During the third calendar quarter of 2013, the Seafarer Overseas Growth and Income Fund gained 3.17% and 3.26% for the Investor and Institutional share classes, respectively. The Fund’s benchmark, the MSCI Emerging Markets Total Return Index, rose 5.90%. By way of broader comparison, the S&P 500 Index rose 5.25%. The Fund’s two share classes began the quarter with net asset values of $11.04 per share; the Investor Class and Institutional Class finished the quarter with prices of $11.39 and $11.40, respectively.
Volatility has been a constant feature of the emerging markets all year, and the third quarter was no exception. However, the pattern of volatility was a bit different: during the first half of the year, most of the major stock markets moved lower, in tandem with one another. Only Hungary and a handful of smaller markets in Southeast Asia were exempt from that trend.
By comparison, the third quarter rendered substantial differentials in the performance of various emerging markets. Some of the larger countries – notably China, Korea and Russia – produced substantial gains; all rose in excess of 10%, as measured in dollar terms.1 Meanwhile, other countries slumped. Chile, India, Indonesia, Turkey and the Philippines all fell 4.5% or more during the quarter.2 Currencies played an outsized role in the disparity of those returns. India, Indonesia and Turkey all experienced sharp currency weakness, whereas Korea and the Eastern European markets (Czech Republic, Hungary, Poland, Russia) saw their currencies rise versus the dollar. All in all, it was a wild quarter.
Amid the turmoil, China’s stock markets performed well, rising swiftly when investors were caught off-guard at the resilience of the Chinese economy. At the beginning of the year, numerous strategists had forecast that China’s economy would grow around 8.5% during 2013. Those forecasts were decidedly wrong. Contrary to prediction, the economy began to slow during the first half; that deceleration, combined with reports of distress within the Chinese banking system, were enough to send Chinese stocks tumbling during the first six months of the year. Equity valuations reflected a pessimistic view on China; I believe that some investors mistakenly anticipated a “hard landing,” in which growth might decelerate sharply (i.e., well below 6%), and which might trigger some sort of “credit event” (e.g., the collapse of a small bank). Yet economic data released during the third quarter suggested that the economy is still holding up reasonably well, expanding around 7.8% per annum. That revelation caught the market off guard, and Chinese shares jumped higher in response.
In the third quarter, the Seafarer Fund underperformed the benchmark index for three main reasons: first, the Fund lacked sufficient exposure to China, and thus it did not fully participate in the aforementioned rally. Second, the Fund’s Korean holdings performed poorly, whereas the Korean stock market performed well, boosting the index’s return. Third, I made an error with a single position that weighed down returns by a bit over 1% during the quarter. I provide further explanation about that error below. However, as the discussion is lengthy and slightly technical, I have included it in a separate appendix entitled “Anatomy of an Error.”
At Seafarer, we invest from the bottom up, meaning that we evaluate each potential investment on its individual merits. This is in contrast to an investment system in which we might place heavy emphasis on economic forecasts and make decisions based on macro themes, or country allocations, or sector weightings. (For a thorough discussion of this topic, please see the Letter to Shareholders dated May 15, 2013.) However, when we invest from the bottom up, we consider carefully how various “macro scenarios” might directly or indirectly impact the prospective investment at hand. One “macro” area where we do concentrate is currencies, mainly because they have the potential to rapidly destroy the Fund’s capital, and because their movements can permanently diminish vulnerable industries and business models.
Over the past two years, we have rejected the prevailing view that emerging market currencies were somehow new and improved, and therefore could serve as an alternate haven to the dollar, or as a means to safely accrue extra fixed income.3 Unfortunately, our skepticism has come home to roost in the past eighteen months, and particularly so in the last quarter, as currencies from the Brazilian Real, to the Indonesian Rupiah, to the Indian Rupee have slumped dramatically. The Fund has not gone unscathed during this downturn – as noted, we invest foremost from the bottom up, and therefore capital is sometimes at risk in currencies where we have concerns – but our currency work has thus far helped the Fund avoid excessive allocations to the most problematic currencies.
As of October 2013, it seems to me that the bulk of the currency-related “pain” that was latent in the emerging markets is now manifest. Surely, there are some countries that still face pronounced risks (India chief among them, I believe). Yet dramatic losses versus the dollar have already occurred; in my view, currency markets tend to overshoot in the short run, and analysts tend to amplify and overstate currency problems only after they have occurred. I think the chief problem that emerging markets face is a lack of growth; none face the sort of dire solvency problems that crushed Latin America in the mid-1990s or Asia in the late 1990s. Those currency blow-ups were caused by asset-liability mismatches: essentially, financial institutions and other intermediaries in the emerging markets borrowed dollars on a short-term basis, and lent or invested long-term (in often dubious projects) that were denominated in local currencies. When the currencies collapsed, the projects’ financial viability collapsed, which caused the currencies to fall further, in a vicious cycle. For the most part, this is not an urgent problem today.
The emerging markets face a deficit of growth, not a crisis of solvency. In my view, emerging market currencies have fallen versus the dollar for two main reasons. First, and less importantly, some equity investors have retreated from the emerging markets, driven by concerns about the developing world’s growth prospects. The resulting selling pressure has pushed these relatively illiquid currencies lower. Second, and more importantly, I believe the recent currency volatility comes as the direct result of the unwinding of a “mini-bubble” that had formed in emerging market fixed income. For a variety of historical reasons, emerging bond markets had long been stunted – too illiquid and too small to finance the needs of borrowers or the developing world’s economic activity. Yet in the past few years these bond markets have been on a hyper-growth trajectory, fueled by demand from global investors seeking to simultaneously flee their home currencies (the dollar, yen and euro, primarily) and pad their fixed income yields. This surge in demand caused the emerging bond markets to mushroom, and in my view, a small financial bubble began to form: fixed income issuers were increasingly aggressive with their terms, bonds valuations were stretched, and local currencies were inflated. The U.S. Federal Reserve’s tentative plan to raise interest rates, as announced in May, was enough to “prick” this formative bubble, and the resulting stampede to sell has pushed most emerging market bonds and currencies to lower prices this year.
What commentary I have read on emerging market currencies suggests that the developing world will face another vicious cycle, in which slow growth begets capital flight and selling pressure. This is supposed to force each country’s central bank to raise interest rates in tandem with the U.S. Federal Reserve, and that will slow growth further, accelerating the downward spiral. I disagree with this view: but for a few important exceptions (India, especially), most central banks in the developing world enjoy sufficient “room” to keep interest rates low. That is to say, most are not facing severe, structural inflationary pressures; I think they should balance domestic growth objectives against the desire to “protect” their currencies’ values via rate hikes. To summarize, I believe there is a small, but growing chance that the bulk of the emerging markets can – and will – slowly de-couple their monetary policies from that of the Federal Reserve.
From a portfolio perspective, the upshot of all of this is that I am still worried about emerging market currencies, but far less so than one year ago. My main concern is the paucity of growth in the developing world. We will continue to invest from the bottom up, on a company-by-company basis; but we will be favorably disposed to those countries whose central banks understand that it is imperative to sustain growth, even if it means their currencies wobble against the dollar in the short run.
On a separate note, the Chinese stock market once again presents the Fund with promise and peril. The promise was visible during a recent trip to Hong Kong: we met a number of companies that are well-situated in service-based industries.4 Most of those industries are relatively new to China, and seem to be undergoing a small boom. You might call it a “boom-let.” The Fund will attempt to gain exposure to some of these companies, though the challenge is always sorting out faddish, concept stocks with high valuations from real companies that have the potential to grow steadily for the long-term. Amid a boom-let, it is possible to confuse the two groups.
Meanwhile, the peril arises from rolling liquidity crunches in China. I am disturbed at the rising levels of “accounts receivable” (essentially, un-collected revenues from customers), suggesting companies are not paid on a timely basis. Many of the deferred payments are ultimately traceable to the central government, provincial governments, or state-backed enterprises, which strikes me as both odd and worrisome. I think constrained liquidity within the corporate sector may prove more dangerous to China’s economic health than the country’s often-discussed property markets and “shadow banking system.” Our aim will be for the Fund to seek exposure to the aforementioned boom-let, while attempting to minimize exposure to China’s liquidity constrained corporate sector. It may prove to be a difficult, if not impossible, task.
Appendix – Anatomy of an Error
Careful observers of the Fund, along with participants in Seafarer’s latest public Shareholder Conference Call (held in July), would have noted that until recently, the Fund held a large position (roughly 3%) in the stock of a company called Sociedad Quimica y Minera (“SQM”). SQM is based in Chile, and it is engaged in a number of extractive, resource-oriented industries: it mines “potash,” a form of potassium; it uses some of that potash to make fertilizers; it harvests lithium from salt fields; and it mines iodine. I added SQM to the Fund in the autumn of 2012, and I sold the shares during the late summer of 2013. During the intervening period, the shares lost roughly half of their value, a substantial portion of which occurred during the third quarter.
In general, I avoid investment in highly cyclical businesses, such as mining and other extractive industries. The inherent cyclicality of such businesses makes them difficult to value properly, and their financial fortunes can swing dramatically in a short period of time, undermining profitability and devastating share prices. I believed SQM was an exception to the general rule. SQM was indeed remarkable: it enjoyed a superior level of profitability, and its revenues were impressively diversified across a swathe of high-growth, niche resource categories. This diversification meant that its profits seemed better insulated against the inevitable price shocks that impact the commodity industry. Most importantly, SQM enjoyed an unusually high degree of “pricing power.” The vast majority of resource companies are “price-takers,” meaning their outputs are commoditized, they have no bargaining power, and their prices are set by global forces of supply and demand. By contrast, SQM’s dominance over its respective niches seemed so substantial that it could influence (or even possibly set) some prices.
Before adding SQM to the portfolio, our team performed a series of analyses on the company. That work demonstrated to my satisfaction that SQM’s growth and profitability were likely under-appreciated by the stock market, and that the company’s share price did not reflect its long-term potential. At the same time, we identified some drawbacks to the position (every investment has blemishes). At the time of its addition, SQM was more expensive than I would have preferred; and I had substantial doubts about the company’s “control party” – an individual named Julio Ponce, who exercises control over SQM via a number of obscure, unlisted holding companies. Yet I believed that the company’s potential was more than enough to offset my reservations, and thus I had the Fund invest last fall.
In the ensuing months, the spot prices of several of SQM’s key products dipped lower, denting the company’s profitability, and the share price followed suit. While that outcome was unfortunate, it was still well within the range of my expectation. Our analysis had stressed deterioration in commodity prices, so we were not caught off guard by subsequent events. While the company’s prospects were somewhat diminished, our analysis suggested it would still enjoy strong potential for profitability and growth. Meanwhile, the shares’ valuation had grown all the more attractive. I chose to retain the position, which I would normally do for any holding that experiences a temporary setback (as happens to nearly every long-held position, sooner or later).
However, by mid-summer, SQM’s situation had deteriorated further. Its potash business experienced a major setback when the global oligopoly that controls the industry was dismantled swiftly and unexpectedly. We had not considered a scenario where the potash segment struggled to this degree. I had been lulled into thinking the segment would serve as the company’s “cash cow,” a steady source of cash flow. I was clearly wrong. Still, the shares’ valuation had become cheaper; and though I was now far more wary, our work still pointed to a brighter future for the company. As a portfolio manager, I tend to gravitate toward growth companies that have valuations hampered by short-term setbacks; and on paper, there was a reasonable probability that SQM could still succeed.
It was at this point, unfortunately, that “control party risk” began to assert itself. (When investing in stocks, it is tempting to imagine that the worst possible events are independent from one another, and therefore unlikely to occur at once. In my experience, this is a fallacy: corporate problems manifest themselves in tandem. When it rains, it pours.) Ponce, the aforementioned “control party” and chairman of SQM, began to experience financial difficulties because of the potash debacle. As mentioned above, I had substantial concerns about Ponce, stemming from two intertwined issues: the provenance of his ownership, and the corporate structure he uses to control the company. SQM’s slumping stock price quickly put my doubts to the test. Our basic analysis suggested (and public articles seemed to substantiate) that Ponce’s holding companies were little more than financial shells, laden with substantial bank debts. The only collateral assets behind those debts are the holding companies’ shares in SQM – and the value of that collateral had obviously declined.
Faced with severe financial distress, Ponce announced that he would seek to merge and recapitalize his holding companies in a bid to retain control over SQM. My fear was (and is) that Ponce would use his control over SQM to force it to provide liquidity to his unlisted entities on a subsidized basis during the recapitalization. If a transaction of that sort were to occur, it would likely be economically detrimental to SQM; and worse still, it would constitute the worst sort of governance.
To briefly digress: in my view, control parties rule the roost at public companies.5 Their control allows them to execute corporate strategy, to take key decisions, and to set the incentive schemes that likely dictate management behavior. The control party is usually the single largest shareholder, perhaps a founder; but it is not always so. In some cases, the control party is a government ministry that wields an all-powerful vote via a single “golden share;” in other cases, a legal trust might represent the interests of multiple shareholders; and there are some cases where the de-facto control party is the “caretaker” management team. This usually occurs when the founding family has abandoned the business in favor of leisure and other pursuits. (For the record: Ponce owns a substantial stake in SQM via the aforementioned clutch of holding companies, but his control is actually exerted via a delicate alliance with an obscure Japanese conglomerate.)
Control parties are usually effective “wealth creators” – that is why we invest with them, after all – as they know how to grow their businesses in an uncertain and rapidly shifting economic landscape. Textbooks suggest that firms belong to their shareholders; but in reality, there is a natural pecking order, and minority shareholders are often privileged to “be along for the ride” as wealth is created. Yet control parties are often self-serving and stubborn. In the emerging world, where legal rights and protections for minority shareholders are scant, wresting control from them is usually a fool’s errand. They often direct the publicly listed companies under their control to engage in self-enriching transactions, almost always at the expense of minority shareholders. In some instances, such events are immaterial, and are incidental to the greater goal of the company’s long-term growth. Mavens of corporate governance might be upset, but little damage is done to intrinsic value. I believe one must be willing to put up with some of this “slippage” from time to time, in exchange for the privilege of investing alongside such wealth creators. In other instances, control parties systematically abuse their position, and engage in damaging transactions, often via obscure means. In my experience, one must avoid such control parties and their organizations at any cost, regardless of any offsetting benefits. In short, you must never take your eyes off of the control party.
Returning to SQM: as Ponce’s grip over the company weakened, the probability that he might commit the company to a damaging transaction increased. In my experience, when a control party faces financial distress or a “cash call,” they often construct a “liquidity transfer.” In such transactions, the control party forces the listed company – which typically enjoys a high degree of financial liquidity in comparison to the control party’s other assets – to provide cash or financial guarantees to the control party’s unlisted, private holdings on a subsidized (or even crooked) basis. Effectively the listed company “bails out” the illiquid (and usually insolvent) off-balance sheet holdings of the control party. I have never seen such deals turn out well for minority investors: they are not properly compensated for the liquidity they provide or the risks they incur. In my view, “liquidity transfers” are among the most nefarious transactions a control party might undertake. Thus when I saw signs that Ponce might do so, this was the final blow; the risk was too great. The Fund quit the shares.
I have made errors before, and I will make errors again. When I execute my job to the best of my ability, I aim for a 60% success rate over the long haul. A 0.600 batting average might not seem like enough, but I am confident that if I achieve this rate consistently, it will be sufficient for the Fund’s strategy to perform as intended. Nevertheless, I am frustrated at having sunk capital into SQM. By most measures, the shares are now “cheap,” and it is exasperating to be shaken out of the stock at such a price. Yet I have never regretted exiting a company where the control party might engage in a “liquidity transfer,” or any other form of material abuse.Andrew Foster,
- The performance data quoted represents past performance and does not guarantee future results. Future returns may be lower or higher. The investment return and principal value will fluctuate so that an investor's shares, when redeemed, may be worth more or less than the original cost. View the Fund’s most recent month-end performance.
- The MSCI Emerging Markets Total Return Index, Standard (Large+Mid Cap) Core, Gross (dividends reinvested), USD is a free float-adjusted market capitalization index designed to measure equity market performance of emerging markets. Index code: GDUEEGF. It is not possible to invest directly in this or any index.
- The 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 9/30/2013, the Seafarer Overseas Growth and Income Fund had no economic interest in SQM (Sociedad Quimica y Minera de Chile SA ADR). View the Fund’s Top 10 Holdings. Holdings are subject to change.
- Performance measurement based on performance of MSCI country indices, measured in dollar terms.
- Performance measurement based on performance of MSCI country indices, measured in dollar terms.
- For further information, please see “On the Brazilian Real,” April 2011; “On Double Invoicing and the Yuan,” Part 1 and Part 2, May 2011; “Three Risks to Emerging Markets Investing,” Morningstar video, June 2011; and “On Teflon and Emerging Market Currencies,” October 2011.
- For further discussion of the potential of China’s underdeveloped services sector, see the Letter to Shareholders dated November 12, 2012.
- It has recently come to my attention that my own statements and beliefs about "control parties" appear to overlap to a substantial extent with those of Marty Whitman and his notion of "control persons" and "control investors." Mr. Whitman is an esteemed value investor, and was formerly the Chief Investment Officer and lead Portfolio Manager of the advisory firm Third Avenue Value. While I certainly know of Marty Whitman, I must confess I have not read any of his writings, e.g., The Aggressive Conservative Investor (1979) and Value Investing (1999) or his various shareholder letters. Given that my thoughts seem to fit well with Mr. Whitman's, I am eager to read his work for further comparison and insight. At the present time, though, my philosophical belief about "control parties" and the practical research process it engenders at Seafarer are my own, developed independently of Mr. Whitman.