Inaugural Shareholder Conference Call
This Shareholder Conference Call featured a discussion of the global investment environment, including the structural deceleration in China's growth. The call also discussed some of the shortcomings and biases that undermine prevailing benchmark indices.
Andrew Foster, Chief Investment Officer and Portfolio Manager:
Good afternoon everyone. This is Andrew Foster of Seafarer Capital Partners. I’d like to welcome you to the firm’s inaugural Shareholder Call. We are excited to host you here today. I understand that there is a competing call at this hour with Jeffrey Gundlach of DoubleLine; we hope to be at least as entertaining, if not as offbeat. So thanks for joining us.
Our intent is to hold two Shareholder Calls per year, in conjunction with the release of the Fund’s Annual and Semi-Annual Reports. By way of background, the Annual Report was just released last week, and can be found on our website, seafarerfunds.com. As for future events, we anticipate that we will hold public Shareholder Calls in early January and July each year.
Today’s call will be approximately one hour in length. I will begin the call with a presentation lasting about 35 minutes. A link to the presentation is available on the homepage of seafarerfunds.com. After the presentation, my colleague Michelle Foster will lead a question-and-answer session, where we will respond to questions submitted via the Seafarer website from audience participants. We will place priority on responding to questions received in advance of today’s call; however, we will also attempt to respond to questions received real-time via the website, as time permits. If you would like to submit a question during the call, please visit seafarerfunds.com, where you will see a “Submit a Question” link on the homepage.
On the call with me today are three colleagues – two colleagues from the investment team, Kate Jaquet and William Maeck, and Michelle Foster, Director of Fund Administration, who will moderate the question and answer session. You can read more about our backgrounds on the website.
Lastly, as for the format of this call, we have everyone in “listen-only” mode. Also, for your reference, we are recording this call, with the intent to later transcribe it and make it available on the Seafarer website.
Before we begin the presentation, please note the Fund regulatory disclosures listed on page 1. View the Fund’s risk disclosures.
With those introductions complete, I’d like to thank everyone for their participation, and let’s now get underway by turning to the agenda on page 2 of the presentation. We will begin by discussing the global investment environment with particular focus on China and Europe, because those two geographies have been at the epicenter of the market’s concern and woes over the past three months. We’ll then touch briefly upon valuations in emerging markets from Seafarer’s point of view. In the second segment of the presentation, we will discuss the Seafarer strategy’s positioning by region, touching on Asia, Eastern Europe, and Latin America, as well as the strategy’s positioning by sector, and the emphasis on service sectors. We’ll then wrap up with the part of the presentation I’m most excited about, which is a discussion of a key component of Seafarer’s long-term investment strategy. We are very much bottom-up investors at Seafarer, researching individual companies and investing in individual securities based on their specific merits. However, there’s one top-down component to what we do, and we call it trying to build a portfolio that anticipates the benchmark. We’ll describe that more later.
Market Environment: China and Europe
Moving on to page 3 of the presentation, let’s discuss China. China has obviously been much in the news, even just last night when its growth numbers were released. China announced that it had grown 7% in the second quarter of this year. China’s slowdown has been much discussed in the press, especially in the past three months, and even going back farther than that, but I want to stress that this slowdown has not caught us by surprise. Indeed it is something that we at Seafarer have been aware of from our outset and it dovetails with some of my own research and writings going back well before this. We recognize that China’s growth is slowing – but it is not stopping in our view – as the economy undergoes a critical and necessary transition.
Our base assumption going forward is that China’s growth will remain attractive over the next five years, averaging about 6%, but ranging between 4% and 8%. So I want to stress: there could be quite a bit of volatility in China’s growth path from here. We believe that for the most part, except for a few one-off quarters, China’s period of exceptional growth, 9% to 12%, is over.
Nevertheless, even though China is decelerating, we believe China’s current growth is improving in its quality and sustainability. China’s economy is shifting from one set of economic drivers to another set. That transition is causing the deceleration. The economy is at the front end of a long, gradual shift from dependence on external markets (for example, exports) and physical capital (for example, infrastructure and property), to one that emphasizes domestic demand, especially service sectors such as healthcare, media, travel, leisure, entertainment, information technology, and software. We think these are very interesting sectors because they are not necessarily ones associated with China’s past, and therefore they will beget some interesting investment opportunities going forward. We’ll discuss this idea more later in the call.
We believe that the transition that is underway will be slow and gradual; any notion that China will move quickly to a domestic oriented economy, which has been much discussed in the press, is a false one. It is going to take at least a decade, if not longer. This transition will be sometimes rocky, and very opaque; this will lend passing credence to China’s doubters. You are going to hear every negative story that has ever been out there about China spill out in the press over the next couple years. You have to be ready for it. China has many “skeletons” in its financial closet, and as some fall out, it will create some volatility in China-correlated equities.
We think that this transition is incredibly important for China’s future and will create very interesting growth opportunities over the next decade. So Seafarer intends to stay invested in China, despite this ostensible deceleration in growth, to capitalize on the potential opportunities afforded by transition.
Moving on to page 4, let’s discuss Europe. The recent news that Europe is moving to recapitalize its banks from a pooled financial resource is, in my view, the first material, constructive news to emerge from Europe in the past year. However, it is only news and good intentions at this stage; the arrangements have not yet been finalized, much less put into action.
The reason I am excited about this is that in my view, Europe’s financial problems stem from both poor liquidity and inadequate solvency. There’s been a lot of discussion about how bond yields and spreads are blowing out in Europe and becoming stressed, and this is a sign of poor liquidity. People are calling on the central bank of Europe to try to cure this problem. The central bank has taken up some monetary policy to ease the problem at the margin, so it’s done something, but not as much as some would hope. I do think that solving the liquidity problem is a necessary part of the cure, but it is not sufficient for the cure alone. What has to happen is the solvency in the region’s banking system has to be improved. The banks’ balance sheets must be shored up. This effort is necessary for the central banks’ monetary policy to have its greatest effect. For this reason I am excited that the news about Europe moving to recapitalize its banks is finally coming out, because it looks like Europe is tackling the root problem. We are thus a bit more enthused about equities – provided Europe follows through on its plan.
I do want to stress that our base assumption is that there will be some disintegration of the current membership of the Eurozone going forward. It’s most likely that certain peripheral countries (such as Greece or Portugal) exit; but we do not view this event as a catastrophe. These are smaller economies, and frankly these economies and the markets as a whole have largely recognized this event in my view. What will create a catastrophe is if those bank balance sheets are not shored up in advance of the disintegration. Then you may have greater stress placed on the banking sector; you might even have widespread bank collapse in which case we could move into a more dire scenario in Europe.
There is also a small chance that an inverse event occurs, in which Germany exits of its own accord.
Moving onto page 5 of the presentation, while we think the exit of one or more smaller members of the Eurozone is likely, this will probably create temporary volatility among emerging markets. It will almost assuredly cause uncertainty even though the market has had a great deal of time to prepare. We believe that valuations in emerging markets are quite low to begin with, such that they already reflect all but the most dire scenarios that I discussed a moment ago.
In light of this, we believe that developing countries in Eastern Europe (particularly Turkey and Poland) are still capable of producing positive economic growth this year, despite persistent uncertainties regarding the euro. We find these markets to be attractive investment climates. Valuations in these two markets appear attractive for investors willing to hold for the medium-term, through volatility.
In summary, we believe markets have discounted the bulk of the bad news. What’s critically important is that Europe embraces a solution and moves forward. A resolution of nearly any sort (except for the most extreme scenarios) will likely benefit stocks in Eastern Europe, and emerging markets more broadly.
However, markets will struggle (or even decline) if decisions regarding the solvency of Europe’s banks and the membership of the Eurozone are drawn out, and stasis persists. In our view, a lack of any action is more damaging to stocks than an incomplete or imperfect resolution.
Moving on to page 6 of the presentation, equity valuations in emerging markets are relatively attractive, in our view, particularly within the emerging Asia region. On this slide you can see a table of valuation statistics that I have composed for a broad group of over 3000 companies across the entire emerging region1. The forward price to earning multiple on this set of companies is 11 times. The trailing price to book multiple is 1.3. The nominal growth in earnings per share is about 13%; this growth rate includes approximately 4-5% inflation, on average, across the group.
We think these valuations are fairly healthy and attractive for investors who can hold over the medium term. We do acknowledge that there could be further volatility going forward, as discussed earlier. We are clearly off the lows we hit in May, so I would not suggest that we are at rock bottom valuations. But these are very healthy valuations; as much uncertainty as there is in the world right now, valuations are the one thing I can say are an investor’s friend.
Seafarer’s Strategy: Positioning by Region and Sector
Kate Jaquet, Senior Research Analyst:
Moving onto page 7, this is Kate Jaquet. I am a member of the investment team here and also a registered representative. The table on page 7 shows the Fund’s most recently disclosed regional composition, as of June 30th. The top row – titled “Investment Portfolio” – offers an overall snapshot of the portfolio’s characteristics. The first column indicates the number of holdings in each region; the second column indicates the percentage of net assets invested in each region; and the subsequent columns offer various data points on the valuations and other characteristics of the holdings in each respective region.
As you can see, this regional composition reflects my earlier comments in large part: the strategy is largely centered on Asia, because we believe that the transition underway in China – and Asia more broadly – presents attractive investment opportunities, and you can see that valuations in that part of the world are also quite attractive relative to some of the other emerging regions, at least within our strategy. We are also keen to invest in some of the “frontier” markets of Asia – notably Vietnam – which are in a very different stage of growth altogether, not subject to the same sort of deceleration underway in China. These are truly “emerging” emerging markets. Lastly, there is also a substantive, structural reason that the strategy will have a large allocation to Asia for the foreseeable future – but we will address this in the last segment of this presentation.
Despite the possibility of risk arising from Europe, we are finding more reasons to invest in Eastern Europe, particularly because of compelling valuations there and what appears to be steady growth. In the last few months, we have materially expanded the portfolio’s exposure to Turkey and especially Poland. There is no Russia in the strategy at present, and that is by design, particularly because of the substantial difficulties in approaching that market as a foreign investor. However, we don’t rule out the possibility forever.
Latin America has figured in the strategy from the outset, but valuations in Brazil, and especially concerns over the local currency, the Real, have made that market less approachable. We’ve had concerns about the Real going back quite some time; but at present there is one holding in Brazil in the portfolio, about which we are very positive. Valuations in Brazil have pulled back, the Real has pulled back quite a bit, and consequently we are a bit more constructive, and I think we are going to be doing more work there in the next few quarters. Otherwise, we are more constructive on Mexico, which has exhibited steady growth, better valuations, and a more resilient currency. We are obviously deeply concerned about the narcotics wars, and we continue to monitor events closely. However, Mexico’s industrial base seems to have benefited from steady foreign investment, as China’s competitiveness has been eroded at the margin due to currency strength and other factors. There is ongoing auto investment; Nissan just announced a new major $5 billion investment today.
Lastly, the Middle East and South Africa are within the scope of the strategy. We have several prospective investment targets there, but only one holding as of today. We anticipate the portfolio’s exposure to this region will grow over the next few quarters, but not substantially from here.
Moving on to page 8 - as with the preceding page, this page shows the Fund’s most recently disclosed composition, as of June 30th, but this time from a sectoral perspective. The top row again offers an overall snapshot of the portfolio’s characteristics, and each lower row provides detail for the underlying sector exposures of the Fund. The second column indicates the percentage of net assets invested in each sector.
At first glance, what stands out about the composition of the strategy is that it is reasonably well diversified across most of the major sectors present within the index.
However, what is not immediately apparent from this table, but what is very important to note, is the strategy’s substantial emphasis on service-based industries in lieu of the sectors that classically dominate emerging market indices. The sectors that are normally a big part of emerging market indices are commercial banks (and to a lesser extent, financial services), resources/commodities/energy, and some export-oriented industrials. Instead of these three historical drivers, we are positioning the strategy with exposure to service industries, where we think the long-term opportunities lie. By services, we potentially mean any of the following: consumer services (healthcare, media, entertainment, travel, leisure); business services (information technology, software, consulting, advertising and accountancy); and industrial services (transport and logistics). At present, the healthcare and software industries have the largest representation within the strategy. We are placing great weight within these sectors because we think they are poised for growth, and also because we believe they are underrepresented in the index portfolio and will benefit from greater inclusion in the index in the future, for reasons we will describe in a moment.
Regarding the much discussed emerging market consumer: the Seafarer strategy places greater weight on the domestic side elements of the economies of the emerging markets; to some extent this is accomplished by exposure to consumer sectors, but we largely believe that theme has been tapped out over the last five years or so because it has been chased aggressively by other active managers. Valuations are less attractive as a result. So in our view, services, including some consumer services, but services more broadly, offer better value and growth.
Seafarer’s Long-term Investment Strategy
Moving on to page 9 of the presentation - in this final section of this presentation I address a key component of Seafarer’s long-term investment strategy, which we call “building a portfolio that anticipates the benchmark.”
Before I explain what I mean by this, I wish to stress that Seafarer’s strategy is very much “bottom-up” in its orientation. That is to say: we perform research on individual companies and assess the specific merits of individual securities. We generally avoid making “top down” investments, which rely primarily on betting whether a particular big-picture theme, trend or idea will successfully “play out” in the markets.
That said, there is one key element of our long-term strategy that is “big picture” in nature. Let me explain: we research the prevailing benchmark index to look for places where it may have structural shortcomings. In particular, we look for places where there may be a mismatch between the index’s structure and that of the underlying market fundamentals. What do I mean by this? If you were to pick up a methodology handbook from one of the major emerging markets index providers, you would see that it places a strong emphasis on “investability” (whether a security can be easily replicated (i.e. purchased) by a foreign investor) and “scalability” (whether a security can be purchased in very large quantities).
That is quite understandable, given that the folks who buy the index data from the index provider want the index to be low hassle to track, but those two key features of the index often come at the expense of fidelity to the underlying fundamentals – that is to say, the natural scale and composition of the underlying market, whether measured via capitalization or economic output.
It has been our experience that over time, the index’s evolution will cause it to gradually align with those fundamentals, and not the other way around. By positioning Seafarer’s strategy in line with the fundamentals, we believe the strategy can “anticipate” the index’s future state – effectively investing “ahead” of the benchmark. It is a very long-term process, but it is one that we think holds over time, and which can be beneficial to a long-term investment strategy.
Let me show you some data to substantiate what I said a moment ago about how the index pays more attention to “investability” and “scalability” than it does to fidelity to the underlying market fundamentals. Please turn to the table titled “Divergence: Index vs. Fundamentals” on page 10 of the presentation. So often when we look at an index we assume that it follows the same methodology that we have grown accustomed to in developed markets, that is to say, a market-capitalization weighted index that covers (more or less) most listed companies in the market (or at least a large swath of the top tier of companies).
But for the prevailing benchmark index tracking emerging markets, this simply isn’t so, and you can see it in the differential percentage weights between the first column of this table, “Index-Based Portfolio,” (which is based on a prominent index fund that tracks emerging markets) and the second column, “Market Capitalization,” (which is based on the actual market capitalization of these same markets). I have organized the table by regions, which is the most important aspect to review, but I have also included detail on a few of the key larger developing countries – the BRICS (Brazil, Russia, India, China, and South Africa) – for your interest. You can see that the first and second columns are somewhat similar, but ultimately materially different in the relative weightings.
The third column, “Economic Output,” offers an alternative measure of the underlying fundamentals, which again tries to “weight” the various countries and regions, but this time according to the relative scale of their economic output as measured by GDP (gross domestic product). I offer this column as an alternative indicator because sometimes in developing countries, even market capitalization is not a great guide to relative size. So this is a viable second alternative, in my view. You will notice that but for some small differentials, the third column largely reflects the relative weights of the second column, particularly at the regional level.
So why does this matter? The point of this is to show that you simply cannot assume that benchmark indices are necessarily representative of the underlying markets they intend to track. A passive approach can be desirable, but in my view it must be based on a soundly constructed index for it to work as intended. It is this idea that can break down in the emerging markets: because the index places special emphasis on the ease of replication, it foregoes fidelity to the underlying markets, and in doing so, it departs from classic financial theory -- such as investing based on a market-cap weighted index.
So having established that there are some differences between the index and market fundamentals, let’s look at what this means from a strategic perspective on page 11. This page sums up how Seafarer thinks about its long-term strategy. This is the “big picture” idea I alluded to a moment ago, that informs our strategy’s direction, both now and in the future. What we have done here is try to show you where the index is either underweight or overweight the underlying fundamentals in the four main regions that were shown in the preceding table (on page 10). You can see that the prevailing index fails to properly capture the relative weight of East and South Asia, versus the rest of the developing world; the same is true of Eastern Europe, though on a lesser scale. Meanwhile, it gives disproportionate weight to Latin America and the Middle East.
The bars on page 11 show these relative over and underweights; to calculate them, all we did was take the average of the 2nd and 3rd columns from the prior page, and then subtract the first column from that average. This very simple math indicates where the fundamentals hint that the underlying region in question is either bigger (or smaller) than the index’s current allocation would have you believe.
I wish to stress that there is nothing that is absolutely definitive or iron-clad about this analysis. I cannot conclusively prove that the index underweights East & South Asia by exactly 7%. The fundamental measures we have used – market capitalization and economic output – are best thought of as broad based indicators, and not as precise measurement tools. Thus the results presented here are best interpreted as being directionally correct, and not an exact guide to the index’s shortcomings.
Moving on to page 12, some of you may be wondering: “sure, there seems to be some differential between the index and the underlying fundamentals, but what does that matter to an investment strategy?” My answer to that question is visible in the four charts presented on page 12.
What these charts show is how over long periods of time (14 years in this example), it has been largely the case that the index has gradually moved in line to match the underlying fundamentals, and not the other way around.
You can see from the upper left chart, representing East & South Asia, how this has played out: the index had a relatively low weighting in the region in 1997 (indicated by the blue bar), whereas the fundamentals (indicated by the dark blue diamond, above the blue bar) suggested a weighting that was quite a bit higher. Moving near to the present, you can see that the blue bar has risen quite dramatically, much more in line with the original, underlying fundamentals. What’s happening here is the following: China was woefully under-represented in the past within the index; it’s rise as an economy, and as an investment destination, was largely overlooked by the complier of the index, simply because that market was not as easily replicated as some others. Ultimately, the fundamentals won out; they functioned as a better guide to the future construction of the index than the index itself.
Moving to the upper right-hand chart, which represents Latin America, you can see the opposite was true. Fourteen years ago, the index (indicated by the blue bar) placed a larger weighting on Latin America than the fundamentals (indicated by the dark blue diamond) warranted, presumably because it was easier than other regions to replicate. But moving forward to the present, you can see the weighting in the index has declined fairly sharply, converging once again with the fundamentals.
The same outcome is again true in the Middle East and Africa. Eastern Europe is the sole region where convergence did not occur in the manner I have described – and this is mainly because the index and the fundamentals were not terribly misaligned to begin with, so their later convergence was not as dramatic.
In my view, these charts on page 12 demonstrate that the index will, gradually over time, come to look more like the fundamentals of the markets, and not the other way around. As we compose our strategy, we pay close attention to the divergence between the fundamentals and the index – this is the one “big picture” theme that informs what we do, and it means we will most likely maintain a substantial allocation to East & South Asia, relative to the benchmark, for a long time to come, because the fundamentals warrant it. We think a similar, even more powerful trend will unfold in the services sector over the next decade – and again, the index is underweight there based on our research. This is the core of Seafarer’s idea that it will strive to build a strategy that “anticipates” the benchmark and invests “ahead” of where it is likely to go.
To wrap up this presentation, we will briefly review the Fund’s performance since inception. Please turn to page 13 of the presentation. Since the Fund’s launch on February 15th of this year, and through the end of the calendar quarter at June 30th, the Fund’s performance is marginally positive, returning 0.21% on the Investor class and 0.26% on the Institutional class. Over the same period, the benchmark index (the MSCI Emerging Market Total Return Index, gross of taxes) has declined by -10.02%. View the Fund’s performance disclosure.
Since our launch in mid-February, markets have been exceedingly choppy, and on a downward bent overall. It may seem like a distant memory now, but emerging markets were in the thrall of a mini-bull run at the time of the launch. It has not been a particularly easy time to launch a new strategy, but overall we are pleased with how it is shaped up thus far, and we appreciate your support.
This concludes our formal remarks today. Michelle will now lead a question-and-answer session for the remainder of this call.
Question and Answer Session
Michelle Foster, Director of Fund Administration:
For the question and answer session, we will place priority on responding to questions submitted in advance of today’s call. However, as time permits, we will also attempt to respond to questions received on a real-time basis. You can visit our website at seafarerfunds.com where you will see a “Submit a Question” link on the home page. Please note that we may modify the nature of your question, either for compliance reasons or to consolidate it with other similar questions. Also, for compliance reasons, we cannot respond to questions about specific securities.
Andrew, let’s begin with a question submitted regarding Europe. Can you elaborate on a potential Eurozone breakup and why you’re not more concerned that this could be a catastrophe for global markets?
As I mentioned earlier, I believe a breakup of the Eurozone – one in which some of the smaller members pull out - is not in and of itself a catastrophe. In fact, the currency flexibility that is afforded by doing so, especially for the smaller countries such as Greece, may be the cure to their economic future. The key linchpin for the Eurozone is making sure that the banks are solvent and have their balance sheets fortified against this prospect. There is going to be a great deal of financial stress and strain put on the system in the event of a pull-out, and that is the real key issue here. I have always felt that the Euro’s creation was more of a political project than a financial one, because there was insufficient financial integration amongst the Eurozone nation members to make it really work. So the problem is the politics are beginning to fray and that’s the only thing holding the currency together - so unfortunately I do feel that an exit of one or more peripheral members is the most likely outcome, and it may actually represent a better one. I believe markets have largely caught up with this fact. Six trillion dollars have been wiped off of market capitalization since the outset of the Greek crisis about two years ago. While there will be some continuing shock if the event occurs, if the banks are strong and at least reasonably healthy, I believe we will get through it alright. What you need to watch out for is if the banks are not properly recapitalized - that’s where things could be more problematic.
Thanks, Andrew. Our second question on Europe comes from a shareholder who asks: has the financial crisis in the Eurozone offered up good investment opportunities within Europe and the surrounding region?
The answer is yes, indeed it has. We have been doing a fair amount of research in the Eastern European markets. I recently traveled in Turkey and Poland and, as I alluded to in the presentation, we are finding the investment climate to be attractive in those markets. In particular, we are finding some of the valuations afforded in those markets to be interesting to the strategy. The strategy’s weightings in Turkey and Poland have been rising. Turkey is growing faster than Poland, although I would say its growth is certainly more precarious than that of Poland. Poland is growing slower but I believe its growth will be steadier. Short of the most dire circumstances that I have described, where there are widespread bank panics and collapses engendered by a very messy disintegration of the Euro, I believe these economies will continue to grow and provide a good investment back drop.
Andrew, let’s move on to two questions that were submitted regarding China. First, you mentioned in the presentation that China’s growth is slowing - but not stopping - and that the economy is undergoing a transition. How can you be sure that this is the case, and can you offer us any evidence?
I hope I did not paint myself too much of a macroeconomist, because I am certainly not that. I’ve been an analyst following China for quite some time and I don’t have the macroeconomic tool set to definitely state that China will grow. I’m not sure macroeconomists do either, for that matter. But what I would say is that as an analyst, I tend to think as hard as I can about what I would like to see happen at a company or in an economy so as to substantiate its future sustainable growth. If I were to put up a list of the things that China needs to do to make sure that its growth path will be relatively sustainable in the future, and that the country will grow on the order of magnitude of 6% as I outlined, China is basically ticking of the items on my “reforms / to do” list, one by one.
I want to elaborate further on this concept because it’s really important. China three decades ago was incredibly poor; the nation had a huge surplus of labor and very little financial capital. Deng Xiaoping kicked off a series of market-based reforms that engendered the growth that we have become accustomed to over the last two decades. What happened back then was not necessarily a full-fledged market liberalization; it was a liberalization of the end outputs of production. China was closed internally to competition and to external markets. The end markets of production were liberalized and that fueled what we have experienced over the last two decades.
What was not liberalized three decades ago were the key input factors to production. I want to stress those input factors were not liberalized. What do I mean by input factors? I mean labor, energy, financial capital, foreign exchange, and information. Those are five key areas where markets were not liberalized even in small ways, much less so in the meaningful ways that could support China’s ambitions to grow over the long term.
Consider the example of labor markets: there were a number of constraints over these markets including what’s known as the Hukou policies that constrain internal labor mobility. There were also a number of inadequate worker protections that have been bolstered in the last five years by the implementation of new labor laws. There was formerly a concerted effort to suppress manufacturing wages, which in the last two years has been relaxed. So labor markets are beginning to be liberalized for the first time in earnest.
Take energy markets as another example. Price controls and, to some extent, rationing of resources have been widespread in China, causing inefficient allocation of resources within the economy. Most energy prices do not reflect their true marginal cost. While the authorities are very worried about inflation, they are gradually releasing such restrictions on the prices of energy and other key resources. They realize that from an environmental prospective they are destroying their future, and also that they need to have a more efficient allocation of these precious resources in order to ensure their growth.
Financial markets - in particular, corporate bond markets - provide another example of an input factor that was not liberalized. There is no real municipal bond market in China even though the country desperately needs one. Now, the country is beginning to reform these markets.
Lastly, the most sensitive of the five input factors I mentioned is, of course, information. This goes to the heart of the Communist Party’s control over the economy: its ability to dictate the flow of information in the economy. I strongly believe that the Chinese economy will not achieve its full potential unless there is greater freedom of information in the country, and I would not want to suggest that meaningful freedom of information exists today. It is plainly evident there is a great deal of suppression of information; and yet, the situation is radically different than was the case ten years ago. Information flows much more freely through a number of different mechanisms in the country. Political discourse is much more robust and to some extent cannot even be suppressed by the authorities unless there is a real concerted effort. Meanwhile, interestingly, the authorities have allowed most of the formerly state-owned media conglomerates - which were small entities - to actually merge and gain more economic clout. You could look at those mergers as a two-sided coin but frankly, if you really wanted to suppress your media outlets, you would keep them small and easily under your thumb. As you allow them to merge, perhaps you have fewer outlets to control but you also are dealing with more powerful enterprises.
Thanks, Andrew. Continuing on the topic of China’s growth, we heard you say earlier that China’s growth rate could fall as low as 4% and will likely average around 6%. Aren’t these levels dangerously low? It’s commonly believed that the Communist Party must maintain 8% growth to preserve social stability.
That 8% figure is quite interesting because it’s one of these figures that gets bandied around so much that it eventually becomes a truism and is accepted as a “fact” by folks everywhere. I definitely agree that there is a correlation between growth and social stability and the Communist Party’s mandate to continue to govern the society, but I no longer think there is anything particularly magical about the 8% threshold. China has experienced significant gains in incomes and the quality of living, particularly in the coastal cities, and I believe China realizes that it’s more important to re-fashion its economy to become more sustainable than to stick to an arbitrary growth figure. Also, as I alluded to a moment ago, the nature of political discourse in China, while still suppressed, is vastly richer than what I saw when I started my career. There are more outlets for discourse – and even disagreement – than there were in the past; this means that China will not necessarily veer into chaos as soon as growth falls below some magical threshold. I do think if growth falls to zero, or goes into reverse, then the sort of strains that the question alludes to would come out. But I don’t expect such a major deceleration to occur.
Let’s turn our attention to a question submitted about the risks in emerging markets. Andrew, how do you get comfortable investing in countries that may suffer from volatile political environments, dangerous conditions, or institutionalized corruption?
This is one of the hardest things we have to do as bottom-up investors. We focus our efforts on individual companies, and the way we look at the macro environment is largely through the prism of the individual company’s experience. We want to make sure that the environment that surrounds a company is at least not an incredible impediment, and hopefully a benign environment. The simple decision rule that we use, frankly, is whether or not we are willing to put boots on the ground in a particular country. If we are so concerned over our own personal safety or the governance of a country that we are not willing to visit the companies there, that’s a pretty telling sign right there. We don’t put shareholder capital at risk where that is an issue.
It is important to note, however, that while we carefully consider a country’s political environment and governance, we do not aim for some standard of perfection or enlightened governance before we invest. It comes down to this in my view: when you invest in emerging markets you invest in a lot of things. You do invest in the vaunted emerging market consumer and you invest in these countries’ growth. But in my view, what that really is about is investing in progress and what you’re talking about is people who often are coming from very poor and difficult backgrounds, who are working hard to improve their living standards. They are often working in countries that have less than perfect government regimes, less than stellar institutional frameworks, and what you’re talking about is recognizing that you’re investing in an imperfect environment but one that is transitioning toward a greater state of perfection. It’s that transition from a lesser state of existence to a better state that we try to capture in our portfolios – because in my view that’s the real “driver” of growth in emerging markets. That is also what fuels the expansion of the price to earning multiple over time. It’s investing in an imperfect state that is moving towards a more perfect state. It’s a very important concept to comprehend.
Thanks, Andrew. We just received another question that relates to governance in emerging markets. In light of the China-based equity fraud allegations that have come to light over the past twenty-four months, how does Seafarer navigate Chinese companies? Clearly auditors’ sign off, third-party China banks checks, etc., haven’t properly reported clean bills of health.
Yes, it’s a difficult thing for us to do. In terms of the company financials, we rely on audited statements. We don’t have the capacity to do the sort of checks that an auditor would do, “behind the scenes” at a given company. But one of the key features of our research process that distinguishes us is that we focus on the control party behind a company. We try as best we can to observe who controls the company and what they are about. People talk all the time about trying to find good management. It’s a great thing to do if you can find it, but it’s also a very nebulous concept. We look for who is actually controlling the company because they tend to set the agenda and the incentives for the company, and that’s usually a more empirical exercise then trying to understand the quality of management. By researching and understanding the control party and its objectives, we can gain a much better sense of the governance of the company and therefore either come to rely or not rely on the caliber of the financial statements to a greater extent.
We also visit companies first hand, on the ground. Occasionally this means we do discover fraud; it’s happened conclusively two times in my experience. But the primary reason for a company visit is to see how the business model works, to appreciate the risks first hand, and to tie together all the research that we’ve done to that point. It’s a moment of intense scrutiny and reflection and it can occasionally turn up fraudulent practices.
Andrew, the next question from a shareholder concerns the Fund’s asset allocation. Are you planning to add more convertible bonds to the portfolio and are you targeting a certain percentage allocation to convertibles?
We do hope to include more convertibles in the Fund. Right now, the Fund’s size is somewhat prohibitive. Most convertible bond trades are done in million dollar blocks. We can trade smaller blocks sometimes. We are interested in moving to convertibles a bit more. However, even regardless of the Fund’s size, the decision to do so is ultimately driven from the “bottom up,” based on the relative attractiveness of a given convertible. We look at individual securities and we sometimes overlay a bit of a tactical view about valuations and markets; from that perspective I’m pretty positive about equities for a three-year view. That said, we are making individual security decisions.
However, if I really had to project where our long-term average will lie, I imagine it will be an asset allocation of approximately 80% common equities, 20% convertible bonds and other instruments. I think this is where we will eventually come out over time as the portfolio grows, but it will be driven by individual security decisions.
Our next shareholder question concerns Seafarer’s investment approach. Andrew, how do you define quality in the context of the companies you research as candidates for the portfolio?
Quality is not a term I use very often. I focus on three primary factors in evaluating companies. One of them is the control party issue that I alluded to a moment ago. In my view, the best thing you can do is, rather than look for quality management, look for a control party that has the right drive and ambition to grow their company in a sustainable way. These are observable and empirical measures. It’s important that the control party never forgets about the small shareholders along the way. I’ve seen some very, very big companies grow very, very fast and forget entirely about their smaller shareholders, and that does make a difference. That’s one element of quality, I suppose – not forgetting about your smaller shareholders. The second key element is the sustainability of growth. Emerging markets produce a lot of types of growth. We are much more attracted to the kind that can be repeated over time, even if it’s slower. You can sometimes be dazzled by very high rates of growth but they are often driven by one-off factors that unfold over a year or so. Maybe they are even due to some temporary circumstances like special favors or subsidies that a particular company is receiving. We generally try to avoid these types of situations.
The last element of quality is balance sheet flexibility. People talk about balance sheets in a lot of different ways. For me, the key reason to invest in a healthy balance sheet - generally one that is liquid and less levered - is that it gives flexibility. So much of long-term success is just driven by survival. Companies that maintain healthy balance sheets have more flexibility to survive and ultimately prosper. During times of broad, macro-economic growth, companies with levered, tightly-wound balance sheets can often generate flattering profits; but when those same companies enter a downturn, they lose several degrees of freedom, possibly compromising their very survival. I look for balance sheets that are built for long-term survival.
So I would break down quality into balance sheet flexibility, sustainable growth, and a control party that imbeds even minority interests in their scope and view.
Thanks, Andrew. Let’s turn our attention to currencies. I’m going to combine a few questions that we received on this topic. What is Seafarer’s view of emerging market currencies? Does the Fund engage in currency hedging and, if so, do you consider it a hedge or an investment in the currency?
The Fund’s Prospectus does contemplate the possibility of hedging, but in practice we think it will be a rare event. I have a couple of reasons for saying that I don’t hedge much. First of all, I should state that we make some tactical attempts to mitigate some currency risk by simultaneously investing in companies with contrasting business models. For example, we might pair an exporter – which would generally benefit from currency weakness – with an importer – which would generally benefit from currency strength.
However, the reasons I prefer not to do much financial hedging – with derivatives or swaps – ultimately run deeper than such tactical considerations. There are two main concerns that drive my thinking on the matter. First, from a practical perspective, it’s often very difficult to create long-term stable currency hedges at a reasonable cost. We are investing in a portfolio on a long-term basis and in most of the markets in which we invest, hedging tools don’t exist, except for some shorter horizons. If we were to attempt to purchase longer-term hedges, they would be inordinately expensive or non-existent.
Second, I have a philosophical concern. Even though financial theory says that one can unbundle a currency risk from a security risk, I find it a very difficult thing to do in the context of my research process. I’m trying to find companies and invest in their securities for the portfolio over the longer term, ideally for an undefined period that is as long as possible. It is difficult for me to separate the security risk from that of the underlying currency over such a horizon.
The analogy I use is finding the perfect home for your family. You find that home, and your intent is to buy it and hopefully live there for 20-30 years. You also hope it will be a good investment along the way. It’s obviously a key financial asset for you. In my view, the notion that you would somehow go short or hedge out the risk of the property that is sitting underneath that house, or indeed the neighborhood around the house, is problematic over such a time horizon. Formally speaking, the property and the house are different financial assets and can - on paper - be unbundled, but their values are inextricably intertwined to an extent that you have to invest in them together, along with the surrounding neighborhood. To me, the house is analogous to the security, and the property underneath the house is analogous to the currency.
I’m going to turn over this question to William who has done some new work for us on how to think about currencies in this sense.
William Maeck, Associate Portfolio Manager and Head Trader:
We attempt to see warning flags before serious currency events, considering a currency’s restrictions or stability. Our approach to currency risk is binary for the most part. It’s a go or no-go decision. In some cases currencies will fall into a middle ground and when they do so, we reserve the right to hedge.
In terms of my house and neighborhood analogy, we look for markets where we think the currency is stable enough that we are willing to tolerate a certain degree of volatility. Emerging market currencies are volatile, as we have emphasized in our past research efforts. We have written essays, available on our website, that stress the importance of not trusting in false stability in emerging market currencies. We believe that we can identify a certain set of currency environments that are relatively healthy; I would liken them to good neighborhoods into which we are willing to move. There is also a set of neighborhoods that we try to identify and stay away from altogether because the risks are just too severe, either because we anticipate a very sharp currency drop - not a small one, but a sharp one - or the imposition of draconian capital controls.
Lastly, there may be a small set of neighborhoods in between that I would liken to transitional neighborhoods, where on limited occasions we might stake out a claim and wait for the neighborhood to improve around us a bit. However, only a narrow set of currencies fall into this transitional category; these are the “middle ground” currencies that William alluded to, where we may consider hedging, and that’s why the Fund’s Prospectus does contemplate this possibility.
Andrew, can you discuss Seafarer’s investment philosophy and process. In particular, how do you make decisions regarding adding or subtracting a name from the portfolio?
We discussed some important elements of the investment process earlier on this call, in terms of researching and understanding a company’s control party and its objectives.
Also, for those of you who are interested, we describe our investment philosophy and process in detail on our website, seafarerfunds.com.
To highlight another key element of the research process, we do a deep dive into the company’s business model, particularly how it generates cash flow, and seek to understand where the risks might lie around that model. We spend a lot of time thinking about sustainable growth as I alluded to.
We look at the control structure. We then spend some time thinking about where the best part of the capital structure might be. More often than not, we hew towards equities. We tend to be predominantly equity investors but we do occasionally look to other parts of the capital structure such as preferred equities, fixed income and especially convertibles where they are attractive.
As the last element of the research process, we spend some time thinking about the liquidity of the capital structure, to hopefully ensure that the securities we purchase remain liquid. But we also want to make sure that the company itself has access to capital markets on a go-forward basis. As I alluded to earlier, a company with sufficient balance sheet flexibility – which can include access to capital markets – is much more likely to survive a time of stress and ultimately prosper.
In terms of the decision making over the portfolio, we collaborate a great deal on our research efforts but I as lead manager take full responsibility and accountability for all the decisions that are made on a day-in, day-out basis. The decisions rest with me but I work very extensively with Kate and William to collaborate on decisions. We are generalists and we work across our regions. We do come from specific backgrounds where we have more expertise in one region or another, but we work as generalists and as a team.
Thank you. Let’s address a question we received regarding the Fund’s performance results that Kate provided earlier in the call. Andrew, can any of the “since inception” return outperformance be attributed to you holding cash during this period? In other words, were you fully invested during the period? Also, can you tell us what a normal level of cash will be for the Fund?
We believe that a normal level of cash will range between approximately 0% and 5%. We launched in mid-February with cash levels around 20% to 30%, and by the time our fiscal year ended on April 30, the cash level in the strategy was about 6%, roughly in keeping with our long-term intention.
It’s true, we were a bit higher in cash in the first few weeks of the strategy, around 20% to 30%. By my recollection markets were very choppy during that period but not really falling, they were just zigzagging up and down very dramatically. Our portfolio – that is, the portion that was invested in securities – gained a little amid the choppiness, and ironically, this relatively high cash level represented a small drag on performance.
By the end of April, at the close of the Fund’s fiscal year, the Fund was nearly fully invested, with the cash level falling to 6%, for better or worse. It turned out that it was marginally for the worse, because markets actually began to fall in earnest in May, instead of only zig-zagging up and down, as they had done between February and April. So the Fund was near full investment at the moment that it would have helped to have a high level of cash. So much for market-timing! Markets fell through the end of May or early June, at which point they began to rally through the end of June.
So in summary, cash did play a role in the Fund’s performance during the first few months of the Fund’s existence, but frankly it was more of an impediment than anything.
Let’s move on to our final question for this session. Andrew, we received this follow-up to the question you addressed earlier regarding alleged fraud in Chinese companies. The question is: You mentioned that on two occasions, you discovered seemingly fraudulent practices during company visits. Would you take a short position in this situation or, if not, how do you respond to uncovering fraud?
That’s an excellent question. The fraud cases that I mentioned earlier were revealed by onsite company visits. We would not necessarily take a short position in the portfolio because the 1940 Investment Company Act regulations that guide mutual funds make it very difficult to do so. Furthermore, local regulations in most markets in which we invest generally make shorting a very difficult if not dangerous portfolio exercise or prohibit it outright. So shorting is generally not on the map.
The ethical obligation to respond to potential fraud is trickier. In the two instances I mentioned earlier in the call, I did not bring the potential fraud public. I was 95 percent convinced that these companies were committing fraud after I visited them; in both cases it turned out that I was right. However, at the time of each visit, I had some reservation about the fact that I might be wrong. In my view, what drives success over the long term is always being very cognizant of how you might be wrong.
Thus, in both of the cases I have experienced, I did not feel it was my place to bring down the relevant company - which might represent many innocent people’s livelihoods and efforts – because I had reserved some substantial room for the possibility I might be wrong.
Now there is a flip side to that which I can’t ignore. A truly fraudulent company sucks in innocent people’s capital and destroys it. For this reason, if I really did have 100 percent clarity that a company was committing fraud, I would step in and try to do something about it. But this is obviously a very tricky ethical question.
We are going to wrap up our discussion here today. I want to thank everyone for participating on the call. We look forward to having future conversations with you. If you should have any questions about Seafarer or the contents of our presentation, please visit our website at seafarerfunds.com or email us at email@example.com.
If you have any questions regarding the Seafarer Overseas Growth and Income Fund, including how to open an account, you may call the Fund’s transfer agent for more details at (855) 732-9220. Or click the blue “Invest” button on the home page of seafarerfunds.com.
Thank you everyone for your time, and for entrusting us with your capital.
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 Index, Standard (Large+Mid Cap) Core, Gross (dividends reinvested), Total Return USD is a free float-adjusted market capitalization index designed to measure equity market performance of emerging markets. The MSCI Emerging Markets 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.
Kate Jaquet and William Maeck are Registered Representatives of ALPS Distributors, Inc. Neither ALPS Distributors, Inc. nor Seafarer Capital Partners is affiliated with DoubleLine Capital LP.
- Sources: Factset, Seafarer. Data as of 7/6/12. “Emerging Markets” based on 3,087 companies which a) have market capitalizations in excess of $500 million, and b) originate within one of 21 countries classified as an “emerging market” by MSCI. These countries include Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey.