This Shareholder Conference Call offered a Fund retrospective, a discussion of selected portfolio holdings, and an examination of the "BRICs" theme – why it did not work, and yet why it might hold relevance for the future.
Andrew Foster, Chief Investment Officer and Portfolio Manager:
Good afternoon everyone. This is Andrew Foster of Seafarer Capital Partners. Welcome to Seafarer’s third semi-annual Shareholder Conference Call.
We value these calls as an opportunity to interact directly with our existing and prospective shareholders. So thank you for joining us, and we encourage you to participate in the question and answer session that will follow today’s presentation.
On the call with me today are two of my colleagues from the investment team, William Maeck and Kate Jaquet. Later, Michelle Foster, our President, will join us to conduct the question and answer session.
Today’s call will be approximately one hour in length. I will begin the call with a presentation lasting about forty minutes. A link to the presentation is available on our website, seafarerfunds.com, and also in the reminder email you received this morning with the conference call details. After the presentation, we will hold a question and answer session for the remainder of the call.
With these introductions complete, I would like to thank everyone for joining us today, and let’s get underway by turning the presentation. On page 1 (“Disclosures”) please note the Fund’s risk disclosures. Also, please note that while we will discuss specific Fund holdings today, these holdings do not necessarily constitute investment recommendations, as they may not be suitable for you or your portfolio.
Now please turn to the agenda for today’s call on page 2 of the presentation. We will begin with a brief Fund retrospective, focusing on the Fund’s movements and major events in the last six months. We will then discuss some key portfolio holdings within the Fund. Our third segment will discuss the phenomenon known as the BRICs. We will revisit that phenomenon, examining how the BRICs have performed and the consequences for investors. We will conclude our main presentation with a segment we have featured on our prior calls, which I call “Around the World in Five Minutes.” We will comment on the investment landscape in some of the key markets in which the Fund invests: China, Brazil, Turkey, Japan, and Vietnam. I am happy to address questions about those markets or other markets in the question and answer session, as well.
Section 1: Fund Retrospective
Let’s turn to the first section of the presentation, "Fund Retrospective," on page 3. This chart shows the Net Asset Value (NAV) movements of the Fund, from its inception on February 15th of last year to July 16th of this year. The NAV movements in the most recent six months are highlighted in dark blue.
I would call your attention to the key milestones over the last six months. In early January the Fund reached $30 million dollars under management. This asset threshold allowed the Fund to achieve some modest economies of scale. We wished to pass these economies along to shareholders as soon as possible, so that same month we introduced a voluntary fee waiver that reduced the net expenses for both share classes of the Fund by 20 basis points, to 1.25% for the Institutional share class and 1.40% for the Investor share class. Furthermore, I am pleased to announce that the voluntary fee waiver put in place in January has been made contractual this very week. It will be extended from September 1st of this year, with the intention to renew it annually on a rolling basis.
You can see the performance of the Fund has been a bit volatile as of late. It was not all that long ago that the Fund reached its all-time high on May 21st, of $12.27 per share for the Investor class. It obviously has fallen since May 21st. The downward movement was primarily triggered by the comments of Ben Bernanke, Chairman of the U.S. Federal Reserve, on May 22nd – the very next day – which caused a contraction in asset prices the world over. A month later, the downward movement was, in part, due to a distribution that the Fund paid in late June of $0.145 per share on the Investor class, and a similar amount on the Institutional class, which depresses the NAV but does not represent a loss for shareholders. The Fund finished the quarter at $11.04 per share. The Fund regained some ground as of yesterday to close at $11.24.
With that introduction of the Fund’s past six months, I will turn over the conversation to my colleague William Maeck to discuss Fund performance. William will highlight the last three months where, as you can see from the chart on page 3, all the action has been.
William Maeck, Associate Portfolio Manager:
Thank you, Andrew. Page 4 (“Fund Performance”) of the presentation shows performance as of June 30th of this year for the Fund and its benchmark, the MSCI Emerging Markets Total Return Index. During the second quarter the Fund outperformed the benchmark. The Fund declined -4.39% and -4.37% for the Investor and Institutional share classes, respectively, while the benchmark fell -7.95%. View the Fund’s performance disclosures.
It is clear from the benchmark’s dismal performance that emerging markets had a tough second quarter. Interestingly, as Andrew mentioned, weak performance was concentrated in the last five weeks of the quarter. In fact, the quarter began on a positive note and markets were generally stable, and inching higher, through the middle of May. The Fund reached a NAV high of $12.27 on May 21st. Since then, the drop has been rapid and sharp.
The trigger for the decline was the May 22nd testimony of Ben Bernanke, where he indicated the Central Bank might gradually curtail its large-scale asset purchase program, otherwise known as quantitative easing. Following Bernanke’s statement, emerging market stocks and currencies began to sell off. The benchmark index plunged -9.70% in dollar terms from the date of Bernanke’s speech to the end of the second quarter, and a full 30% of that decline was due to declining currencies, as opposed to falling stock prices.
I would like to say a few words on the decline in emerging markets following Bernanke’s speech. Bernanke’s statement was something that I think most market participants expected, or at least it was in some of their planning or scenarios for the year, given the steadily recovering U.S. economy and employment picture. I think there was a sense that the Fed might slowly withdraw from its policies. Yet the reaction to Bernanke’s speech has been a very pronounced movement in financial assets the world over and, in particular, in the emerging world.
So, why is that the case? Why is Bernanke’s statement disrupting the picture for the emerging world to the extent that it has? I think that there are two issues occurring here. First, folks who have joined us on prior Shareholder Conference Calls are aware that we have been discussing the idea that growth in the emerging world is rather tepid. On this call six months ago, we spoke about the idea that growth is slower. Growth is not zero, but it’s not particularly strong, and there were some misplaced expectations about that growth. For the past two years we have been discussing, in particular, the fact that China was structurally – not cyclically – slowing.
The problem is, with Bernanke potentially paving the way for higher interest rates in the future, this will create yet another headwind for what is slow growth in the emerging world. In fact, a number of central banks in the emerging world seem to have begun following suit behind Bernanke. Brazil, India, and some other markets have either talked about or began to raise interest rates in line with the Fed.
The second issue that William touched on – the action in emerging market currencies – is very important to note. This is another topic we have been commenting on quite a bit here at Seafarer. The flight from the dollar was understandable. There has been a lot of concern about growth in the U.S. and the unorthodox policies adopted by the Fed. Folks have looked for “yield pick-up” or any other alternate to the dollar as a haven for their capital. The problem is that the emerging market currencies are not necessarily a safe haven for large quantities of risk-adverse capital – maybe for some speculative long-term capital, but not for risk-adverse capital. This movement into emerging market currencies is becoming unwound very quickly. It’s not necessarily a surprise to us but it’s still been painful.
Moving onto page 5 (“Source of Performance – Regions”), let’s review the sources of Fund performance in the second quarter. This chart shows contributions to the Fund’s NAV by region. The green bar represents a positive contribution to the NAV. The red bars represent negative contributions to the NAV, including the effect of net fund expenses and brokerage commissions. The gold bar represents a distribution to shareholders, which depresses the NAV but does not represent a loss for shareholders.
As you can see on this chart, Latin America was by far the Fund’s weakest spot during the second quarter. The region accounted for roughly 75% of the Fund’s losses. Within the region, the losses were heavily concentrated in just two holdings in the commodity sector, which we will discuss later in this presentation. Those two positions accounted for about 50% of Latin America’s losses within the portfolio, or 40% of the Fund’s total losses.
Eastern Europe was the second weakest performing region. The Fund’s largest holding in Poland was negatively impacted by political risks. Meanwhile, the Fund’s Turkey holdings were beset by currency losses and the recent riots in Istanbul.
There was one substantial bright spot during the second quarter: the Fund’s holdings in Asia gained slightly during the quarter, even as the benchmark index for the Asian region fell approximately 5%. This outperformance was due to two primary factors. First, the Fund’s holdings in Asia health care stocks performed exceptionally well. Second, the Fund’s new holdings in Vietnam made a welcome contribution.
Section 2: Selected Portfolio Holdings
Thank you, William. Let’s move on to the next section of the presentation, titled “Selected Portfolio Holdings,” on page 7. In this table you will see the top ten holdings of the Fund as of the end of June. This table shows that the Fund offers a fairly broad swath of exposure to the emerging world – all sorts of different capitalization sizes and different geographical exposures. Represented in the Top 10 are various countries including Japan, a number of different sectors, and even, to some extent, different valuation parameters.
The overall portfolio characteristics as of the end of the month are available to you at the bottom of the Top 10 table, in the row titled “Overall Portfolio Characteristics.”
In a moment we will discuss the sixth and eighth holdings on the Top 10 table, Sociedad Quimica y Minera (SQM) and Cia Vale do Rio Doce (Vale). Those are the positions that William referred to a moment ago that did a fair amount of damage to the Fund’s returns in Latin America. We will share our thoughts on why we held these positions and why we continue to hold them.
Before we address those two positions, let’s discuss another position that does not show up in the Top 10 – Hartalega, a health care company based in Malaysia. Please turn to page 8 (“Asia – Health Care”) to see Hartalega’s market capitalization and valuation statistics. Hartalega is a mid-capitalization stock (on the “small side” of mid-cap, if you will), and it is a focused producer of nitrile gloves. Nitrile gloves are a substitute product for latex rubber gloves and are often used in medical procedures and sometimes in surgery. Nitrile has three key advantages over latex. First, it’s generally a more durable and stronger material. Second, it doesn’t cause the same allergic reaction that latex can sometimes prompt. Third, nitrile’s feedstock, used to manufacture the gloves, has enjoyed costs that are much more stable than the cost of latex rubber. Latex rubber prices have fluctuated a great deal in the past three or four years and that’s caused a certain volatility in the end prices of latex gloves and created some havoc in those markets. So, the medical industry has been looking for a stable supplier of low-cost gloves, and this has given Hartalega room to enter and exploit the glove industry’s weakness.
Hartalega is quite interesting to me because it possesses unique advantages. It has some proprietary equipment and technologies that allow it to produce nitrile gloves thinner than just about any other company in the world. Hartalega is the largest producer of these thin gloves in the world, as far we can ascertain, and it is growing steadily over time. The company is conservatively run by its founding family, the Kuans. The father is still involved in the company and his sons are beginning to take over.
I have been pleased to see that the company has paid steady dividends, basically since the company’s public listing in 2008. I have been following the stock since 2009, and the stock has been in the Fund since the Fund’s inception. It has yielded about a 60% return, inclusive of reinvested dividends, since the Fund’s launch. Hartalega continues to pay steady dividends despite the fact that the company is investing heavily in its own future. The company is growing its capacities about 15% a year over the next two years so as to maintain its dominance.
As valuations on this stock have gotten steeper, we have been trimming the holding so as to keep it in good balance with the portfolio. Hartalega is a bit more on the expensive side of the spectrum, but based on what we know as of today, this is going to be a long-term holding. It was indeed the biggest contributor to the Fund’s performance during the second quarter.
Let’s move on to page 9 (“Latin America – Commodities”) to discuss the two Latin America commodity sector holdings that I mentioned earlier in the call. SQM is based in Chile and Vale is based in Brazil. I will turn the conversation over to my colleague Kate Jaquet to discuss these holdings.
Kate Jaquet, Associate Portfolio Manager:
Thanks, Andrew. The Fund invested in SQM, a mineral extraction company in Chile, in late third quarter of 2012. We met with the company in its Santiago headquarters in August 2012 and made our initial investment shortly thereafter. The Fund’s investment was driven by a valuation that we found very attractive, as well as the company’s strong market position. SQM operates in high-growth markets and has dominant market share in these markets. These factors contribute to the company’s strong free cash flow and quality balance sheet.
SQM enjoys 31% market share in the global lithium market. As I’m sure most of you know, lithium is used in cell phones, tablet computers, power tools, and a variety of other products. Demand for this rare earth metal is growing at about 30% per year and SQM’s long-term concession in northern Chile runs through the year 2030. SQM owns not only the infrastructure associated with this concession, but also the hydro and environmental rights.
I would highlight SQM’s cost advantage in the lithium market. The company’s lithium costs delivered and depreciated to port are roughly $2,000 per ton. This compares to approximately $4,000 per ton for competitors in China and Australia.
SQM also has a strong market position in the global iodine market, with 41% market share. Iodine is used as an x-ray contrast medium in the pharmaceutical industry and also in human and animal nutrition. Iodine prices have been trending up in the last twelve months.
SQM is distinguished by its diverse revenue streams. Lithium and iodine together account for about 30% of the company’s total revenues. SQM is also a key player in the potassium and specialty plant nutrition markets. SQM has diverse end markets for its products – split evenly between emerging markets and the developed world. Lastly, I would note that SQM’s dividend yield is attractive at 3.1%.
In summary, SQM’s fundamentals remain attractive. The company has strong free cash flow, enviable market positions in several of its product lines, and a solid balance sheet. All of this should result in increasing dividends to its shareholders. With the sell-off that we have experienced in the first half of 2013, SQM’s valuation has become more attractive.
Thanks, Kate. I will offer some brief context around Kate’s remarks. SQM is a really unique company in my mind. I have never seen anything like it in my experience in Asia or other parts of the world within the commodities sector. Its sheer dominance of a number of key high-end, high value-added commodity markets is really unique in and of itself. So much so, that SQM enjoys a degree of pricing power that I have never seen before with a commodity player that is usually a price-taker.
This pricing power gives the company a strong and stable source of cash flow that is really special, and which I believe will be translated into higher dividends and a more solvent balance sheet over time. I had envisioned that this very stable cash flow would insulate the company from a great deal of cyclicality. So far we have been wrong about that, to be honest, but we revisited the fundamentals and are ever more certain that the fundamentals are still intact. So, we are continuing to hold the position after it has cheapened.
Kate, can you discuss Vale.
I would add that SQM is a very well-run company, versus other emerging markets commodities players. This gives us a lot of comfort.
Vale is a Brazilian iron ore extractor. The Fund took a position in Vale in the first quarter of 2013. We found the valuation attractive – with a price to earnings ratio of 6.0 and a price to book value ratio of 1.4 – and we anticipated a rebound in the materials sector at some point. We met with the company in their Rio headquarters last summer, and I met with them again in May of this year.
This investment has gone the other way on us, with the movement of the stock driven by market sentiment – related to the slow-down in China and Bernanke’s comments on the Fed intentions – rather than on company-specific fundamentals. I would refer specifically to iron ore prices, which have held up reasonably well. They have been trending down a little bit, but not as much as the stock.
We have increased Vale’s weighting in the Fund as the stock has sold off. Today, we are ever more confident in this position. Vale looks extremely cheap, based on enterprise value to EBITDA, earnings, or book value multiples, and certainly on any number of asset valuation metrics.
Vale is an exceptionally well-run company with an excellent reserve base. The company’s ability to control margins has been impressive, as evident in the EBITDA per ton statistics – especially when you consider the complicated mining codes and much publicized inadequate infrastructure in Brazil. Vale’s conservative management team does not speculate on commodity prices and strives to maintain an asset and liability match as closely as possible. We like the company’s demonstrated willingness to cut capital expenditures by pushing projects out until they become economically attractive. Vale delayed a few big projects in Brazil and elsewhere and they outright cancelled one in Argentina.
The aspect that provides the most comfort to me is Vale’s attractive asset valuation. The current price to book value is 0.9 times. Even when haircuts are applied to certain assets on its balance sheet, such as equipment, railroads, and mine development costs, the price to book value is still below 2.0 times. And even more relevant, in my opinion, is taking this haircut book value and ascribing some value to the company’s mining concession, which, as per accounting rules, is not represented on the balance sheet. Ascribing a conservative value to the concession, Vale has about 340 million tons of capacity under a twenty year concession and it computes to an adjusted price to book value of 0.8 times.
The last point I will highlight on Vale is the very attractive dividend yield at 7.6%.
It was obviously a tough quarter to be a Vale shareholder. When the Fund made its initial investment in Vale, we were aware that some market sentiment could push the name lower, and that’s why we started with a small position and have added to it as the stock has sold off. Vale’s fundamentals have not changed. The valuations have become more compelling.
Both Vale and SQM remain attractive to us because of the quality of their businesses, the strength of their cash flow, and the safety of their balance sheets.
I think Vale is a very different kind of holding from SQM, even though they are both based in Latin America, both commodity-oriented names, both extractive industries. I have been impressed with Vale’s cash flow discipline, as Kate mentioned. The company has done what it has needed to do in the past to preserve cash flow margins that have been quite strong, even in depressed market circumstances, certainly circumstances more depressed than what we are facing today. The company has cut back on investment and cut back on other cash costs so as to maintain profitability. So, that strength of cash flow is really what stands out, combined with the very solid work Kate has done on the valuation of the company’s book value. We stress tested the valuation under a number of different environments.
When the Fund took a position in Vale, we recognized that there was room for it to fall a bit. We were not trying to buy this off of the most depressed valuation ever. In fact, we did not put a full position weighting in for this very reason. Unfortunately, the stock has realized a lot of the downside that we thought could be on the table, very quickly. That has given us some room with the powder we left dry to add to the position, as Kate mentioned.
Taking a step back and looking at these two positions together, which have really been the sore spot in the portfolio this quarter, one might wonder why the Fund invested in them in the first place, given that just six months ago on our Shareholder Call I spoke about the fact that the world generally had misplaced expectations for emerging market growth. So, why are we investing in this sector, which tends to be cyclical and driven by high-beta perceptions over growth? The reason is we really did the work on the individual names – I hope that comes through in what Kate has just outlined here – and I am confident in the underlying merit of these individual securities. The Fund’s investment in these two holdings was not an attempt to call the commodity sector as a whole.
But I also did recognize an important point. We are trying to build what I would call an all-weather portfolio here at Seafarer – a portfolio that will function well both in good days and in bad days, in environments that we have imagined, and in environments that we might not have imagined. Given that most of our portfolio was hanging on the idea that growth would be slower, these two commodity names that we added based on their individual merits did give us some exposure, or some balance, to the idea that this core outlook we had could be wrong, or that a different set of scenarios would emerge. I think a very unhealthy portfolio is one where all the ideas are trading together in tandem, because that kind of approach will work well in one environment but not in another.
So these two holdings represent a way we offer diversification or balance in the portfolio. Unfortunately, these holdings had a tough second quarter. These two investments were always predicated on good underlying fundamental work in the individual names, so we are excited to be shareholders at this stage. For those of you who have read my second quarter portfolio review, you will note, though, that as a measure of risk control, I intend to limit the Fund’s exposure to these two stocks, taken together, to roughly 7% of net assets. We are not going to allow the exposure to grow. We are not going to chase a falling knife perpetually. We left some powder dry to buy into these stocks as they dipped, under the potential scenario that they might do so, and they have. For reference, the two holdings comprise about 6.5% of the Fund at present. We are going to stay invested. Barring some major change in circumstances, we are excited about the valuations of these holdings, and based on what we know now, we are going to stay invested in these names for some time to come.
Section 3: BRICs, Revisited
Let’s move on to the next section of the presentation, “BRICs, Revisited,” on page 11. BRICs is an acronym that refers to the four largest emerging market countries – Brazil, Russia, India, and China. I have found the BRICs to be an interesting phenomenon to watch, as someone who was first an Asia-focused investor and now an emerging markets-focused investor. It has really been a big marketing push. The term was coined in 2001 by Goldman Sachs but the real weight behind this idea got underway between 2006 and 2008, when all the various indices, index-tracker products, and funds that were focused on the BRICs scene got off the ground. Brokers and fund managers heavily promoted the BRIC markets as a key theme for investors to follow.
I find these developments fascinating because these acronyms and big-picture themes really seem to sell well and capture people’s imagination. I do not know why this is. I suppose it’s because some of these foreign markets are so distant and sometimes very obscure, and having a framework seems to put some healthy shape around it and help people grapple with these challenges.
I think the acronyms and themes are generally something you should avoid. I believe, if we were to map this sort of behavior to our own domestic market, we would not do it. As a joke I put some names for domestic ETFs and other products on page 11, to demonstrate how the BRICs theme would not translate well to the domestic market. The point is, overbroad themes are not something we generally do at home, so I would question whether or not it really works abroad. The reason is, that by the time these themes are recognized, packaged in products, and marketed with catchy acronyms, it’s usually too late. The underlying asset is near its peak. It may not be at its peak, but it’s probably close. There might not even be a whole lot of economic coherence to the underlying idea anyway.
You can see this by turning to page 12 (“Thematic Investing – A Cautionary Tale”). This chart shows the performance of the MSCI BRIC Index versus, or relative to, the MSCI Emerging Markets Index as a whole, over the past ten years. These are indexed to each other, so I only show one line. When the line is rising, the BRIC Index is outperforming the Emerging Markets Index as a whole. When the line is falling, the BRIC Index is underperforming the Emerging Markets Index as a whole. The line begins at 100 because the indices are at parity at the beginning of the chart.
Notice that if you wanted to outperform for the past five years within emerging markets, you should have invested anywhere but the BRICs.
What I would also stress is that the BRICs are collectively about 44% of the emerging world. The BRICs are the single biggest chunk of the Emerging Markets Index. So, when the line on this chart is falling, it means that the BRICs are really underperforming all the rest of the names – all the rest of the regions within the emerging markets, which are generally much smaller and do not have as much weight within the index. So, this line, if anything, may either overstate or understate the BRICs relative to the rest.
It is important to point out that the peak of the chart – when the BRIC Index was outperforming the Emerging Markets Index by the greatest margin – happened in the summer, late fall of 2007. This happens to coincide with the very time frame when the largest BRIC ETF was launched. The peak in BRIC as a search term on Google was about a year and a half later. I would emphasize that by the time these products make it into the mainstream, the underlying asset is near its peak, and these over-broad themes are not all that coherent to begin with. By the time the products are packaged up and marketed, it is too late.
I try to avoid heavy, over-broad themes like this when investing. That said, please turn to page 13 (“BRICs Sink, Value Rises”). I find something interesting about the BRICs phenomenon at this stage. The BRICs have fallen so far out of favor at this juncture that they may be worth a second look, for at least long-term investors.
On this chart the three lines represent aggregate valuation metrics, again measured on a relative basis, between the BRICs and emerging world. The blue line represents the relative price to earnings ratio; it’s on the left axis. The red line represents the relative price to book ratio; it’s also on the left axis. The green line represents the dividend yield; it’s on the right axis. I’ve drawn these lines so that parity is 100%. In other words, if valuations on a price to earnings basis are equal between the BRICs and the emerging world, the blue line would run at 100%. When the line is above that threshold, the BRICs are more expensive, and when the line is below that threshold, the BRICs are less expensive, by corresponding amounts.
You can see here that based on a variety of metrics, the valuations in the BRICs versus the rest of the emerging markets have generally and steadily been trending downward, versus that peak that I showed you a moment ago. The four BRIC markets have underperformed to such an extent that their aggregate valuation, when compared to the emerging markets as a whole, is as low as it has been in eight years. The valuation for emerging markets is largely set by these four BRIC markets. So, the residual emerging markets countries are at much higher valuations versus the BRICs.
I find this interesting. I cannot “call a bottom” in these four markets – but I cannot help but think that, just as dedicated investors in the emerging markets did well to shun the BRICs over the past five years, investors will do well to embrace them over the next decade. To be clear, I am not going to chase the BRICs as a theme. I do not want to give anyone the wrong idea. However, I think it is time for long-term investors in the emerging markets – folks with five- and ten-year horizons for investing – to revisit these bigger countries, now that they have fallen so far out of favor. I admit there are a lot of challenges ahead for these markets. We are going to talk about that in a moment. But at least the valuations are on your side, and that’s a powerful thing.
Section 4: Around the World in 5 Minutes
Let’s move on to the last segment of our presentation, called “Around the World in 5 Minutes,” on page 15. We will make brief comments about the investment landscape in some of the countries in which the Fund invests. We are happy to address other countries in the question and answer session, as well.
We will begin with China, the biggest of the four BRICs. China is at a really tricky point right now. This is something that we have been talking about for two years at Seafarer, so we are not caught off-guard by this. China is going through a difficult crossroads in the economy, beset by structural slow-down at the same time that the country is trying to undertake some structural reform. I think what is lost in the headlines about slow growth is that there are small, but numerous and cumulatively meaningful, battles for reform being won.
I will provide a couple of examples. The government has definitely been willing to ratchet down its own growth rate and target higher quality growth and higher quality of living in the country, particularly with respect to the environment. The new president is beginning to make some real noise about protecting the environment, in lieu of growth. I think this is an encouraging sign. Second, the country is beginning to experiment with municipal bond markets, which is brand new. A few provinces are being allowed to issue what is tantamount to a municipal bond. I find this development very encouraging because – if it is successfully rolled out – it will alleviate some of the major distortions that exist in the Chinese banking and financial system.
The biggest reforms still lie ahead. There is a system called hukou in China that is very difficult to describe succinctly, but it is probably best described as the social entitlement system, not unlike our social safety net here in the U.S. It is the third rail of Chinese politics as far as I can tell. No one wants to touch it because it is a system of rights established by where you reside within the country, and it basically pits urban residents against agricultural and rural dwellers. The rights are bifurcated between them and the economic and social rights primarily flow to urban dwellers. So, this is obviously a very contentious system and it affects all sorts of issues – the pace of urbanization, the social fairness in the society, the breadth and stability of growth within the country. There are a lot issues wrapped up in hukou.
China is apparently starting to tackle hukou reform. Guangzhou Province is apparently beginning to waive hukou registration systems, which is a real shocker. I talked to some friends in China just in December, and they said this would never happen in China. Yet the country is beginning to experiment with it, which I find very interesting.
There are still other tough reforms ahead. I do not think China is going to go through this very easily. These are very tumultuous reforms. We may see more rolling liquidity crunches. As you may be aware, there was a liquidity crunch in China just in the last few weeks. It seems to have been intentionally manifested and orchestrated by the government to send a warning shot across the bow of some poorly-run banks. But nonetheless, this is symptomatic of some broader problems. I do not think we will necessarily see a bankruptcy – an outright panic, a real solvency issue at the heart of the system – or at least I would not call that a “primary scenario.” But I do think there will be rolling liquidity crises that could put real strain on growth, real strain on certain sectors. This is something to watch out for, and it’s possible it could trigger a solvency issue.
On our Shareholder Conference Call one year ago, I warned the participants that they should contemplate much lower rates of growth for China, around 6%. I said the growth rate could fall in a range between 4% and 8%, but my core assumption was 6%. Now, I am afraid that as I look forward to the next five years, I might even go a little lower still, to somewhere between 5% and 6%, with a broad range around that (that is to say, plus or minus 2% spread) as to what any single year might deliver.
I think China is going to be growing at a structurally slower rate, and investors should be aware of that. The good news, if there is any, is that I think these reforms that are taking place may pave the way for a much more sustainable sort of growth, a higher quality growth, in the future.
Kate, can you comment on Brazil?
Brazil has also been stewarding reforms, with very few sectors of the economy left untouched by the Rousseff administration. One bright spot I would highlight is that President Rousseff has reacted swiftly and firmly to corruption within her administration, though there is obviously much more to be done not only within her administration, but also across the entire government.
The proposed infrastructure concessions are another bright spot. The overall size of these concessions is too small at $60 billion, and the first round was not a success. But the concept is certainly the right one. There has been a recent cut in payroll taxes and – more importantly – a simplification of the tax codes (moving some payroll taxes from revenue to profit based) that I think is a really positive change. Beginning last year and continuing into this year, banking reforms have forced the entire sector – led by the state-controlled banks, Caixa and Banco do Brasil – to reduce their spreads.
The insurance, petroleum, and electricity sectors have all been impacted by various policies that are ultimately aimed at reducing the “Custo Brasil,” which is the elevated cost of doing business in Brazil, as well as keeping inflation in check. We could argue about the strength of these policies or the overall level of intervention in the economy. But one thing that is clear is that the government is spearheading changes and making reforms.
There are some bright spots in Brazil. The middle class continues to expand. Unemployment rates continue at historic low levels. I believe that with the right execution on the right initiatives related to education, transportation, and health care, the administration could handily address the concerns of the protesters in Brazil and pull back from this tumultuous corner faster than most people expect.
I would like to say a few words on the recent protests in Brazil and Turkey. The nature of these protests is different, but I think the underlying nature of these protests has a commonality that I would like to comment on. This may sound counterintuitive, but I think that these protests represent the emergence of a middle class. And here’s why.
When we look at what is going on in Turkey – the protest against Prime Minister Erdogan and his government – there is basically a well-educated, generally employed, younger group of Turkish citizens, mainly in the urban centers, who are protesting their fears of a tyranny by the majority. Erdogan definitely has a majority. It’s a substantial majority, but it’s not so large that he controls the whole political spectrum. People are rejecting some of his policies, and even more so, his autocratic style. The protesters are organizing via social media, so they are obviously able to get online and have the financial strength to do so.
The protests in Brazil are somewhat different on the surface. They are very broad-based protests throughout the cities in Brazil. The protesters’ primary grievances are government corruption, the slow pace of growth in the country, and especially how the gains from such growth are shared throughout society. There is a lot of frustration that too much investment has been made in hosting the World Cup soccer matches and the Olympics, and not enough in transportation infrastructure or medical services.
When I look at the protesters’ complaints in Turkey and Brazil, what’s interesting about them is the absence – for the most part – of complaints over basic necessities, such as food, jobs and housing. So, what we have in both countries is a series of protests organized by social media. An online-savvy, generally younger and employed population, that has benefitted from the growth in the country in recent years, is protesting for more advanced sorts of demands. I think this is strangely a key sign of the very messy emergence of a real middle class, demanding greater political voice. The protesters are demanding reform and change, not basic necessities.
It’s so interesting to me because when I read financial reports about the emergence of a middle class, it is always singularly reduced to over-glorified images of a consuming class. Invest in the middle class because it will consume ever more and you can bank on this in your portfolio by investing in the right kind of stocks. In fact, this is one of those heavy themes right now that I think people should be wary of because of the valuations in the consumer sector.
These protests have shaken people, and they disturb me. They disturb me because they could always spill over into violence and chaos and something unhealthy. But ironically, insomuch as the protests are resolved peacefully under law and order, they provide a really strong sign that the middle class is emerging. And this is actually a development that long-term investors should expect and even embrace. We are seeing the formation of a middle class that is demanding a political voice. The protesters have achieved their basic necessities but they want to advance their societies.
Ironically, the recent depressed prices that are on offer in these markets offer an entry point for folks who understand what is really going on here. We have to be wary and vigilant about the risks of these protests spilling over into something much more destructive, and I cannot promise that will not occur. But insomuch as what we see happening right now has been mostly peaceful and mostly progressive, I think we are seeing the emergence of a middle class.
This concludes our presentation today. We will now move to the question and answer session.
Section 5: Question and Answer Session
Now I will introduce Michelle Foster, our President. She will conduct the question and answer session today.
Michelle Foster, President:
Thanks, Andrew. I will begin with a couple questions that were submitted via our website in advance of this call. The first question is from Erryl in Illinois. Andrew, Erryl remarks that the last month has been tough. China and other emerging markets have been weak, depressing year-to-date returns. Do you have any strategies for minimizing the damage if these markets continue to weaken?
Yes, it has been a very tough month on markets as a whole and on the Fund. I am frustrated with the Fund’s performance over the last five to six weeks. I am happy to report that we are just barely holding our head above water as of yesterday, in terms of year-to-date returns, and we are substantially outperforming our benchmark index, which is down quite a bit further in negative territory. But it has been a tough time.
In response to Erryl’s question, while I appreciate the frustrating pattern of returns so far, ironically I am pretty comfortable with where valuations sit in the emerging world. I think there are a lot of other challenges. Will there be enough growth? Will China emerge from its slump? Will Brazil get past this very difficult moment in its society? I think these are serious questions that we are continuing to track. But valuations are not necessarily one of my major concerns right now. So, I think as a long-term investor, ironically, this is a time to get a bit more aggressive. I do not mean to suggest to anyone on this call that we are going to get hyper-aggressive and very concentrated, but this is a time for us to get focused in our best names, to get a bit more concentrated in the portfolio construct.
Back in May, believe it or not, I did take a few steps to reduce risk in the portfolio. I did not have any particular awareness that Bernanke’s comments would trigger the decline they did. To be honest, I thought his comments were “well priced in,” – that is to say, understood and anticipated by markets. But, I had enough instinct to know that things were too good, and so I did remove some risk from the table in May, before markets started to tank. I wish I had done more. Hindsight is always perfect. But based on what I know now, this is a time to get slightly more aggressive in our construct in preparation for long-term growth, with a backdrop of what are generally attractive valuations.
Thanks, Andrew. The next question is from Rodney in Massachusetts. Rodney asks, how much of the Seafarer Fund should he allocate to his portfolio at this time considering the attractiveness of the Fund and emerging markets, relative to other investments?
This is one of the toughest questions we get asked regularly at Seafarer. Unfortunately, we are not well equipped to answer it. As an investment adviser, we focus on constructing portfolios of securities for funds, for broad use by investors, and not on tailoring portfolios to individual use. So let me say first and foremost, we are not in a good position to specify portfolio allocation for anyone on this call.
The reason is: there are three key factors that describe how you might allocate to the emerging world or to the Seafarer Fund. We at Seafarer cannot advise you on portfolio allocation since we do not know how these three key factors apply to you. The first, and perhaps most important factor, is your investment horizon. Can you invest for the long-term? I would suggest that unless you can maintain a five-year horizon or longer for your investment, emerging markets are just too volatile. Even our own Fund is too volatile for most people to stomach.
Second, your allocation depends on your own risk tolerances and preferences. How much risk can you handle?
And third, there is a need to have some familiarity with these markets. We try to hold these Shareholder Calls so the participants will become more comfortable with these markets and understand what the underlying issues are and where the risks lie. I think ultimately, investors need to have a certain level of familiarity because even if you enter these markets with a long-term horizon, high risk tolerance, and the best intentions, these markets are very volatile. They often have obscure price movements and lack transparency. It is helpful if you have some familiarity with the markets; perhaps you have lived overseas or you have studied these markets.
So while we are not in a good position to specify portfolio allocation, I can try to answer the question in a more focused way by suggesting a maximum cap or constraint on how much emerging markets exposure you should have in your portfolio. As William highlighted earlier, the currency risks in emerging markets have been severe. This is something that we have been talking about and warning about at Seafarer. I personally think that the currencies are volatile enough in the emerging world that they should not be a place for anything more than speculative capital in your portfolio. I have never accepted the argument that emerging market currencies were an alternate haven from the dollar.
So I would suggest that as a maximum cap, folks look at their net assets within their portfolio, calculated as assets minus their future dollar denominated liabilities. If you know you have cash outflows in the dollar for college payments, mortgage payments, rental payments, or other expenditures, you really should not expose more of your portfolio than the net amount would allow for. And that’s because these currency risks are too volatile, too swift, and very hard to hedge against for any investor, professional or otherwise.
I would really suggest you constrain your portfolio in this way. I say this because it wasn’t very long ago I heard investors saying they might take 30%, 40%, 50% of their portfolio overseas with the largest portion of that dedicated to emerging markets. So, the net of that might have been 25%, 30% of their assets in emerging markets. I had trouble thinking this made sense because of the currency risks this might entail, especially the potential short-run impact. With this approach you are bearing a significant asset-liability mismatch, between your emerging market assets and your dollar denominated liabilities.
All that said, as I mentioned a moment ago, I am pretty positive about valuations at this moment. If I had to put them on a scale of 1 to 10, with 10 being the best, 1 the worst, 5 neutral, I would say we are solidly in 7 territory, if not moving toward 7.5 or 8. Yes, there are still further risks that could take us lower, but we are definitely in a period where there are attractive valuations in the emerging markets for long-term investors. That’s the main offset to the caution in my remarks a moment ago.
We have a question from Martha from Texas. Martha, please go ahead with your question.
Hi, Andrew. My question is related to currency risk. Can you tell us what percentage of the current portfolio is denominated in local currencies, excluding Japan?
Almost the entire portfolio is denominated in local currency. The Fund holds one dollar denominated bond. It is a small position, comprising about 1% of the Fund at present.
The Fund holds a couple of ADRs that together represent 6% of the Fund. These ADRs are technically dollar denominated, but these instruments effectively represent direct claims to the underlying stocks, and so they trade very much in a fashion that mirrors both the underlying stock and the underlying currency at the same time. I guess you could say that while the ADRs are functionally dollar denominated assets, from a risk perspective, I would not necessary cleave them apart as something separate.
Most of the portfolio is concentrated in emerging market currencies. As you correctly noted, the Japanese yen is a fairly different kind of currency in terms of its depth and liquidity. The other two currencies I would single out are the Hong Kong dollar and Singapore dollar. The Hong Kong dollar is formerly pegged to the U.S. dollar, so it tends to behave more like a U.S. dollar denominated asset. The Singapore dollar has been a very strong, stable currency over long periods of time with deep capital markets, so it is also different from the emerging market currencies.
Effectively, nearly the entire portfolio has exposure to local currency risks, whether directly denominated in such currencies, or exposed to volatility indirectly via business models and balance sheets.
Thank you for your answer. Good luck going forward.
I would add that we do not hedge currencies here. We try to create some organic hedges in the construct of what we hold within the portfolio, positions that will do well and offset currency weakness, and vice versa. But we do not formally hedge anything.
Thanks, Andrew. The next question is from Erryl in Illinois. Erryl is wondering how you define your investment universe along geographical lines, especially as the definitions of developed, emerging, and frontier markets are in flux?
And I would add, as an example of how these definitions are in flux, that index provider MSCI recently announced that over the next year, Greece will be reclassified from Developed Markets to Emerging Markets, and Qatar and the United Arab Emirates will shift from Frontier Markets to Emerging Markets.
So Andrew, how do you define the Fund’s geographical universe in light of all this?
We think of ourselves as emerging market investors. When we put together the strategy for this Fund, we did not want to be beholden to any particular index author’s definition of the emerging world, precisely because we did not want to be caught in these sorts of index definition shifts that tend to be very binary. These shifts do not capture the nuances of what emerging market growth can or should be. And sometimes, these shifts are very political, in my view.
I did not want to be beholden to MSCI or any other index author in this regard. That said, the folks who put these indices together generally have the right set of countries in their scope. I do not disagree with them in any big manner.
Let me address the border between frontier and emerging, which is a relatively clear border in my mind. The frontier markets are the smallest emerging markets. They have not emerged enough to be called emerging markets by the index authors. Examples include Sri Lanka and Vietnam and number of small Middle Eastern and African countries.
We generally avoid investing in frontier markets because they do not meet the three requirements that I seek. First, I am looking for size – the outright scale of these markets, not necessarily their current size but their long-term potential afforded by the size of their economy, populace, etc. A lot of these frontier markets are just too small to warrant a long-term investor’s attention, even if they are cheap.
The second requirement is liquidity. Most of these markets do not have well enough developed capital markets to afford a sufficient level of liquidity. I worry about a lot of capital being pushed into the frontier markets. I think frontier markets are an intriguing investment idea, but they do not afford as much liquidity as even the emerging markets. And the emerging markets themselves are often liquidity-constrained. I think that liquidity is a key metric that observers can use to distinguish between what is “on the frontier” versus what is “currently emerging and maybe one day will be developed.”
The third major requirement is a qualitative evaluation. I won’t put money to work where I won’t put boots on the ground. If we believe there are safety issues for me or for my team to travel and visit companies in a particular country, we should not be putting investors’ capital to work there. I have heard stories of people traveling into Pakistan or other parts of the emerging world with bodyguards. I figure if you have to do that, that’s just not a safe place to put money to work. Some markets where we invest, such as Brazil and Mexico, may not always be safe places to travel, but they offer a general level of capacity to move through society and get your work done. Our approach is old-fashioned in this regard, but that is how I think about it.
The line between the developed and emerging markets, as Greece’s own transition bears witness to, is a trickier one to define. As an emerging markets investor, I am looking for markets that benefit from the low base effect. They are at an earlier stage in their development. They have not made as much progress as developed markets. They have a lot of long-term potential to grow as the society makes progress, economic and otherwise. I believe that progress is captured at least partly in gross domestic product and partly therefore in corporate profits.
I define emerging markets as societies that are at a low state of development and have a lot of distance to cover until they achieve a greater state of development. And it’s that long-term growth and the potential it affords that hopefully fuels the sustainable growth that we seek to reproduce within the context of our Fund, if all goes well.
I think there are a lot of markets around the world that can fit that very broad definition. You can even argue that Silicon Valley is an emerging market because it is currently at a low state of “development” compared to its long-term potential. The difference between the present state and the future potential is so great that it might fuel a lot of sustainable growth over the decades to come. At first glance, that seems like an “emerging market” to me.
There is a key difference, though, between a generic, high-growth “emerging market” (which might conceptually include Silicon Valley) and the kind we target for the Fund (which does not include Silicon Valley). The difference is this: we look for investment opportunities in markets, industries, economies and countries that are traveling a mostly-known and well-trodden path.
Thanks, Andrew. Let’s take one more question and then we will conclude the call today. This question is from Mark in California. Mark asks, are there any plans for a new fund?
We are not planning to launch another fund at this stage. We are honored by the idea that we might launch a new fund. But our energy and efforts are pouring into making the current Fund as good as it can be for the long-term. In other words, we are putting our best ideas into the Fund in an effort to make sure it works for long-term shareholders.
More broadly, from a business philosophy perspective, you will not see Seafarer launch a large number of products over the long-run. I would not necessarily suggest that we will never launch a new fund. If we truly have a differentiated but well-rounded strategy, a broad-based solution for investors’ portfolios that is different from the growth and income fund we offer today – possibly a pure growth fund or something of that nature – we might pursue it at the right time if we had the resources to competently offer it.
What you will not see us do is launch a suite of very narrowly defined strategies that target very specific intersections of geography and style, strategy or asset class. I believe very strongly that funds should be good, long-term solutions that carve out a decent breadth of the world and offer more or less a go-anywhere capability to move across different asset classes and sub-strategies to provide long-term value to shareholders. I do not want to give investors a confusing menu of narrowly defined strategies to pick from, where they need to attempt to figure out which fund is going to be hot over the next twelve months.
With that comment I am going to wrap up our discussion today. I want to thank everyone for joining and participating on the call. We look forward to having future conversations with you.
Please reach out to us if you have questions about Seafarer or the contents of our presentation. Our email address is email@example.com. Also, please sign up for our email updates if you would like to be notified of our next Shareholder Conference Call.
Again, thank you for joining us 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 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.
As of 4/30/2013, SQM (Sociedad Quimica y Minera de Chile SA ADR) comprised 3.0% of the Seafarer Overseas Growth and Income Fund; Vale (Cia Vale do Rio Doce, Pfd.) comprised 1.9% of the Fund; and Hartalega Holdings Bhd comprised 2.4% of the Fund. As of 4/30/2013, the Fund had no economic interest in Caixa (Caixa Econômica Federal) or Banco do Brasil. View the Seafarer Overseas Growth and Income Fund’s Top 10 Holdings. Holdings are subject to change.
William Maeck, Kate Jaquet, and Michelle Foster are Registered Representatives of ALPS Distributors, Inc.