During the first quarter of 2015, the Seafarer Overseas Growth and Income Fund returned 8.58%.1 The Fund’s benchmark, the MSCI Emerging Markets Total Return Index, rose 2.28%. By way of broader comparison, the S&P 500 Index gained 0.95%.
The Fund began the quarter with a net asset value of $10.96 per share. It paid no distributions during the quarter, and finished with a value $11.90 per share.2
The Fund’s performance within the quarter was particularly attributable to a single position, Sun Pharmaceutical Advanced Research Company (“SPARC”). SPARC contributed half of the Fund’s gains during the period. SPARC was first mentioned as a holding of the Fund in the portfolio review for the fourth quarter of 2014.
By way of background, SPARC is an India-based pharmaceutical company engaged solely in research and development activities. It has three main areas of focus: it researches new drug delivery systems (e.g., making an existing, powder-form drug soluble so that it can be injected, or tweaking a drug so that it digests slowly in the gut, thereby enhancing its efficacy); it is engaged in the discovery of “new chemical entities,” (i.e. new drugs); and it develops medical devices (e.g., improvements for inhalers to treat asthma). SPARC is a relatively small company, though its market capitalization exceeds the equivalent of US $1 billion, thereby qualifying it as a “mid-capitalization” company in Seafarer’s nomenclature.
SPARC is a unique holding, as it represents a substantial departure from the Fund’s “core” strategy of seeking steady growth along with steady and growing dividends. Unlike most other holdings, SPARC’s business model is not yet well established. Its revenues are scant; it has only recently begun to produce sporadic quarterly profits, which are still intermingled with occasional losses; and its cash flow is inconsistent, rendering it unable to pay a dividend. In short, SPARC is a speculative venture when compared to the seasoned businesses that comprise the majority of the Fund’s portfolio.
I selected SPARC for the Fund because Seafarer’s research highlighted the firm’s potential value, and my long experience following the firm helped to minimize the concerns I would normally associate with an untested company of this sort. I have followed SPARC since its inception about eight years ago – it was spun out of a parent firm, Sun Pharmaceutical (“Sun”). Over the past ten years, I have watched as Sun progressed from being a small company, one of many generic drug makers within India, to become one of the most prominent generic drug makers in the world. Consequently, I knew Sun’s business model well. The company was run in a risk averse fashion: it was highly diversified across many generic drug markets, and very disciplined with respect to managing costs and generating cash flow.
As SPARC is focused on pure research and development, its business model is naturally more aggressive than that of its parent; it cannot depend on a steady stream of cash flow from selling established generic drugs. Yet because of the common management and ownership between the two companies, I perceived many parallels. Like Sun, SPARC is highly diversified. SPARC has not attempted to “shoot the moon” by investing heavily in a single, breakthrough drug or therapy; instead it has undertaken a large volume of research, carefully diversified across many small, non-blockbuster therapy areas. This may sound less exciting, but importantly this diversified approach reduces the risk associated with the research pipeline. Meanwhile, SPARC has exhibited a decidedly practical bent, pursuing therapies that could generate cash flow in the near term, and thereby reducing the risk that the company might consume its seed funding before becoming self-sustaining. Indeed, news on this point appears to be what stimulated the jump in the stock during the first quarter: at least one of SPARC’s therapies for glaucoma is nearly ready to market to the general public, suggesting the company’s cash flow might improve within the next year or two.
SPARC is arguably the most aggressive holding admitted to the portfolio since the Fund’s inception, and it represents an exception to the conservative rule that normally governs the Fund’s strategy. I made room for this exception because I followed the company for many years, and because I believed it pursued a low-risk business model, despite operating in a high-risk industry. Shareholders should note that exceptions of this sort will not constitute a regular part of the Fund’s strategy, but I will draw upon my experience and judgment whenever I can to invest in exceptional companies of this sort. As of March 31, SPARC remained in the Fund’s portfolio, though the position size was reduced after the stock’s sharp appreciation during the quarter.
On a related note, I wish to briefly address the Fund’s historical performance versus its benchmark over the past three years. As of March 31, the Fund’s annualized return over the preceding three years was 8.18%3, whereas the benchmark index rose at an annualized pace of 0.66%. Everyone at Seafarer is proud of the Fund’s performance over that horizon, but we are acutely aware that such performance is unlikely to persist.
As discussed at greater length in preceding commentaries, I believe that the developing world has recently undergone a period of anemic and disappointing growth. Corporate profits did not expand much, and consequently emerging market equities offered little in the way of positive gains over the past three years. Ironically, those same conditions have proven ideal for the Fund’s strategy. The Fund does not necessarily pursue high rates of growth, but rather seeks companies that can grow in a steady manner. Seafarer’s research suggests the Fund was successful in its efforts to invest in sustainable growth, as the underlying holdings produced profit growth that was considerably more reliable than that of the index portfolio. (For more on this topic, view the Portfolio Briefing video for the first quarter.) I believe the holdings’ sustained growth, during a time of otherwise anemic conditions, accounts for much of the Fund’s outperformance.
However, the next three years may be markedly different. I believe that profit growth will re-accelerate. If it does, the Fund might struggle to keep pace with equity markets. If history is any guide, investors tend to aggressively pursue reinvigorated growth; at the same time, they shed many of their concerns regarding valuation. When such conditions prevail, the Fund’s relatively conservative approach acts as an impediment to its relative performance – especially if markets jump higher, quickly. In any case, I wish to caution shareholders that the Fund’s strategy is designed to produce only moderate outperformance over long periods of time. Given that the Fund has instead generated considerable outperformance over a short period of time, I suggest that the Fund’s recent history may not serve as a reliable guide to its future performance.
During the past quarter, the Fund made no major changes to its regional composition. Apart from a modest reduction in the portfolio’s exposure to the industrials sector, the Fund’s sector allocation went largely unchanged.
Early in the quarter, the Fund exited two manufacturing companies: Dry Cell, a very small Vietnamese producer of automotive batteries, and Keppel Corp., a Singaporean off-shore oil rig builder. Dry Cell constituted a small but moderately successful investment within the portfolio. The Fund exited the stock on valuation grounds, and because the position might prove difficult to scale over time.
The Fund exited Keppel not because of concern for the health of its rig-building business, but rather because the recently appointed CEO executed a dubious transaction. In January, Keppel announced an expensive tender offer to privatize one of its subsidiaries, a property development company known as Keppel Land. Keppel’s management seemed to view the acquisition as a cost-effective way to diversify the company’s earnings away from the troubled oil industry. Seafarer took the opposite view, as the transaction seemed inordinately expensive, and unnecessary given that Keppel already enjoyed control over the subsidiary in question. The Fund quit Keppel’s shares shortly after the announcement.
The Fund did not accumulate any new positions during the quarter.
At the margin, Seafarer is paying closer attention to Brazil, where the stock market has declined in tandem with the local currency, the Real. We believe that, despite the country’s difficult economic environment, there are a number of valuable, well-run Brazilian companies that have seen their capitalizations dwindle when translated to U.S. dollar terms. Such companies produce steady profits, and are capable of sustained growth; some even enjoy substantial domestic or global market share within their respective industries. Yet the Real’s sharp decline has meant the valuations of these companies have declined to unreasonable levels – legitimately “mid-sized companies” have become “small caps” through no fault of their own, but rather because of the Real’s movement.
Seafarer’s goal is to find such companies, and then to research them sufficiently well so the Fund may invest steadily over the long term. If the Fund does so, I am confident that the capitalizations of such companies will eventually recover, thereby reflecting the companies’ true worth as expressed in U.S. dollars. For Seafarer, the key to a country such as Brazil – a country with an unstable currency, and myriad economic woes – is that our research process must pay extra attention to the quality of the underlying assets that support each business. We must know the businesses well enough to hold them despite the currency’s volatility, and against prevailing macroeconomic headwinds. If the Fund can find high-quality businesses and hold them over a long horizon, I am confident that short-term currency movements will ultimately “come out in the wash,” and that global investors will come to recognize the true value of such companies. This in turn will be reflected in larger capitalizations as expressed in dollars – though whether such appreciation will be reflected in stock price growth, currency appreciation or a combination of the two is unknowable at this time.
In the immediately preceding Portfolio Review, I stated that in the next year or so, “the conditions that induced weakness among the emerging currencies [would likely] continue, but ultimately moderate.” Three months later, it appears this statement was right and wrong at once. I was correct in my assertion that the forces that drove currency weakness are still very much at work; but I was wrong to suggest that moderation lay ahead – several emerging market currencies suffered pronounced declines during the first quarter.
Still, I will stick by my original statement: while currency weakness may continue for the immediate moment, I believe that such pressures are set to abate. The dollar has risen very far, very quickly; I question whether such a pronounced gain will prove sustainable. Even if the dollar retains its strength, I have observed enough evidence to believe that the growth in corporate profits within the emerging markets will stabilize this year (as opposed to decelerate sharply, which was the case for the three preceding years). There is even a reasonable chance that profit growth might re-accelerate modestly over the next two or three years. I believe this shift in growth – from deceleration, to stability, and possibly to re-acceleration – will be enough to underpin emerging currency values, arresting their decline.
I will close with a brief comment on India. The election of India’s government in 2014 lifted equity prices in the country, based on the prospect of economic reform. The challenge for Seafarer is that this politically fueled enthusiasm has rendered most stocks quite expensive. I find this strange: while I understand the excitement over reform, I doubt whether all (or even most) publicly-listed companies will prosper in the post-reform era.
I think a small number of companies might do very well in that era, and thus their stock prices will over time prove to be cheap, even if their present valuations appear elevated. However, the vast majority of stocks are “priced for near perfection,” as if every one will be a “winner” from reform. I think this has rendered most stocks excessively valued. Seafarer must distinguish between the first, small group of stocks, and the second, larger group. Still, I acknowledge that important change may be coming. During a trip to India earlier in the quarter, I met with a construction company that participates in major infrastructure projects across the country. In the meeting, I was impressed that there were a number of subtle signs that infrastructure spending and investment might finally take off in the country. Projects that had previously been stalled for years were quietly moving forward. If so, India might finally realize observers’ long held – and long frustrated – hopes for sustained growth.
Thank you 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 March 31, 2015, Sun Pharmaceutical Advanced Research Company comprised 3.6% of the Seafarer Overseas Growth and Income Fund. The Fund had no economic interest in Dry Cell & Storage Battery JSC or Keppel Corp. 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) returned 8.58% during the quarter.
- The Fund’s Investor share class began the quarter with a net asset value of $10.95 per share. It paid no distributions during the quarter, and finished the quarter with a value of $11.89 per share.
- As of March 31, the annualized return of the Investor share class over the preceding three years was 8.08%.