Letter to Shareholders – Annual Report
Period ended April 30, 2016
Dear Fellow Shareholders,
I am honored to address you again on behalf of the Seafarer Overseas Growth and Income Fund. This report addresses the Fund’s 2015-16 fiscal year (May 1, 2015 to April 30, 2016).
During the fiscal year, the Fund declined -8.32%, while the Fund’s benchmark, the MSCI Emerging Markets Total Return Index, fell -17.56%.1 By way of broader comparison, the S&P 500 Index increased 1.21%.
From the Fund’s inception (February 15, 2012) through the end of the fiscal year (April 30, 2016), the Fund generated an annualized rate of return of 5.88%.2 The benchmark index fell at an annualized rate of -2.64% over the same period.
The Fund began the fiscal year with a net asset value of $12.66 per share. During the ensuing twelve months, the Fund paid two distributions: $0.060 per share in June 2015 and $0.081 per share in December 2015. Those payments brought the cumulative distribution per share, as measured from the Fund’s inception to the end of the fiscal year, to $1.172. The Fund finished the fiscal year with a value of $11.46 per share.3
Everyone at Seafarer is proud of the Fund and its performance record. Yet as I write this letter, I do so with a degree of disappointment and frustration. The emerging markets have been a poor investment destination over the past four years, and it is wearying to contemplate a fiscal year in which the Fund generated a substantial loss.
There are a number of considerations that place the Fund’s performance in better stead: during the fiscal year, the Fund outpaced its benchmark in relative terms by a substantial margin; as of the fiscal year end, the Fund produced annualized gains since its inception, even as the index failed to do so; and over its life, the Fund’s performance has been substantially less volatile than that of the index.
Yet even if the Fund’s long-term performance is thus far in keeping with its objectives, I am acutely aware that many shareholders have subscribed to the Fund only recently. Such shareholders only know the Fund for the losses it has wrought within their portfolios. As such, I sincerely appreciate the patience afforded by all, given the challenging investment climate within the developing world.
China’s economy and its stock markets cast a substantial shadow over both the Fund and the index during the fiscal year. Early in 2015, immediately prior to the commencement of the fiscal period, Chinese markets rose rapidly for a variety of reasons, forming a mini-bubble of sorts. The bubble burst in the middle of May 2015, ostensibly when officials sought to restrict access to the margin financing that had stoked frenzied trading among small investors. Chinese equities plunged shortly thereafter, with no safe harbor in the market.
Prior to the collapse, I was aware that valuation conditions were extreme and warranted caution, even as I did not know when or how a correction might occur. Given such uncertainty, I attempted to mitigate risk by reducing the portfolio’s allocation to the China, and by emphasizing those positions I thought offered “defensive valuations.” At the time, I thought certain securities might have prices low enough and dividend yields high enough to partially withstand the correction in the market. Unfortunately, this tactic proved fruitless. In May 2015, the Fund held eight China-linked securities (seven stocks listed on the Hong Kong Stock Exchange, and one convertible bond). All the equities fell in tandem with the broader market, and while the bond fared somewhat better, the Fund’s “defensive” positions in China were not the haven I imagined them to be. Still, by the middle of the fiscal year, the Fund was ahead of the index, even as the emerging markets declined broadly in sympathy with China's correction.
As the emerging markets slumped into the late summer of 2015, they were further rattled by the announcement that China would sever the long-standing exchange rate relationship between its currency, the renminbi, and the U.S. dollar. For the 20 years preceding the August announcement, China either formally pegged its currency to the dollar, or it maintained a “dirty peg,” an arrangement in which the authorities made small, manual adjustments to the currency’s value versus the dollar. However, the announcement in August heralded the end of the dirty peg: the Chinese authorities announced the currency would instead adopt a market-based arrangement – still subject to certain restrictions and trading guidelines – but in which the market would play a dominant role in setting the daily value of the currency. I describe the new system as a “dirty float,” as opposed to a freely-floating currency.
Unfortunately for China, the implementation of the new currency arrangement was not well communicated, and the timing shocked many observers; the new policy was poorly received. (For the record: I have always thought China would announce exactly this policy at a time of perceived weakness, when external observers least expected it. The only thing that shocked me about the announcement was that it occurred at least three years earlier than I had imagined – in other words, China adopted this essential reform faster and more aggressively than I ever thought possible.)
The furor over the change has since died down, in large part because markets were so rattled that China felt obliged to temporarily reinstate some of the stability associated with the former “dirty peg” system. However, in my view, no one should suffer under the illusion that China has reversed course. Last August, China ended what was the most important, de-facto currency union in the world – the informal, but rigid link between the dollar and the renminbi. For more on the potential consequences of China’s decision, please see my Letter to Shareholders as of October 31, 2015, particularly the section entitled “China’s Prominence.”
Stocks markets in the developing world enjoyed a brief period of calm during the late fall of 2015. However, this calm was shattered in the first weeks of 2016 when Chinese stocks plunged again, mysteriously. At the time, pundits speculated that China’s currency was to blame: the popular view was that the renminbi was unstable, and would soon come unglued. Many speculated that the currency’s instability was somehow instigating the panicked downturn in Chinese equities. That explanation was widespread, but it lacked merit. The renminbi was nowhere near as unstable as the pundits then suggested; and the small fluctuations that occurred did not provide a satisfactory explanation for the swift and broad-based decline in Chinese stocks. Simply put, this was not a case where the tail was wagging the dog.
In the portfolio review for the fourth quarter of 2015, I advanced two possible causes for China's swoon in January. First, I stated that the behaviors of China’s currency and equity markets were both consistent with deteriorating domestic liquidity conditions. I suggested that the erratic behavior of the two markets might portend distress within China’s financial sector – not necessarily a “hard economic landing” (e.g. an abrupt economic deceleration), but more likely acute liquidity distress, the sort that might trigger a major bankruptcy (or chain of bankruptcies). Second, I wrote that perceptions of instability and schisms within the senior leadership of the Chinese government might also have destabilized markets. The two scenarios are only speculation on my part, though I believe both hold a degree of truth.
During January’s sharp decline, the Fund held up better than the market overall, mainly because of the limited, “defensive” exposure to China that was implemented prior to the beginning of the fiscal year. However, in short order, China no longer dominated headlines within the developing world; by the end of January, Brazil was at the forefront, as a long-simmering graft scandal there came to a head.
A dogged team of prosecutors laid out evidence against senior political leaders previously deemed untouchable. The investigation culminated in an impeachment vote, and President Rousseff – the architect of many economic policies that have gone awry – was suspended from office. Brazilian stocks and the local currency moved swiftly higher, driven by the speculative hope that a new government might arrest the country’s economic decline. The Fund and the benchmark both rallied in response, and most emerging markets – including China – climbed from the lows of January.
The Fund sustained its outperformance through the end of the fiscal year because of its substantial exposure to Brazilian stocks. For the past two years, the Fund maintained a meaningful allocation to the country, despite its very weak performance as measured in dollars. The Fund’s goal was to accumulate shares of profitable companies, capable of generating reasonable profits and dividends even amid the country’s economic crisis.
By holding the shares of “survivors” until the economy stabilized, I hoped the Fund would profit from the eventual recovery of such companies. It was not my intention for the Fund to speculate on the political environment in Brazil, nor did I wish to gamble on the short-term performance of the economy. Yet Brazilian stocks reacted swiftly and positively to the mere idea that the country’s economic distress might diminish, driven by a prospective change in government. The market’s sharp recovery seemed to confirm the basic cheapness that I thought was present in many Brazilian equities.
Still, political speculation was at the root of the stock market’s rally, not a recovery in economic fundamentals. The Fund’s allocation to Brazil was no accident, and happily, that exposure had a beneficial impact on performance versus the index. Nevertheless, after the rally subsided I reduced the Fund’s allocation to Brazil, as I did not wish for a large and growing portion of its capital to be “held hostage” to the rapidly vacillating sentiment associated with the country’s politics. Accordingly, the Fund’s allocation to Brazilian equities (well over 15% after the market’s surge) was trimmed at the margin, and the proceeds were distributed broadly throughout the remainder of the portfolio.
Amid a fiscal year dominated by such volatility, two of the Fund’s best performing positions warrant description. Aselsan and Arçelik are mid-capitalization companies located in Turkey. Aselsan is a systems engineering company; Arçelik is a maker of “white good” consumer appliances, such as refrigerators, air conditioners and washing machines. The Fund has held the former position for four years, and the Fund added the latter two and a half years ago. When the two positions were added to the Fund, neither was remarkable for its obvious cheapness or for its pronounced growth prospects. Further, both were domiciled in a country that was struggling with political crisis and bouts of severe currency weakness. Neither company was particularly well known within the global investment community, in large part because both then had (and still have) capitalizations below $5 billion, lower than the minimum thresholds that global funds often set. Yet both have contributed handsomely to the Fund’s long-term returns, arguably because both embody the growth and income strategy that drives the Fund.
Despite operating in different industries, and despite facing uncertain conditions in their respective markets, both firms enjoyed strong competitive advantages and tangible, incremental opportunities for growth. The steady nature of their businesses meant that each was able to realize meaningful expansion over the past few years, even as many industries in the developing world experienced contraction amid waning demand and extreme currency fluctuations.
The two companies’ stable revenues and disciplined cost controls allowed for the production of healthy profit margins amid the market turmoil. Neither business has extensive requirements for capital investment, and thus both were able to translate a large portion of their earnings into free cash flows. Most importantly, the companies enjoyed sufficient liquidity and solvency, enabling them to pay out a substantial portion of their cash flows consistently to shareholders. The companies’ consistent dividends burnished the liquidity of their shares, buffering them against the extreme volatility that has been evident for the past four years.
The balanced, multi-dimensional set of characteristics exhibited by these two companies exemplifies what I search for in the growth and income strategy. The Fund was able to initiate (and subsequently augment) both positions at reasonable valuations, particularly as assessed by prospective cash flow yield and dividend yield. The Fund’s strategy usually works best when reasonable valuations (defined primarily by yield) can be overlaid on companies with sustainable growth in revenues and cash flow. Ultimately, I think this set of conditions is what allowed Aselsan and Arçelik to stand out amid a year fraught with losses – despite being two relatively unknown, small-to-mid sized companies, hailing from a part of the world that many professional investors deem too risky to contemplate.
The assets in the Seafarer Overseas Growth and Income Fund grew considerably during the past fiscal year, from $183 million to $1,219 million. The firm is five years old. At the firm’s inception, I made plans for its future. I did not think the present scale would be attainable for many more years, if ever. We are grateful for the growth the firm has experienced, and for shareholders’ willingness to entrust us with their capital.
Seafarer’s growth has engendered interest in our plans for the company. We have developed a vision that should guide our firm’s development over the next fifteen years. I will share a brief outline of that vision below, particularly as it impacts four key areas: scale, strategies, team and culture.
Regarding scale: though the firm has already grown faster than expected, our long-term plan calls for further expansion. We take nothing for granted, especially the prospect of future growth. Nevertheless, we are preparing for a long-term vision in which the firm attains a scale that is somewhat larger than it is today. However, I am determined that the firm will remain, unmistakably, a “boutique” in both its investment practices and its relationship with shareholders and clients – and therefore there are definitive limits to the growth we will pursue.
We believe growth will afford two main benefits to shareholders and clients: better cost efficiencies and greater investment resources. One of the long-term goals of the firm (first described in an essay from 2012) is to lower the cost associated with overseas investment. Our analysis suggests that greater size will yield meaningful economies of scale, which we will reflect in lower costs to the firm’s clients over time. We also believe that additional scale will allow the firm to augment the resources of the firm in a beneficial manner, particularly with respect to technology systems and personnel. Seafarer is committed to making substantial investments in its research team and its technology over time, in keeping with its scale.
As the firm pursues new avenues for growth, we intend to explore opportunities to attract clients abroad. We believe that diversification of the firm’s client base is essential to the firm’s long-term stability and strength; expansion overseas is one powerful way for us to diversify our business. Such efforts will undoubtedly introduce complexity to our business. However, we think this complexity will ultimately prompt us to serve all of our clients better, as we will continue to “raise the bar” with respect to our compliance standards and fiduciary obligations.
Regarding strategies: the firm’s plans for the future include the management of at least two strategies, and perhaps one or two more beyond. Unlike some other small firms, I do not believe there is only “one right way” to invest in the emerging markets. Rather, our aim is to identify, study and exploit persistent market inefficiencies (i.e., inefficiencies we believe will endure 15 years or longer). Today, we are confident that there are at least two structural inefficiencies that we can harness to the benefit of our shareholders and clients; we intend to explore other possibilities over the next decade, and perhaps one or two will be manifest in new strategies.
Today, Seafarer is best known for its “Growth and Income” strategy. That strategy seeks to exploit a pervasive inefficiency whereby markets habitually undervalue companies growing at low but sustainable rates, and overvalue companies growing at high (but perhaps unsustainable) rates. Dividends and other current income act as a signal to identify and evaluate companies that might be capable of sustained growth.
I am pleased to introduce a second strategy at Seafarer, one that seeks “value” in the emerging markets. On May 31, 2016 Seafarer launched the Seafarer Overseas Value Fund. This strategy aims to exploit certain long-term structural changes in the developing world, changes that we believe will force various companies to realize a portion of the value that is embedded in their balance sheets. The strategy is founded on the premise that some shares have been overlooked because markets favor rapid growth prospects over balance sheet analysis. I am pleased to announce that my colleague, Paul Espinosa, will serve as Lead Manager to the new fund, and I will support him as the Fund’s Co-Manager.
Though Seafarer may one day expand beyond “Growth and Income” and “Value,” our vision does not allow for a plethora of strategies. Our curiosity and our desire to serve our clients and shareholders drive us to explore new possibilities; yet we are committed to being highly selective and responsible in our efforts. We will not proliferate strategies lightly.
As the firm grows, so too will the team that supports the firm’s activities. Seafarer is committed to investing responsibly in its people, so as to ensure the organization is fit for long-term evolution. We are especially keen to expand the operational and administrative breadth of our team within the next 18 months.
Many investors are keen to understand how the investment research team might change or grow. The team will certainly expand, but at a measured pace.
I believe in teams comprised of highly-skilled generalists, in which all members are endowed with substantial authority and responsibility. I prefer to keep teams small to maximize communication, constructive criticism, decisiveness, and accountability. Small teams also tend to minimize politics and unnecessary bureaucracy. Our goal is to make informed decisions on a timely basis, something that I believe small teams do very well.
The expansion of the research team will be limited and selective. Our research process is one in which skilled analysts work to “discover” the rare securities that fit our strategic parameters over the long term. Accordingly, we see no need to “cover” the full extent of the emerging markets, as much of the universe is not germane to our investment strategies. We think a large team would do little to help our clients’ success, and might impede it.
Over time, the firm’s evolution will necessitate greater specialization by strategy. My intention is for the team to be comprised of generalists from a country/sector perspective, capable of analyzing a broad swathe of companies. Seafarer’s team will be organized by strategy, with portfolio managers and analysts named to clusters that support specific investment mandates and any associated portfolios.
As Seafarer’s research team grows, you will see it evolve in a manner that emphasizes accountability, integrity and strategic continuity. With this in mind, I am pleased to announce the promotion of Kate Jaquet and Paul Espinosa to Co-Managers for the Seafarer Overseas Growth and Income Fund. As lead manager of the Fund, I remain the author of its strategy. However, Kate and Paul will be afforded a higher degree of discretion in my planned absence (e.g. work-related travel or personal vacation). I have had the privilege to work alongside both for several years now, and both have developed a broad and deep understanding of the Growth and Income strategy, the Fund and its construction. I am very pleased to enact this promotion – Kate and Paul have earned it.
Apart from these promotions, I am pleased to welcome Jia Zhu to our research team as an Analyst. Jia joins us with a great deal of experience in East Asia, and she will contribute to our research efforts around the globe.
In my estimation, one of the hardest things to do in a growing company is to preserve the investment culture that gave rise to the firm’s initial success. A strong culture often has intangible elements that are not transmitted quickly or easily. The problem of transmission is compounded because any capable organization must remain open to change, progress and development. Thus it is no solution to rigidly enforce a historic culture simply for the sake of doing so. A capable organization must promote a culture that embodies continuity and change at once.
I believe Seafarer’s culture, though young, is worth preserving as the firm evolves. It is a culture that is suited to a small, focused boutique, managed by a team of accountable professionals. The firm is dedicated to delivering an investment experience to its clients that is founded on long-term performance, low costs, transparent communications, and whenever possible, risk adjusted returns.
My pledge to shareholders and clients is that Seafarer will not grow at a pace that overwhelms its unique culture. I do not want Seafarer to become so large that, culturally, the professionals at the firm lose sight of, or contact with, the clients they serve. Seafarer’s ownership structure and governance is arranged such that I have the control to deliver upon this commitment.
This promise will present certain challenges: even as the firm aspires to grow, it will remain “small at heart,” and small in terms of support personnel. We will not hire ghostwriters or large numbers of marketing staff to apply polish to the rough edges of our firm. Doing so will not only drive up costs, it will also dilute the intimate connection between the people at Seafarer and the clients they serve. Seafarer’s communications may not match the volume and timeliness of larger firms, but we are committed to delivering insights directly from the individuals who manage your money.
We are honored to serve as your investment adviser in the emerging markets, and we appreciate your investment in the Funds.
Sincerely,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. 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 April 30, 2016, Aselsan Elektronik Sanayi Ve Ticaret AS comprised 2.1% of the Seafarer Overseas Growth and Income Fund, and Arçelik AS comprised 1.9% 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: SIGIX). The Investor share class (ticker: SFGIX) declined -8.39% during the fiscal year.
- The Fund’s Investor share class generated an annualized rate of return of 5.75% from the Fund’s inception through the end of the fiscal year.
- The Fund’s Investor share class began the fiscal year with a net asset value of $12.64 per share. The Fund paid two distributions: $0.059 per share in June 2015 and $0.076 per share in December 2015. Those two payments brought the cumulative distribution per share, as measured from the Fund’s inception to the end of the fiscal year, to $1.130. The Fund finished the fiscal year with a value of $11.44 per share.