During the fourth quarter of 2014, the Seafarer Overseas Growth and Income Fund declined -3.09%.1 The Fund’s benchmark, the MSCI Emerging Markets Total Return Index, fell -4.44%. By way of broader comparison, the S&P 500 Index rose 4.93%.
The Fund began the quarter with a net asset value of $11.60 per share. During the quarter, the Fund paid a semi-annual distribution of approximately $0.282 per share. This payment brought the cumulative distribution, as measured from the Fund’s inception,2 to $1.031 per share. The Fund then finished the quarter with a value of $10.96 per share.3
During the calendar year, the Fund declined -0.32%, whereas the benchmark index fell -1.82%.4
[Please note: this portfolio review encompasses only the fourth quarter of 2014, and not the entire calendar year. The Fund operates on a fiscal year that concludes April 30; as such, Seafarer offers comprehensive portfolio reviews for its annual and semi-annual periods, which are published in the Fund’s Shareholder Reports in late June and December respectively. Previous Shareholder Reports are available in the Archives.]
Both the Fund and the benchmark experienced substantial volatility during 2014. At the outset of the year, they swung together into the red; by midsummer, both had generated substantial gains; and by the end of the year, the gains evaporated, and both produced small losses. While the Fund managed to outpace its benchmark for both the quarter and the year, there were no gains to compensate shareholders for their trouble.
When I examine the Fund’s performance last year, I am pleased by one thing: the Fund swung around somewhat less violently than its benchmark. The Fund’s lower volatility was particularly evident when markets were falling. The Fund made up ground at such times, and because markets fell more than they rose during the year, it beat its benchmark, albeit by a marginal amount.
This sort of outperformance, characterized by lower volatility, is important: it is a hallmark of the kind of performance that Seafarer seeks to generate for shareholders. The Fund’s secondary investment objective is to “mitigate adverse volatility.” Our experience suggests that a strategy characterized by lower volatility can improve risk-adjusted returns. We also believe a strategy of this sort will encourage shareholders to remain invested during difficult market conditions, and thereby improve the prospect of capital appreciation over the long term (which, of course, is a critical element of the Fund’s primary investment objective).
Nevertheless, lower volatility and marginal outperformance is thin compensation for shareholders’ patience over the past year. The Fund’s performance also stands in stark contrast to the performance available from U.S. stocks over the same period. In a technical sense, I am pleased that the Fund’s strategy is performing according to Seafarer’s expectation; but I am frustrated with the Fund’s absolute returns, as I imagine many shareholders are. Still, we will stay the course. Both history and my experience suggest this strategy works well for long-term investors – and based on the conditions I perceive in the emerging markets, I believe it will do so again.
Throughout the quarter and the year, emerging currencies imposed a substantial drag on returns. MSCI calculates that absent currency movements, the benchmark would have risen 0.08% in the fourth quarter, and 5.57% during the year.5 Clearly, currencies acted as a headwind against performance. Ironically, though, the most problematic currencies were not necessarily those predicted by pundits at the outset of the year.
During the second half of 2013, currency strategists coined the phrase “fragile five” as a loose way to describe the currencies of Brazil, India, Indonesia, South Africa and Turkey. The five were deemed susceptible to currency weakness for various reasons, mainly due to presumed dependency on foreign funding for their economic growth. At the beginning of 2014, the financial media were replete with shrill warnings regarding “the five;” indeed, all five weakened versus the dollar over the course of the year. Yet all five “fragile” currencies did better against the dollar than the Mexican Peso, the Polish Zloty, the Colombian Peso, and the Russian Ruble – four currencies that were not marked for trouble by currency strategists. I believe there are two lessons in this result. First, whether their fortunes are waxing or waning at any given time, emerging market currencies are inherently volatile and risky relative to the dollar, regardless of what anyone says. Second, most currency forecasts are worth less than the paper on which they are written.
Examining individual markets, Turkey is one that performed notably well for the Fund. The portfolio includes three Turkish stocks – a military systems company, a biscuit maker, and a home appliance maker – and one government bond that matures in 2023. All four positions contributed positively to the Fund’s performance during both the quarter and the year, even as the Lira weakened 8% versus the dollar in 2014. The three companies all produced steady profits, despite the tepid growth of the Turkish economy. Turkey also received an economic tailwind from the decline in oil and gas prices – roughly half of the country’s trade deficits are tied to the importation of energy, primarily from Russia. I remain very optimistic about the future of corporate Turkey; yet sadly the Turkish political landscape is fraught with risks, as the prevailing government has demonstrated increasingly despotic tendencies. The Fund will remain invested there, but we continue to monitor the country’s political risk closely.
The Fund’s two positions in India also did well, though in hindsight, the Fund should have invested more capital there. Indian equities and the local currency recovered sharply from a period of distress in late 2013, and then climbed to all-time highs following the sweeping victory of Prime Minister Narendra Modi during national elections last spring. Modi is perceived as a reformer, with a pro-business agenda; his Bharatiya Janata Party won a decisive mandate, and as such was able to form the first government in over 30 years without resorting to a coalition structure. India’s stock markets, ever hopeful for the prospect of economic reform, leapt sharply higher in response.
The Fund’s larger India position, a software company called Infosys, saw its valuation rise after a change in management brought shifts in its corporate strategy that produced steadier growth. The smaller position, Sun Pharma Advanced, is a research-and-development driven pharmaceutical firm. Its valuation improved after the company realized a few “wins” with respect to drugs currently under development.6 Both stocks effectively gained because of company-specific events, and not so much because of the broad-based rally that took place in India following Modi’s election. While this sort of company-specific performance is in keeping with Seafarer’s desire to invest from the “bottom up,” the Fund obviously missed out on the substantial “top down” opportunity generated by Modi’s win. To aggressively engage in India now presents challenges: valuations are elevated, and Modi’s party has promised far more reform than it has actually delivered. Still, I am hopeful for the country’s future, and we continue to research this market in order to discover opportunities for long-term investment.
China posed challenges for the Fund throughout the year. China’s economy flirted with disaster in the spring. Decelerating economic growth placed a financial strain on the property sector, commodities, and some heavy industries such as steel, glass making, and shipbuilding. Tight liquidity conditions exacerbated the financial stress, invoking the possibility of crisis. Yet by mid-summer, no crisis broke, and the looming threat was seemingly averted. This close escape from trouble paradoxically initiated a recovery in share prices: markets speculated that weak economic conditions and financial distress would prompt Chinese authorities to relax restrictions on credit, and also enact new fiscal and monetary stimulus. Investors seized on what were then low share prices, and stocks moved higher.
Over the summer, the Xi administration announced a number of welcome economic reforms, including changes to national energy policy, promotion of the renminbi as an international medium of exchange, and further liberalization of the hukou system (a household registration system that determines access to certain public and social services in residential areas). Then, in the fall, China launched a revolutionary program to integrate its domestic stock markets with the rest of the world. China’s domestic stock markets, generally known as the “A-shares,” had previously been closed to most foreign investors. However, the launch of the “Shanghai – Hong Kong Stock Connect” program linked mainland markets to the rest of the world, such that investors can buy A-shares in China through a special clearing account at the Hong Kong Stock Exchange.7 The advent of this program gave domestic Chinese investors greater reason to cheer, and they pushed the stock market sharply higher during the final six weeks of the year.
Speculation over the Stock Connect program led to a swift, sweeping gain in Chinese equities – particularly companies with larger capitalizations, and particularly those associated with industries that had previously faced financial distress in the spring (i.e., property stocks, banks and cyclical industrials). Unfortunately, the Fund failed to participate in the rally.
Seafarer has generally avoided larger capitalization bank and property shares in China, for fear that these companies are precisely those most exposed to the country’s economic deceleration and financial distress. In the past, that has served the Fund well, but not so during the final six weeks of the year – the Fund’s holdings simply did not keep pace. The Fund is mostly invested in the service sector, and mostly in small and mid-sized companies. It has limited exposure to property, and it has no holdings in commodities, industrial cyclicals or banking (all of which led the rally). We remain confident in the Fund’s holdings, and we believe it was prudent to avoid this speculative surge in Chinese share prices, even as our approach placed a substantial drag on relative returns during the fourth quarter.
The most notable change in the Fund’s construction versus the prior quarter is its greater concentration.
During the quarter, the Fund shifted from 47 positions to 42. An additional position was sold shortly after January 1, such that the Fund has only 41 positions as of the date of this report. This level of concentration is in line with my original statements about the Fund, in which I indicated that Seafarer would generally maintain 40 to 60 positions within the portfolio.
The decision to concentrate the Fund rests on two constructs: first, the greater concentration is a luxury afforded by Seafarer’s growing research resources. Managing a concentrated portfolio is desirable, yet it is arguably more difficult than managing a highly diversified one. Our experience suggests that greater concentration helps to maximize the returns from good decisions. Yet it also requires a deeper understanding of every position, so as to thoroughly vet and manage the specific risks associated with each holding. Higher concentration effectively means less ability to depend on “diversification” to balance out risks. Seafarer has been able to achieve this concentration mainly because of the continued investments it has made in its investment team. Two new personnel joined the firm during the summer. Their individual contributions, along with the additional research capacity they represent, have helped move the Fund toward a more concentrated construct.
The second reason that the Fund is more concentrated is that I believe it is time for the Fund to become a bit more aggressive. By no means do I wish to suggest that it’s time to get “bullish,” or that 2015 will be an easy year for shareholders. In fact, I anticipate several risks will weigh on markets throughout the year (those risks are mentioned in the next section). Yet despite such risks, valuations have grown compelling, and I believe concentration is the best way to exploit this potential within the portfolio. I am also confident that, even if 2015 proves to be another tough year, we know the positions well enough to be confident they will weather it well. While I will always assert that diversification is one of the most practical tools for the mitigation of risk, the Fund needs less of it now than it did before.
Please note: for additional comments regarding the Fund’s portfolio construction provided after the publication of this Portfolio Review, see the Message to Shareholders as of January 26, 2015.
I do not expect that 2015 will be a quiet year for the emerging markets. Financial shocks and volatility were present throughout 2014, and I doubt 2015 will be any different. I suggest that long-term investors focus on four ideas amid the noise: differentiation, currencies, crisis, and renewed growth, now available at a reasonable price.
First, the preceding year witnessed clear differentiation in the performance of major emerging markets, and I expect this “trend” to continue. Frankly, it’s not a new trend – at least not for any careful observer of the developing world. The countries that comprise the loosely defined asset class have always had stark differences in the structure of their economies and their level of socio-economic development. That those differences are glaring and now seem to “matter” is mostly a function of the emerging markets’ newfound prominence and scale. The largest developing countries have grown too big to mask their idiosyncrasies behind simplistic acronyms (“BRICs”), or silly catchphrases (“fragile five”), or to hope naïvely that disparate markets will behave in a synchronized fashion.
In 2014, China and India stood apart, mainly because their economies exhibited sufficient depth, breadth and scale to withstand the pressures that sank other countries. Brazil’s economy is reasonably broad, yet it is still overly dependent on its export-oriented resource sector. Until economic reforms change that basic fact, the country’s aggregate potential might be stunted. Meanwhile, the hazardously narrow nature of the Russian economy – long obscured by the riches of its energy sector – was revealed in sudden and stark fashion. The implication is not that China’s and India’s success will continue unabated, or that other markets will fail to recover. Instead, the structural differences between these markets will place them on distinctly different paths to development, with unique growth trajectories and resultant long-term potential. In time, the most obvious thing about the “emerging markets” may be how little they have in common, except for a shared and obsolete moniker.
Second, I expect the conditions that induced weakness among the emerging currencies to continue, but ultimately moderate. Three years ago, when Seafarer launched the Fund, one of the major concerns I had was that the growth of the developing world was anemic. I have always been confident the Fund could find equities of reasonably valued companies with stable growth in revenues and profits – and the evidence presently at our disposal suggests we have done so. Yet I was also worried that the overall level of growth was decelerating, mainly because the largest countries had done too little to modernize their markets. Without reform, those countries were beginning to experience natural limits of scale. I was further worried that as the economies decelerated, corporate profits would follow suit. This appears to be exactly what happened: growth in earnings per share for the benchmark index has been tepid over the past three years, and each year it has fallen far short of expectation.
My assumption for this low-growth environment was that central banks within the developing world would adopt accommodative monetary policies (i.e. keep interest rates low), while governments implemented fiscal and economic reforms. I hoped this policy combination would rekindle higher rates of growth. However, I also worried that if such policies were adopted at the same time the U.S. Federal Reserve was “tightening” the money supply (i.e. raising interest rates), the dichotomy could induce weakness in emerging market currencies. My view was that the emerging markets would experience short-term currency pain in exchange for long-term growth gain.
In hindsight, my ideas were broadly correct, but I had absolutely no idea of the severity of the reaction that would ensue. Many emerging market currencies crumbled over the past two years to depths I did not guess. The dichotomy I imagined came about: most central banks in the emerging world have refrained from rate increases, and some have cut rates, all in a bid to reignite growth; this has occurred even as the Fed has publicly discussed ending its quantitative easing (QE) program. The difference in monetary policies – relaxing versus tightening – is the most pronounced I have seen in my career. The consequence has been steep losses in emerging currencies: from the Fund’s inception to the end of 2014, the basket of currencies that comprise the benchmark index has declined -17.5% versus the dollar. Given that Asian currencies comprise roughly 60% of that basket, and given that most Asian currencies have been stable versus the dollar over the period, you can imagine how severe the declines have been in Latin America and Eastern Europe in order to produce a -17.5% decline.
Looking forward, Seafarer’s analysis and my instinct both suggest that most of the currency “pain” is in the past. Certainly, the conditions described above still exist, and consequently the trend may continue for some time. How long I do not know. Yet it is difficult to underestimate the magnitude of the adjustment that has already taken place. I believe it may be sufficient to correct the worst economic imbalances. One thing is certain: the currencies are in no way as “expensive” as they were a few short years ago; their relative “attractiveness” has improved substantially. Meanwhile, I believe the combination of lower interest rates and economic reform will begin to bear fruit, vindicating the central banks’ decision to use accommodative monetary policy to stabilize growth.
Personally, I think the severity of the reaction of the currency markets is in some way the inverse of 2011, when investors were infatuated with alternatives to the dollar. The pendulum has now swung the other way, to such an extent that I doubt the dollar’s ascendance has been driven entirely by its “fundamentals.” It is more likely the result of an overcrowded strategy gone awry. As the dollar climbs ever higher versus commodities, energy, foreign currencies and gold, it might signify weak global demand; or it might simply indicate that the dollar has grown too strong relative to everything else, the opposite of conditions only three years ago.
Third, I think investors must continue to keep a watchful eye on the events that might disturb markets. Of course, the events that no one predicts will unsettle markets most. Still, I would suggest that investors watch for instability in Russia, and its international consequences; Greece’s struggles with the Eurozone (personally, I believe default is likely and exit is ultimately inevitable); and the continued prospect of some sort of large-scale financial collapse or liquidity crisis in China. I think it is unlikely that China will experience such a crisis, but I cannot dismiss the possibility altogether. At the same time, I think shareholders should begin to imagine a world in which China has decoupled its currency (the renminbi) from the dollar. I have always assumed this would occur, but I presumed it would happen well after 2020. The pronounced (and possibly excessive) strength of the dollar may force China to accelerate such plans.
Fourth, investors should not lose sight of the fact that stocks in the emerging world are reasonably valued. I think some equities are beginning to look “cheap,” especially when measured in dollar terms. Also, as suggested above, structural reforms may begin to bear fruit. If so, and absent any major crisis, I expect that the anemic, sub-par growth of the past three years will give way to a new period of low but stable growth. When the dust settles on 2015, I think growth will re-accelerate a bit in the emerging markets. Those two characteristics – reasonable valuations combined with low but stable growth – will make the emerging markets more attractive to long-term investors.
Thank you for your patience, and for entrusting us with your capital. We are, as always, 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 December 31, 2014, Infosys Ltd. comprised 4.0% of the Seafarer Overseas Growth and Income Fund, and Sun Pharma Advanced Research comprised 2.7% of the Fund. View the Fund’s Top 10 Holdings. Holdings are subject to change.
- References to the “Fund” pertain to the Fund’s Institutional share class (ticker: SIGIX). The Investor share class (ticker: SFGIX) fell -3.10% during the quarter.
- The Fund’s inception date is February 15, 2012.
- The Fund’s Investor share class began the quarter with a net asset value of $11.58 per share; it paid a semi-annual distribution of $0.272 per share in December; and it finished the quarter with a value of $10.95 per share.
- The Fund’s Investor share class declined -0.52% during the calendar year.
- MSCI is the company that provides the Fund’s benchmark. Statements regarding the performance of the index absent currency effects are based on the performance of the MSCI Emerging Markets Total Return Local Currency Index (Bloomberg ticker code: GDLEEGF).
- For additional comments regarding Sun Pharma Advanced provided after the publication of this Portfolio Review, see the Message to Shareholders as of January 26, 2015
- The Fund has not yet participated in the Stock Connect program because it presents certain compliance-related challenges to U.S. mutual funds. Seafarer hopes such challenges will be resolved during the coming year, and if they are, the Fund may establish one or more positions in the A-share market.