouble With the “Top Down”
Let me illustrate the difficulty with a “top down” approach. One year ago, the macro-economic outlook for the world was murky at best, and downright awful at worst. There were fears that the Eurozone would disintegrate violently, that China would face a “hard landing,” and that the U.S. would face a severe fiscal crisis, fall into recession, or both. If you adopted a “top down” approach, you most likely opted for cash, or went short.
One year later, little has changed: the macro outlook is still murky, and most economies around the world remain in poor shape. The U.S. economy appears rehabilitated – few accurately predicted its rapid recovery! – but even so, there are plenty of critics who suggest its fiscal and monetary policies place it on thin ice. Thus a portfolio built on “top down” principles would be nearly unchanged; yet the interim twelve months offered an excellent opportunity to grow one’s financial capital. What accounts for this discrepancy?
The problem is not that returns from stocks were predictable (they were not), or that the U.S. recovery was obvious (it was not). The problem lies in the idea that anyone can make a consistent, accurate forecast about something as large and complex as an economy, even when holding to a short time horizon (e.g., six months). Even for a short-run forecast, the intricacy of a large economy is so great that it requires construction of a complex, multi-factor model (which means the model must incorporate many different variables – essentially moving pieces). Obviously, it is challenging to get such a model right – you have to specify all the variables correctly (tough!) and then you have to make the right assumptions about all the input values for each variable (even tougher).
Once that forecast exceeds anything beyond the shortest possible horizon – anything longer than a few months, really – I believe the complexity of the model rapidly approaches infinity. There are too many moving pieces; there are too many potential outcomes, some of which are known with varying probabilities, and some of which are unknowable until they unfold. This near-infinite complexity means the model’s predictive capacity rapidly falls to zero.
If you try to extend the model to incorporate other economies and their interactions with each other, I will believe you will transgress the boundaries of the near-infinite and slip into the realm of the impossible. How can your model possibly specify this complex, multi-economy environment accurately, with correct assumptions about all the underlying variables? And even if you miraculously do all of this, do you really think a model of this complexity will render practical, consistent, and timely investment advice? It seems to me that if the resulting “top down” portfolio performs well, it is by little more than random chance.
The trouble with such models and the forecasts they produce is that they are so darn appealing. They prey on our human frailties: they purport to explain everything, which alleviates our innate fear of the unknown; they are (superficially) logically consistent, and thus appeal to our sense of intellectual pride; and they often come with pithy slogans – witness the “New Normal”2 – which exploit our preference for simplicity over complexity. These models even tap into our tendency to favor action over stasis. They appear to provide the means to react to various macro-indicators and economic signals; they seem to give us tools that allow us to “do something” about the frustrating and confusing world around us. In my experience though, those tools are illusions that only amplify our natural exuberance and fear.
Ultimately, the “top down” approach appeals because it helps you convince yourself that you know something about the big picture, and what matters to your portfolio. This is a fallacy in my view; unfortunately, you have fooled yourself, albeit with the best intentions. In truth, the big picture is unknowable – or at least, it is beyond anyone’s ability to make timely, consistent and clear forecasts for the purpose of investment advice.
For proof of the fallacy, consider what happens when such models fail, publicly. If the forecasters are still in business – which is rare – they are usually engaged in convoluted efforts to re-purpose their models, employing tons of jargon to disguise the inconvenient fact that their analysis failed to capture the breadth and complexity of reality. At such moments, the “top down” model is exposed for what it is: a concept with little substantive basis. At the same time, it is obvious that the forecaster’s contorted attempts to defend the model are only self-delusion.
A Little Bit Is Better Than Nothing At All
Investing “from the bottom up” is the opposite exercise, as the name suggests. A “bottom up” approach means you start and finish with the unique merits of individual investments. Importantly, if you truly inhabit this process, you must mostly abandon the idea that you know how the big picture will play out, or which themes will work. Essentially, you must embrace a perspective rooted in humility: you don’t pretend you know a lot about everything, but realize clearly that you know almost nothing at all.
Naturally, knowing almost nothing is frightening. However, as a bottom up investor, you enjoy two advantages that can alleviate this fear. First, you have the ability to arm yourself with tangible facts about the risks and rewards afforded by the individual investment under consideration. Second, because you are cognizant of your own ignorance, you are highly attuned to the potential for loss, and are thus more likely to undertake practical solutions to guard against such loss.
First, you have the advantage of basing your decisions on discrete, empirical facts rather than an abstract, untested hypothesis. Unlike a massive, complex macro-economy, a single company is just small enough that a human being can understand it, and wrap their mind around it. With effort, you can grasp a company’s financial position, its risks, its opportunities, its frailties. You can know a company’s assets; its revenues; its products; its operations; its competitors. These are tangible things you can measure, or see, or sometimes touch.
There are of course severe limitations to the knowledge you can accumulate. You are not an insider; and there is a constant risk of fraud and deception. Even if fraud is not part of the picture, shocks are frequent, and businesses fail for unexpected reasons. Yet even with all of these shortcomings, your bottom up research is a very valuable tool: at least you can discern and analyze real facts. If you do your homework, you will know a little bit about something with some certainty; you will no longer know nothing at all.
A quick clarification is in order. The bottom-up investor does not abandon the macro for the micro when researching an individual investment. Quite the contrary: it is healthy to develop a basic perspective about where the macro fault lines might lie. Just make sure that you constantly question that view, and never lean on it too much. Meanwhile, the key is to use the individual company as a tangible, real-world frame of reference to digest your macro thesis. Your beliefs will be sharpened in the process: you will abandon the grand but abstract framework in favor of facts drawn from the real world.
Thus the bottom up investor asks: how will this macro event affect my individual investment? What frailties (or opportunities) will it expose? What can I do within my portfolio to control the associated risks, and maximize the potential rewards? The beauty of this approach is that you remain grounded in a practical reality. Also, as your approach is necessarily empirical, you often collect data that force you to retool your macro hypothesis. Certainly, you run the risk that your data set is not representative, thereby falling prey to anecdotal evidence. Yet even with this risk, I think it is still more scientific to formulate my “macro” perspectives from the bottom up. Otherwise it is all too easy to twist the data to suit my macro theory, rather than the other way around.
Accepting (And Then Controlling) Risk
The second advantage of a bottom up approach lies in your awareness of how little you know. Armed with that knowledge, you are naturally vigilant against risk, and highly attuned to the potential for loss, as you assume nothing, and take nothing for granted. Managing risk within your portfolio thus takes on central importance.
Before you manage risk within your portfolio, though, you must first accept it. Whether you are an equity investor trying to capture growth, or a fixed income investor harvesting illiquidity premia from creditors, you are necessarily exposed to risks. You must accept that the biggest risks are beyond prediction, and even mundane risks are difficult to predict in a consistent and timely manner.
However, once you have passed over this scary threshold, the knowledge is liberating: you quickly realize that just as you can’t control such risks, no one else can, either. Anyone who suggests they can radically reduce portfolio risk is engaged in fabrication (e.g., exaggerated risk management skills), or they are selling you something that is so expensive that it will do damage to your portfolio (e.g., products that offer a guaranteed return), or they are obscuring their own financial frailties (e.g., hidden counterparty risks). This awareness represents another small but vital piece of knowledge.
So, how does one take every reasonable precaution against the unknown, and the unknowable? In my view, there are only two time-tested, cost-effective means to do so. First, you must make efforts to control risk from the bottom up, by vetting your individual investments carefully. You must do your homework, and “look under the hood” to understand what you are getting for your money. In the process you will develop firsthand knowledge of the real frailties of the investment, as opposed to what the salesperson told you. Imagine relying on investment slogans and second-hand analysis during a time of financial crisis – now that is a scary thought!
Second, you must diversify. History has shown that diversification is cheap and effective. If you have done your homework from the bottom up, you will find it is surprisingly useful, as you will have direct knowledge about how to offset the important risks against each other. The approach is time-tested, and though it is not perfect, it works as well as any fancy risk management model, at lower cost.
Obviously, these two methods reduce risk, but they still leave your portfolio exposed to considerable hazards. Unfortunately, I do not have an answer to this; and no one else does – or if they do, the answer is not legal, or they have not shared it. This realization is again frightening. Yet in this fear, do not lose hope. Keep pushing yourself to find opportunity. Here’s why: there is only one constant in markets, and that is change. Where change exists, there is at least the opportunity to make progress; and progress is what begets growth (and financial profits). Change and the potential for progress always exist, even in the darkest and most confusing markets. Thus there is almost always an opportunity to invest, and grow your capital – if you are patient, disciplined, and invest “from the bottom up.”
A Brief Outlook, As Promised
For those of you who followed Seafarer’s various portfolio reviews and shareholder calls during the past year, you know I have expressed concern about whether the pace of earnings growth in the emerging markets would live up to investors’ elevated (and misplaced) expectations.
I noted last fall that the rapid gains in valuations seemed out of step with reality – a reality that would likely be characterized by a slower (but still reasonably good!) rate of growth. This has come to pass. Corporate profits have fallen below expectations in the first four months of this year. In my own opinion, the lackluster performance of emerging equities is largely attributable to the market’s belated recognition of this fact.
However, as of mid-May, the market landscape is once again different. A good deal of the valuation excesses that were apparent last year have been wrung out of the markets – with the caveat that some absurdly high valuations persist within the consumer sector. Meanwhile, corporate earnings continue to expand at a reasonably good (albeit slower) rate. As usual, I see plenty of specific issues to worry about in various countries throughout the emerging world, but nothing that appears immediate or fatal. Indeed, my research on individual companies leads me to be optimistic that growth might accelerate, just a bit.
Of course, a number of major “macro” issues cloud the picture. Will Japan collapse, or will Europe implode? Will quantitative easing beget hyperinflation? Will fixed income markets melt down? I can speculate about all of these things, but I will know none with any certainty. However, I do know there are plenty of prospective investments that satisfy the risk and return criteria the Fund seeks, and thus I am an enthusiastic investor.
Thank you for entrusting us with your capital. As usual, the future is murky, and I do not know whether the year ahead will bring success to the Fund. However, I do know one small thing, with certainty: we are very serious about our job.
We are honored to act as your investment adviser.Andrew Foster 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. The MSCI Emerging Markets Total Return Index consists of the following 21 emerging market country indices: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey. Index code: GDUEEGF. 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.
- Please note: the Fund’s inception was February 15, 2012.
- “New Normal” is a slogan for an investment theme propagated by PIMCO, a large fixed income investment manager. For more information on this topic, please see PIMCO’s latest discussion of the “New Normal”: “New Normal . . . Morphing,” May 2013.