During the second quarter of 2016, the Seafarer Overseas Growth and Income Fund gained 2.92%.1 The Fund’s benchmark, the MSCI Emerging Markets Total Return Index, rose 0.80%. By way of broader comparison, the S&P 500 Index gained 2.46%.
The Fund began the quarter with a net asset value of $11.26 per share. During the quarter, the Fund paid a semi-annual distribution of approximately $0.088 per share. This payment brought the cumulative distribution, as measured from the Fund’s inception, to $1.260 per share.2 The Fund finished the quarter with a value of $11.50 per share.3
Measured from the beginning of the quarter, the Fund and its benchmark traveled within a relatively narrow corridor, swinging modestly between negative and positive performance. Relative to the pronounced volatility that has characterized the emerging markets for the past several years, this was the first relatively calm quarter in quite some time.
This stable performance of emerging markets was all the more notable given that it occurred despite “Brexit” (the United Kingdom’s choice, enacted by national referendum, to exit the European Union, or EU).
Still, the performance of currencies in the developing world was mixed. Some of the currencies that had depreciated sharply in the past few years rebounded (e.g., the Brazilian real rose about 10%, and the Russian ruble about 5%); whereas currencies that had enjoyed relative stability showed signs of weakness (e.g., the Chinese renminbi slid about 3%, and the Indian rupee fell roughly 2%). Disconcertingly, the Mexican peso and the Polish zloty both weakened precipitously, both falling about 5.5% during the quarter.
The Fund’s outperformance during the period was spurred by holdings domiciled in Brazil, South Korea and Japan, whereas the Fund’s holdings in Poland acted as a drag on returns.
One of the Fund’s oldest positions in Brazil, Odontoprev, performed particularly well during the quarter. The Fund has held a position in the company since the summer of 2012. The company’s revenue growth has decelerated since that time: Odontoprev once grew its revenues at a rate between 15% and 20% per year, but has more recently experienced revenue growth closer to 8% and is forecast to expand approximately 10% next year. Nevertheless, the company has distinguished itself in that its business has expanded even as Brazil’s economy has shrunk; and during this time it has produced a remarkable EBIT margin, comfortably in excess of 20% every year. Odontoprev’s continued growth and consistent profitability has allowed the company to pay a steady dividend that has expanded since the time of the Fund’s first investment.
The reason for the stock’s pronounced increase in the second quarter is not immediately clear. The financial performance of the company (i.e., the “fundamentals”) is largely unchanged and does not explain the sudden gain. The company won a favorable judgment for one of its subsidiaries from Brazil’s Supreme Court. The judgment suggests Odontoprev will operate under fewer regulatory burdens in the future, and thus may be able to augment its dividend payments, though the ultimate consequences of the case are not certain at this time. The recent increase in the share price seems to have exaggerated the prospective benefit from the judgment, in any case.
The Fund also gained due to other Brazilian holdings, particularly Banco Bradesco (one of the country’s largest private sector banks) and TOTVS (a software company). Both holdings moved higher in tandem with the gains in the overall market.
Samsung Electronics also played a material role in the Fund’s performance. Samsung is based in South Korea and is a globally recognized producer of consumer goods, especially technological products, mobile phones and televisions. The Fund’s holding in Samsung is based on several features of the company’s financial condition. First, the company has nearly $60 billion in net holdings of cash, which constitutes over one quarter of the company’s market capitalization. Second, it produces substantial free cash flow, and, given its current stock price, the cash flow gives rise to an attractive yield. Further, the Fund owns Samsung’s preference share, in lieu of the company’s common stock. The preferred share is priced at a material discount to the common, and that discount enhances the yield of the preferred share relative to the common.
Third, though Samsung’s growth has moderated in recent years, it may yet reaccelerate. Samsung is a dominant competitor in markets for semiconductors and display panels, and important developments in both may buoy Samsung’s growth over the next decade. Fourth, and most importantly, Samsung’s dividend has grown faster than its earnings over the past three years.
The Fund’s lone and long-time holding in Japan, Hisamitsu Pharmaceutical, saw its share price reach an all-time record during the quarter. The company’s shares surged after the company announced strong profitability, improved growth prospects, and an attractive share buyback program. The bulk of Hisamitsu’s revenues are derived from sales in Japan and the U.S.; in its annual report, the company suggests that less than 10% of its sales are derived outside those two markets. However, in practice, Hisamitsu has an extensive branding and distribution network that covers markets such as Brazil, Vietnam, Indonesia and China. It is a well-known brand in many parts of the world, particularly emerging Asia. The Fund has owned shares in Hisamitsu not only because of its attractive cash flow, but also because of the prospect of realizing greater growth from the developing world in the future.
The Fund’s holdings in Poland created a substantial negative drag on performance, in contrast to the preceding quarter. The Fund has three positions in the country, and all three lost substantial ground during the quarter. The losses were in part due to the zloty’s weakness versus the dollar; yet all three positions individually declined in excess of 10%, even when measured in local currency terms. The stock market in Poland has fallen as of late, in response to local politics and EU-related woes.
The current Polish government has demonstrated economic tendencies best described as “interventionist,” and the resulting pronouncements have unsettled global investors and given bond-rating agencies fodder for downgrades. Meanwhile, the “Brexit” has prompted substantial doubt about the EU’s longevity and its future. This is critical for Poland. Not only is the country a member of the EU, the Union is also the country’s largest trading partner. Poland’s outlook is obviously difficult right now. Yet, I remain impressed with the caliber of most companies in the country, along with the people that run them. The Fund has maintained its holdings there as they offer a unique combination of low valuations and conservative management practices. One day they may also offer improved prospects for growth.
The Fund’s structure underwent a few notable changes during the quarter.
The Fund trimmed its equity exposure in Brazil after seeing it appreciate in the first half of the year. At the outset of 2016, the Fund held a substantial “overweight” to Brazil, via an allocation of approximately 14.5%, versus a weighting in the benchmark index near 5.5%. Over the ensuing six months, the Brazilian stock market and the local currency gained.
On the back of those gains, the Fund steadily “trimmed” its exposure to Brazilian equities. It also replaced some of the outgoing equity exposure with a dollar-denominated corporate bond (Cielo, as discussed in the first quarter 2016 portfolio review) and with a local currency sovereign bond. The Fund finished the second quarter with an allocation to Brazil near where it started the year (approximately 14.5%). Had the Fund done nothing, the Fund’s allocation to Brazil would have grown well past this level. The Fund remains “overweight” Brazil, but the magnitude of the overweight has diminished, as the index now hovers near 7.5%. Furthermore, while much of the “overweight” allocation at the outset of the year was accomplished via equities, a meaningful portion has been replaced with fixed income. Roughly 3% of the 14.5% allocation is now in bonds.
As the Fund “trimmed” its exposure to Brazil, it exited its holding in the preferred shares of Vale, a global-scale mining company. The Fund first established that position in January of 2013. Since that time, the company’s shares performed poorly. At their recent nadir, in January of 2016, the price on the preferred shares had fallen in excess of 90% relative to the Fund’s first purchase, when measured in dollars.
Seafarer estimates that the Fund’s internal rate of return from the position was materially better, for three reasons. First, over the holding period, the Fund received dividends from Vale. Second, the Fund did not sell at the January nadir, but instead exited between March and May, at marginally better prices. Third, the Fund dynamically weighted the exposure to Value between its entry and its exit, and this blunted a portion of Vale’s losses.
Still, the position imposed a substantial drag on the Fund, contributing an estimated -2.1% cumulatively to the Fund’s performance since 2013. Most observers would understandably assume that I consider the investment to be a “mistake.” I do not. I would describe it as a “normal error,” though one with consequences that were realized in the extreme.
When the Fund entered Vale’s preferred shares in 2013, it did so only after a substantial amount of work to “stress test” the company’s financial condition under extreme operating conditions, with depressed ore and metal prices. The company ultimately faced actual conditions that surpassed our stress test. Even so, its cash flow mostly met our expectations. Vale is remarkably cash generative, even under such stress. However, the share price swung lower than we imagined possible. Even with the benefit of hindsight, I believe the original analysis was reasonable, given that it rested on a probabilistic view of an uncertain future – as is the case with all forecasts and fundamental analysis.
Certainly, with hindsight, I would approach the analysis differently. However, such hindsight is a luxury that is never available in the present. In order to invest, one must assess probabilities that encompass substantial uncertainties, cope with unknowns, and accept that errors will occur. At Seafarer, we are acutely aware that even if we do our best work, the odds of success will only be a bit better than a coin flip, or a dartboard. Errors happen.
To that end, I find it useful to distinguish between an investment “error” and a “mistake.” The former is akin to an error in baseball: they will happen, like it or not; they are a part of the game, despite best efforts and training; they affect outcomes. Errors can be mitigated in frequency and impact, but not eliminated, because investment entails uncertain outcomes. The latter is something that should not happen, but does when the investment process is not executed properly. I think of a mistake as akin to intentionally subverting proper technique in a sport, perhaps by taking some sort of shortcut.
In my view, Vale was a routine error, albeit a relatively spectacular one. Why did it seemingly go unchecked? It did not: though Vale’s decline was steep, at each stage the holding played an important ancillary role within the Fund’s portfolio. Our analysis suggested Vale had unique fundamental merits, which it mostly demonstrated, even under stress. However, it also served as a hedge, a means to offset the risks that underpinned the remainder of the portfolio.
When I established the Fund in 2012, I held the view that China’s growth would fall below (perhaps disastrously below) prevailing expectations. Consequently, I sought holdings whose performance I thought would be resilient in the event of a “let down” in growth forecasts. Most of the Fund’s holdings were selected with this view in mind.
At the same time, I was aware that my view on China was based on probabilities, not certainties. I was concerned that the portfolio’s underlying strategy might backfire if events played out differently. Thus when I put the portfolio together, I sought a few high quality issuers that could meet the Fund’s normal growth and income criteria, but which might also offset the risk that the underlying strategy was wrong. Vale was introduced to the portfolio on its own merits, but it served a second purpose, acting as a hedge against the probability that China’s economy was resilient.
In the end, the portfolio’s strategy worked as intended. Vale faced stressed conditions, more so than we forecast. Yet its financial performance never fell dramatically below our stressed expectations, even as the stock price did. It was a difficult experience, but I would make the same decision again, if presented with the same probabilities.
The Fund sold Vale in May, not necessarily because the stock was expensive or because its financial performance was irrevocably ruined. Rather, the Fund exited because there were better investment opportunities available; because the Fund no longer needs to hedge against an unexpected acceleration in China; and because the Fund could opportunistically harvest some long-term tax losses.
There were two notable positions added to the Fund during the quarter: Pou Chen, a Taiwan-based holding company with two main subsidiaries, one that produces athletic footwear and another that retails sportswear; and Vanguard Semiconductor, a Taiwan-based semiconductor foundry, serving the fabrication needs of firms that design computer chips.
Pou Chen was added to the Fund because, as a holding company, it enjoys substantial cash flow from its subsidiaries; that cash flow appears to conform to the requirements of the growth and income strategy, both in terms of its prospective growth and its current yield. However, Pou Chen’s supplemental benefit is that it oversees a complicated balance sheet that may, over time, become simplified. If it does, the company and its shareholders may realize additional value that exceeds that derived from its operating subsidiaries alone.
Seafarer recently posted a video commentary that discusses Vanguard and the features that led to its inclusion in the Fund. The discussion of Vanguard begins roughly at the 14:27 mark in the video, and ends at the 21:21 mark.
My opinion regarding the outlook for emerging markets has not changed materially from that of the preceding portfolio review for the first quarter of 2016.
If I could re-write that commentary, I would make two modifications. First, I would clarify that valuations for emerging market stocks, when measured in aggregate, do not include much hope for a recovery or re-acceleration in earnings growth. There are certainly wide variations in valuations across industries and individual stocks – some are ostensibly quite expensive, implying an expectation for substantial future growth. However, in my opinion, when measured in aggregate, stocks in the developing world are not priced in a manner that implies aggressive assumptions for growth.
This is important because, if growth re-accelerates even marginally, in unexpected fashion, the response from equities could be pronounced. However, I wish to remind everyone that corporate financial performance remains weak, and I see little sign as yet that there is any fundamental improvement underway. Still, stock markets often anticipate improvement or deterioration before it actually occurs.
The second modification I would make would be to re-emphasize some of the financial risks that currently surround the Chinese economy. I have written on several occasions about elevated risks there (for example, the fourth quarter 2015 portfolio review and the Letter to Shareholders for the period ended October 31, 2012).
In my preceding portfolio review, I wrote, “there are two competing tensions within the emerging markets, each of which is vying to shape the investment outlook for the next 12 to 24 months. The first tension is that economic conditions generally favor lower interest rates, and the resulting cuts might stimulate growth. The second tension is that regardless of whether rates are headed lower, growth is very sluggish at present, so much so that monetary stimulus might prove useless.”
I stand by this statement. However, when I wrote it, I casually assumed that readers would understand that I was simultaneously quite concerned about liquidity conditions in China. In hindsight, I regret that I made this assumption, and consequently wrote something unclear. I would prefer to amend my prior statement to the following: “there are two competing tensions within the emerging markets, each of which is vying to shape the investment outlook for the next 12 to 24 months, provided that China’s liquidity conditions do not deteriorate markedly, in which case any resulting difficulties will likely dominate all other considerations.”
Apart from these two modifications, I encourage investors to consider two additional issues.
First, given the “Brexit,” investors must give serious consideration to the idea that this event will not be a “one off,” and that the European Union may not hold together in its current form. I do not think it is a foregone conclusion that the EU will necessarily come undone; in fact, I would not even consider it the dominant probability. Still, the UK’s decision to exit will likely weaken the ongoing union, and give voice to those in other countries who wish to exit, and the end result may be further disrepair.
Personally, I think the situation will be binary: either the EU will reinvent itself in a positive and cohesive manner, thereby giving member nations strong incentive to remain, or the EU will ignore the implications of the UK’s decision, and hunker down “as is,” and consequently watch further nations peel away. Regardless of one’s view, investors must weigh the probability of a break-up more prominently. At this time, I do not know what such a break-up might mean for the emerging markets, though I imagine it will be critical to pay attention to any international trade alliances that either wither or flourish as a result.
Second, I suggest that investors re-examine their presumptions regarding emerging market currencies. I question the orthodoxy where higher interest rates in the U.S. will necessarily beget further depreciation among developing country currencies.
When Seafarer launched in 2011, the U.S. dollar was under stress. In August of that year, Standard and Poor’s (S&P) downgraded its credit rating for U.S. debt. At the time, the widely reported sentiment was that the U.S. dollar would weaken against hard assets (gold, silver), commodities (oil in particular), and alternative currencies (particularly emerging market currencies). In fact, only a few days after the downgrade, the dollar arrested its decline versus developing world currencies and began a long-running bull market, contrary to popular sentiment.
Please see the chart below for the MSCI Emerging Market Currency Index. The index is comprised of a basket of currencies, whereby each currency’s weighting in the index is determined by the corresponding country allocation in the MSCI Emerging Market Total Return Index (which serves as the Fund’s benchmark). When the line on the chart is rising, the emerging market currencies are appreciating versus the dollar; when the line is declining, emerging markets are depreciating versus the dollar.
Today, the prevailing view seems to be that the dollar will inevitably climb versus emerging market currencies, at least insofar as the U.S. Federal Reserve (“the Fed”) continues to increase rates. This view is based on the belief that higher U.S. rates will entice capital to exit the developing world, in search of better prospects at home (or, to pay off debts given higher funding costs).
Certainly, this view has been evident in the currency markets since May 2013. At that time, emerging market currencies suffered as the Fed announced it would gradually wind down its “quantitative easing” program (this came to be known as the first “taper tantrum”). Curiously, though, from the date the Fed actually raised rates in December 2015, emerging market currencies have mostly stopped declining against the dollar. The belief that emerging market currencies would collapse after a rate increase seems misplaced – at least so far. Yet again, currency markets have behaved in a manner nearly contrary to popular sentiment.
Please note that even as I would encourage investors to examine their assumptions regarding currencies, I am not implicitly offering a prediction of my own. I have no idea what the dollar will do next. In fact, I reject currency forecasts of any sort – including my own. Foreign exchange markets are generally the most liquid financial markets, surpassing all other asset classes. I think this liquidity makes them highly efficient, and consequently impossible to anticipate. I do not have an outlook of my own; I would only encourage investors to re-assess their assumptions. What might seem obvious was likely priced into the market months or years ago, and therefore is useless in understanding what might happen next.
We appreciate your decision to entrust us with your capital. We are both privileged and honored to serve as your investment adviser in the developing world.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 MSCI Emerging Markets Currency Index tracks the performance of twenty-five emerging-market currencies relative to the US Dollar. The Currency Index measures the total returns of the currencies of countries in the corresponding MSCI equity index (i.e. MSCI Emerging Markets Index). 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 June 30, 2016, Odontoprev SA comprised 3.8% of the Seafarer Overseas Growth and Income Fund, Banco Bradesco SA, ADR comprised 3.2% of the Fund, TOTVS SA comprised 3.5% of the Fund, Samsung Electronics Co., Ltd. comprised 4.6% of the Fund, Hisamitsu Pharmaceutical Co., Inc. comprised 2.8% of the Fund, Cielo SA comprised 1.0% of the Fund, Pou Chen Corp. comprised 2.4% of the Fund, and Vanguard International Semiconductor Corp. comprised 2.1% of the Fund. The Fund had no economic interest in Vale. 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) gained 2.91% 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 $11.23 per share; it paid a semi-annual distribution of approximately $0.087 per share during the quarter; and it finished the quarter with a value of $11.47 per share.