During the third quarter of 2014, the Seafarer Overseas Growth and Income Fund declined -1.94%.1 The Fund’s benchmark, the MSCI Emerging Markets Total Return Index, fell -3.36%. By way of broader comparison, the S&P 500 Index rose 1.13%.
The Fund began the quarter with a net asset value of $11.83 per share. No distributions were made during the period, and the Fund finished the quarter with a value of $11.60 per share.2
During the first nine months of the calendar year, the Fund returned 2.86%, whereas the benchmark index rose 2.75%.3
The third quarter was marked by substantial swings in performance for both the Fund and the index. July and August began well. Emerging market equities moved higher, fueled by perceptions of an improved economic outlook in China, and separately, by (sparse) poll data that hinted at political change in Brazil.
During the previous quarter, as noted in Seafarer’s portfolio review, Chinese equities were spurred higher by two main causes: first, stock prices had become overly depressed in the spring, and were poised for recovery; and second, the Chinese government had ample cause to provide mild stimulus to the economy, not only to offset slowing growth, but also to facilitate the recapitalization of the state-backed domestic banking system. Markets were further cheered by news in early August that a former member of China’s elite politburo had been arrested. Investors took this as a sign that a long-running and wide-ranging anti-graft campaign was near an end – and consequently that politics and economics “as usual” might soon resume. Together, these three factors sustained Chinese stocks through the late summer.
Meanwhile, Brazil’s markets and currency convulsed throughout the quarter, surging and swooning on the release of each new poll result. Brazil will undertake a general election on October 26, in which voters will determine a runoff between the sitting president, Dilma Rousseff, and contender Aécio Neves. Investors in Brazil associate the incumbent with failed economic policies and stagnation; consequently any poll that hinted at political change was an excuse for the market to hurtle itself higher. No poll suggested more than a slim margin of victory for either party, so stocks were consigned to a topsy-turvy, roller coaster ride, generally moving higher in July and August.
With Chinese and Brazilian stocks rising, the first two months of the quarter ended higher, extending the gains of the prior quarter. Between June 30 and September 3, the Fund gained 4.31%, and the index rose 5.63%. However, September’s arrival ended the markets’ run.
Early in the month, a series of economic reports indicated that the U.S. economy was growing faster than was broadly anticipated. Economic strength prompted investors to re-evaluate their expectations regarding the pace and magnitude of future interest rate increases, even as the Governors of the Federal Reserve cautioned that “conditions may . . . warrant keeping the target federal funds rate below levels [viewed] as normal” for some time to come.4 The resulting change in expectations brought about a sharp decline in global stock and foreign currency markets.
Around the same time, a number of unwelcome events struck the emerging markets simultaneously. First, the Chinese economy was weak, despite a number of minor stimulus measures. Second, Brazil’s poll data suggested the ruling administration might be re-elected, which sent Brazilian stocks into further convulsions. Third, geopolitical concerns regarding Russia’s involvement in Ukraine resurfaced, and currency markets slumped after the release of new reports that Russia’s government was contemplating closing its capital account to foreign exchange. All of these events combined to eliminate the gains of the Fund and the index such that both finished the quarter with losses.
The bulk of the Fund’s holdings were unable to escape September’s downdraft, contributing negatively to performance for the quarter. Two of the Fund’s larger holdings in the technology sector – TSMC and Samsung Electronics – slumped on fears that the two chip-making giants would engage in a price war in order to win market share within the next generation of semiconductor chips. I think the market’s fears are exaggerated and mostly unfounded, so the Fund has marginally increased its exposure to these two stocks on the back of their recent decline.
Meanwhile, all nine of the Fund’s holdings in Brazil and Turkey fell sharply. Both countries’ stock markets reacted badly to the prospect of higher interest rates; their respective currencies fell very sharply, too. Of the two markets, Brazil was especially hard-hit just before the end of the quarter, swooning on the aforementioned poll data. I acknowledge that both countries’ currencies are somewhat vulnerable in the short run to changing interest rate conditions; but I am not particularly concerned about currency risks in the context of the Fund’s construction and long-term investment horizon.
Four of the Fund’s best-performing positions during the quarter were small and mid-sized companies: Sindoh (office electronics) and Dongsuh (instant coffee) from South Korea, and Dongfang Electric (turbines) and Xinhua Winshare (publishing) from China. Apart from their geographical proximity, the four companies share little in common, except that I believe each to be especially “cheap” based on traditional measures of balance sheet value. These positions are relatively “forgotten,” in that three of the four are not actively researched by any brokerage analysts. Overlooked and cheap, all four have behaved idiosyncratically in past quarters, not necessarily rising or falling with the broader trend of the market. I believe their cheapness also helped insulate each from the broad-based sell off that took place in September. In the Outlook section below, I address at length the relative merits of a “value” oriented investment approach within the emerging markets.
The Fund undertook a number of changes during the third quarter, including the addition of six new positions, and the exit of six older holdings. Under ordinary circumstances, a new position enters the Fund because it serves as a superior replacement to an outgoing position. An old position is generally a candidate for deletion if its valuation has grown to be excessive, or if the company’s underlying “fundamentals” (operating and financial performance) deteriorate in a material manner that I failed to anticipate. A new position is generally a candidate for admission if it represents a material upgrade to the outgoing position, either on valuation grounds, fundamental grounds, or both.
Three of the positions exited (Beijing Enterprises of China, Ajinomoto of Japan, and PetroVietnam of Vietnam) were sold for reasons mainly pertaining to valuation. The Fund had profited from each stock’s rise, and in my judgment the valuations had grown less attractive; in each case Seafarer’s research team was able to replace the outgoing stock with a new position that offered a lower, more favorable valuation.
Three other positions were exited on fundamental grounds. They were Aliansce of Brazil, AMMB of Malaysia, and Sinomedia of China. In each case I believe the Fund replaced the outgoing position with a new position that offers superior fundamentals and an attractive valuation.
The Fund’s new positions include Sanlam, a South African life insurance company, notable for its strong profitability, surplus capital, and global reach; Xinhua Winshare, one of the dominant media companies of Western China, distinguished by its low valuation and healthy cashflow; Greatview Asceptic, a Chinese company that is attempting to dislodge Tetrapak’s global dominance over beverage packaging; Pico Far East, a Hong Kong based company that is one of the leaders within China’s trade show and event planning industry; a convertible bond from ASM Pacific, a Hong Kong-based firm that happens to be the world’s largest producer of semiconductor packaging equipment; and Hisamitsu Pharmaceuticals, a Japanese drug-maker known for its innovative delivery of drugs via adhesive patches. The common stock of Hisamitsu was a holding of the Fund at its outset; however, the Fund exited in 2013 due to valuation-related concerns. I very seldom repurchase a stock that I have exited; however, the decline of the stock in the past few months was steep enough to warrant re-examination, and ultimately, re-entry.
The aforementioned changes were motivated by the individual merits of each position, and not a specific desire to reposition the fund along geographical or sector lines. However, the cumulative effect of the changes resulted in modest shifts with respect to the Fund’s regional exposures. The Fund’s concentration rose marginally in Africa, and declined a bit in Latin America. The sector effect was more pronounced, with the exposure to Information Technology and Healthcare growing, offset by reductions in Financials and Industrials. The valuation characteristics of the Fund were modestly improved as well, most notably in that its estimated gross yield rose slightly, from 3.1% to 3.2%.
The recent turmoil in global stock markets places the near-term outlook in sharp focus: where are markets headed next? In my judgment, valuations within the emerging markets are generally favorable to long-term investors. Offsetting this is the precarious state of the Chinese economy, tepid growth in Europe and Latin America, severe instability in Eastern Europe and the Middle East, and the prospect of substantially higher interest rates in the U.S. Uncertainty prevails.
Unfortunately – but as usual – I have no means to determine the near-term direction of markets with any precision. Despite prevailing risks, the Fund’s portfolio holdings are attractive, and thus the Fund remains near full investment – very little cash is held in reserve right now. Yet even as the near-term is murky, I believe the longer-term outlook has recently come into sharper focus. A very important structural change – one that I think has been a long time in coming – has just begun to reshape the investment landscape within the developing world. I think the consequence of this change will play out over the next decade, at a minimum.
Before I explain this change, I need to provide some background. For the past sixteen years, I have subscribed to an investment philosophy that stresses “growth” over “value.” By “value,” I mean an investment approach that places its primary emphasis on the inherent cheapness of a company’s balance sheet, and which places secondary weight on the growth prospect of the company’s income statement. Such cheapness usually stems from an excessive amount of cash on the balance sheet; or assets whose liquidation value exceeds the company’s market capitalization; or operating assets that would become substantially more productive (and therefore more valuable) if in the hands of a more capable owner-operator.
When pursuing “growth,” I have never shunned “value.” On the contrary: I know price matters a great deal. I know that long-term investment success hinges on the pursuit of securities with reasonable prices, and the avoidance of securities with excessive valuations. In abstract, I prefer “value” to “growth.” However, I have built the Fund’s investment strategy around a conservative “growth and income” strategy out of practical necessity. In the past, I have had substantial doubts as to whether a classic “value” strategy could be effectively implemented within the developing world.
My doubts stem from the many structural impediments that the emerging markets present to the pursuit of classic “value.” Most of those impediments are a function of the rudimentary state of the protections afforded passive minority investors, especially foreigners (such as the Fund). In order to realize the value embedded in a cheap balance sheet, a minority investor must often invest patiently for an extended period, awaiting the catalyst that will ultimately unlock the value.
The problem with waiting in the developing world is that most countries lack sufficient legal, financial, accounting and regulatory standards to protect minority investors from abuse by “control parties.” Control parties are the dominant owner of a given company. Without appropriate safeguards, minorities have little hope of avoiding exploitation while they wait; nor do they have sufficient legal clout to exert pressure on the control party to accelerate the realization of value. In the past, a prospective “value” investment was more likely to be a “value trap” than a source of long-term return. A passive, minority investor in common stock might be forced to wait a very long time before realizing the “value” underpinning the investment – if they realized anything at all.
Other challenges exist for a “value” strategy in the developing world. “Change-of-control” investors – either private equity firms, or operating companies attempting to consolidate their industry – are typically thwarted in their attempts to wrestle control from negligent control parties, thus precluding an important means by which investors might realize “value.” Change-of-control investors usually face legal and cultural barriers that impede their ability to execute hostile takeovers. Incumbent control parties are often secure in their status, benefiting from political patronage, legal systems that hamper takeovers, and guanxi. Another historical impediment to takeovers has been the stunted nature of debt capital markets. Capital markets in the developing world have historically been small and shallow. Obviously, leveraged buyouts and other “take private” transactions will struggle if local-currency debt markets are not deep enough to provide the requisite capital.
Perhaps the most significant impediment is the relatively minimal presence of large, domestic institutional investors (i.e. pension funds, endowments, and other asset managers) within developing markets. The absence of such institutions can hamper the realization of “value”: institutions with vested economic interests are often critical to ensuring a basic standard of economic discipline and corporate governance within a given market. Furthermore, such institutions usually enjoy as much or more local political clout than the control parties they might seek to discipline; this allows them to exert pressure for better governance in a way that very few foreign investors can. Historically, though, domestic institutional investors have been most notable for their minimal presence, or outright absence. Where such institutions exist, they have been mostly unable or unwilling to exercise their economic power to improve governance and corporate performance. Structural impediments such as these – common throughout the developing world – meant that a classic “value” approach had little chance of success in the past.
Now to the present day: all of this is changing. I believe that the prerequisites for realizing a “value” strategy in developing markets are materializing, slowly but steadily. Accounting standards, for example, have undergone enormous improvements in the past fifteen years. The resulting transparency means that it is much harder for control parties to abuse their position. Legal systems, while still imperfect, enforce much greater equality between shareholders than in the past. This means that minority investors and foreigners are on better footing relative to local investors and incumbent control parties.
Change-of-control investors are beginning to emerge. Private equity, while still small, is much better organized and funded than in the past. Local currency debt markets have mushroomed; they now seem large enough to support takeovers and buyouts efficiently. Perhaps most importantly, large domestic institutions have begun to credibly execute their investment mandates. Political reality has caught up with them: fiscal pressures and looming pension liabilities have forced such institutions to get serious about achieving better returns from their investment portfolios on behalf of their constituents. This in turn has prompted institutions to demand more from wayward companies and their management teams; they expect improved profitability and higher dividends. All of the aforementioned changes suggest the investment landscape has been altered – subtly, but irrevocably. Moreover, I believe the natural evolution of these markets will only magnify and sustain the structural change. The future holds further improvements in accounting and legal standards, the proliferation of change-of-control investors, and the rise of domestic institutional investors.
Taken together, all of these changes suggest the time for “value” has finally arrived in the emerging world. You will see Seafarer explore this approach in the future – though in doing so, the Fund will not deviate in any material way from its “growth and income” strategy. From the Fund’s inception, I have experimented with positions that were heavier on “balance sheet value” and somewhat lighter on “growth and income” than was normal for the strategy. Happily, most of those experiments have born fruit, and consequently, I plan to expand the Fund’s exposure to “value-heavy / growth-and-income” positions. I believe the rise of “value” will be an important feature of investment in the emerging world for the decade to come.
Thank you for entrusting us with your capital. We are honored to serve as your investment adviser in the emerging markets.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 S&P 500 Total Return Index is a stock market index based on the market capitalizations of 500 large companies with common stock listed on the NYSE or NASDAQ. It is not possible to invest directly in this or any index.
- The views and information discussed in this commentary are as of the date of publication, are subject to change, and may not reflect the writer's current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. It should not be assumed that any investment will be profitable or will equal the performance of the portfolios or any securities or any sectors mentioned herein. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Seafarer does not accept any liability for losses either direct or consequential caused by the use of this information.
- As of September 30, 2014, Sindoh Co Ltd comprised 3.0% of the Seafarer Overseas Growth and Income Fund, Dongsuh Co Inc comprised 3.3% of the Fund, Dongfang Electric Corp Ltd comprised 2.2% of the Fund, Xinhua Winshare Publishing comprised 2.5% of the Fund, Sanlam Ltd comprised 2.0% of the Fund, Greatview Aseptic Packaging Co comprised 1.7% of the Fund, Pico Far East Holdings Ltd comprised 2.4% of the Fund, ASM Pacific Technology comprised 2.3% of the Fund, and Hisamitsu Pharmaceuticals comprised 2.8% of the Fund. As of September 30, 2014, the Fund had no economic interest in Beijing Enterprises Holdings Ltd., Ajinomoto Co. Inc, PetroVietnam Drilling and Well Services JSC, Aliansce Shopping Centers SA, AMMB Holdings Bhd, and Sinomedia Holding, Ltd. View the Fund’s Top 10 Holdings. Holdings are subject to change.
- References to the “Fund” pertain to the Fund’s Institutional share class (ticker: SIGIX). The Investor share class (ticker: SFGIX) fell -2.03% during the quarter.
- The Fund’s Investor share class began the quarter with a net asset value of $11.82 per share, and it finished the quarter with a value of $11.58 per share.
- The Fund’s Investor share class returned 2.66% during the nine-month period ending September 30.
- Federal Reserve Board of Governors, Federal Open Market Committee, Press Release, 17 September 2014.