Pursuing Lasting Progress in Emerging Markets®

Letter to ShareholdersAnnual Report

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Dear Fellow Shareholders,

I am very pleased to address you for the first time on behalf of the Seafarer Overseas Growth and Income Fund.

After several months of planning and preparation, the Fund was launched on February 15; as of April 30, the Fund completed its first (truncated) fiscal year. In the months leading up to the launch, Seafarer endeavored to ensure that it was equipped with the right people, processes and compliance to support the Fund’s long-term goals.

We believe the Fund offers a unique new strategy to its shareholders. At its heart, it is a global emerging market fund; however it employs an approach that is less conventional than many peers, in that it can utilize multiple asset classes (equities, convertible bonds and fixed income) and it has a broad geographical mandate, spanning markets that are variously categorized as “frontier,” “emerging,” and “developed.”

We think a broader approach of this sort will serve the Fund best, allowing it to adapt to the complex evolution underway in the developing world. One of the Fund’s principal strategies is to offer shareholders a relatively stable means of participating in a portion of developing countries’ growth prospects, while providing a degree of downside protection. We measure our success in that regard in comparison to a benchmark index that tracks the common stocks of developing countries. Though some clouds hang over the emerging markets, we believe that growth and progress will continue to accumulate in the developing world, and we are pleased to offer a Fund that seeks to participate in the opportunities afforded by such progress.

The timing of the launch has proven somewhat challenging. During the eight weeks prior to the Fund’s launch, developing equities traded mostly upwards. Subsequent to the launch, emerging stocks have alternated between breathless one-day gains, and sharp declines that have undone any forward progress. The end result has been that stocks in developing markets have trended lower since the Fund’s inception.

Amid this environment, I was cautious about deploying the Fund’s initial capital too quickly, and thus the Fund carried a substantial allocation to cash (generally ranging between 10% and 20%) during the first several weeks of its existence. However, by April 30, the cash level was set near 6%, roughly in keeping with our long-term intention—we plan for the portfolio to be 95% to 100% invested under most circumstances.

China and Europe

Emerging market equities have been volatile over the past several weeks for two main reasons: there are concerns over whether growth is slowing in China, and fears that Europe will undergo economic disintegration, with negative consequences for the rest of the world. I share both concerns, but with important caveats.

Regarding China: starting in the latter half of 2009, my research indicated that the country’s growth would necessarily slow. When China began its exceptional development over three decades ago, the country was poor, terribly unproductive, and bereft of capital. Under Deng Xiao Ping, the country opened its markets and undertook needed reforms. What followed was thirty years of astonishing expansion, as the country’s intrinsic productivity was unleashed. Now, China no longer suffers from a shortage of capital—indeed, it enjoys an excess of it—and it no longer enjoys the benefits of growing from a depressed base. The easiest gains have been made, and the bar for growth is now higher.

Inevitably this means that growth will moderate. However, even as the pace of expansion slows, I see ample evidence that suggests that the residual growth is improving in its quality and sustainability. China is beginning to shift from an economy that is dependent on external markets and physical capital (investment-heavy and export-led), to one that emphasizes domestic demand, services industries, and human capital. China’s model for growth is changing, but I still find it attractive. Still, the transition is likely to be opaque and occasionally rocky. Change always rattles markets, and China will be no exception. Global investors have grown comfortable with a simple and consistent growth story in China. As change unfolds, fear will be stoked, giving passing credence to the country’s doubters. One can never rule out the risk of a “hard landing” in China, but I think the current chatter is a red herring. Absent any major disruption in China’s evolution, I intend for the Fund to stay invested there, and to capitalize on the important change that is underway.

As for Europe, I hold very little hope that the Eurozone, as currently defined, will survive intact. My analysis is basic. It has long been apparent that the Eurozone did not embrace fiscal integration sufficiently to ensure the viability of a single currency. Thus I view the present Eurozone’s persistence not as an economic project, but rather a question of political will. Given Europe’s history of war and conflict, I harbor no doubt that substantial will underpins the dream of a unified currency, even now. However, as it has become clear that the rigidity imposed by the euro will leave a generation of young people in Greece and Spain without jobs or hope, the moral force behind the currency will deteriorate. Ironically, the constraints inherent in the euro may beget the very ugliness and instability that a unified currency was intended to mitigate. Exit really may be the best way forward for some of the peripheral countries, especially Greece.

In my view, the only unresolved questions are related to timing, and whether the eventual disintegration will be orderly or chaotic. My basic assumption is that Greece will exit the union within the next few years, and possibly much sooner; Spain and other countries may also exit, but not necessarily so. A smaller, more coherent Eurozone will likely persist, even if some member nations exit. Regarding Greece’s potential exit, I believe there are mechanisms that would allow it to do so in an orderly fashion, but what will happen is impossible to predict. For this reason I have been cautious about the Fund’s exposure to Eastern Europe. Stocks there may suffer from Europe’s woes – though if the disintegration proves chaotic, and the convertibility of major currencies is suspended to prevent panics and capital flight, few markets around the world will go unscathed. Nonetheless, Seafarer’s research efforts are trained on Eastern Europe on the premise that any subsequent sell-off could provide attractive opportunities to accumulate new, long-term holdings.

It might seem incongruous that I would express concern over the euro’s future, but at the same time position the Fund so that it is near full investment, largely in stocks. I have done so for one simple reason: valuations on emerging equities are very appealing in my view. In my career, I have witnessed only two moments where valuations were definitively more attractive than the present, and both occurred at the nadir of panics—the 1997 Asia financial crisis, and the 2008 global financial crisis. Present valuations are not quite so low, but are verging on those levels. The threat that emanates from Europe is severe, but at this moment I do not believe it is as grave as either of those episodes—and markets seem to have already discounted much of the potential for loss. To be sure, valuations may decline further, particularly if Greece’s departure from the currency union triggers cascading bank runs. Even still I believe that present valuations are quite attractive, particularly for investors who can summon the patience to hold for the long term, and persist through what may be considerable volatility. In any case, I intend for the Fund to remain largely invested in equities for the foreseeable future, absent a major structural change to the market environment.

Persistence and Patience

Persistence and patience are important background elements of Seafarer’s investment approach, as can be observed in one of the Fund’s largest holdings, the stock of an Indian company called Infosys. The company offers systems integration and consultancy services to a global client base, and it happens to be one of the first stocks that I researched in the Indian market, over a decade ago.

Infosys recently published its financial results for the latest fiscal year. The reported profits fell a bit below consensus forecasts, and revenues were short of expectation; management’s outlook for the coming quarter did not bolster confidence. The stock immediately swooned on the news, triggering its largest one-day decline in the past nine years. Infosys is now somewhat of a “fallen angel,” as sell-side analysts advocated selling the stock, and published reports with headlines such as “Weakness Writ All Over” and “Loss of Competitiveness.” For the record: during the year in question, Infosys produced sales growth in excess of 15%, profit growth in excess of 15%, pre-interest and tax profit (earnings before interest and taxes, or EBIT) margins of nearly 30%, and it boosted its annual ordinary dividends by 8%.1 Some observers bemoaned the company’s tepid outlook for revenue growth, even as the company signed on 52 new clients during the quarter (12 from the Fortune 500), which set a company record. At least one analyst still called the results “dreadful.”

I have complete disdain for such dubious analysis. I acknowledge that Infosys had a poor quarter, and its immediate outlook is weak. Yet the extent to which some investors have written off the stock is astonishing. Their disproportionate response seems to lack any sense of context, history or patience.

Infosys remains an incredibly well run company. For example: take the aforementioned measure of profitability, the company’s EBIT margin. It is a measure of a company’s core profit from operations, assessed on a pre-tax basis. In my own estimation, Infosys’ margins are not remotely dreadful but rather exceptionally high. Few companies can produce this sort of profitability, regardless of industry or size.

What is so impressive is that the EBIT margin has been sustained, even after the company has grown so large. A decade ago, when the company was much smaller, there was an intense debate among stock analysts as to whether Infosys could maintain its EBIT margins around 28% to 29%, or whether competition would force margins below 25%, before they ultimately settled at 20%. Meanwhile, those same analysts assumed the growth of the company would decline. In contrast to such predictions, Infosys has sustained its margins at levels that exceeded even the highest expectations of that time: the EBIT margin has hovered around 28% to 29% over the past ten years.2 The company has produced that profitability even as it has grown its revenues nearly thirteen-fold. Today Infosys has approximately $4 billion of cash on hand, zero debt, and is primed to make new acquisitions to stimulate its growth, if needed. If only I could arrange a hypothetical conversation between the finicky analysts of yesteryear and the fickle analysts of the present: perhaps the former could impart some perspective and patience to the latter, but I doubt it.

I don’t know what causes the restless trading that characterizes modern markets. Perhaps the tremendous improvement in communications technologies, combined with greatly enhanced access to information, causes some investors to be hyperaware, overly sensitive to even temporary setbacks. Markets now seem to operate on the same compressed and superficial timescale that drives 24-hour cable news stations. Many investors are disappointed by anything short of continuous improvement and instantaneous change. In my experience, progress and change in the developing world accumulates at a slower, more deliberate—but still impressive—pace. Human organizations do not turn on a dime. Yet when they do turn, it can be a powerful, value-creating event. Only patience and persistence unlock such gains, not impatient, unsteady investment. We intend to practice the former.

Seafarer, the Fund and Our Goals

Seafarer was founded last spring with one main goal: to become an adviser to public mutual funds, registered under the 1940 Investment Company Act. Some folks today are frustrated with mutual funds as an investment vehicle, given their relative tax inefficiency3 and the costly nature of their distribution.4 I concur on both points. Yet starting a new investment adviser has only reaffirmed my belief in the underlying structure of mutual funds. In an age in which investment vehicles have been plagued by ponzi schemes, exacerbated liquidity risks, and shoddy valuation practices, I remain utterly impressed with the foresight and care that went into the creation of the 1940 Act. In my view, any drawbacks inherent to mutual funds are vastly outweighed by the accessibility, liquidity, transparency, reasonable costs and fiduciary protections that funds provide investors.5 Seafarer is honored to serve as the investment adviser to your mutual fund.

At Seafarer, our abiding goal as an investment adviser is to deliver long term performance. However, even as I view performance as paramount, I will not consider our firm a success unless it also achieves three ancillary objectives over the long term:

  1. Seafarer is dedicated to lowering the costs associated with overseas investment. Investment in developing countries is legitimately an expensive proposition; and the Adviser’s small asset base hampers our ability to pass on further economies at the present moment. However I view it as one of the firm’s central duties to ensure that expenses become more affordable with scale, and over time.
  2. Seafarer is determined to increase the transparency associated with its investment in developing countries. My aim is for Seafarer to continuously improve the transparency it offers to its clients, albeit subject to constraints imposed by fiduciary standards, regulation and compliance.
  3. My hope is that Seafarer can reduce some of the frustration that often accompanies investment in developing countries. Seafarer’s investment strategies are necessarily exposed to risk, and the results cannot escape the impact of market volatility. However, my hope is that Seafarer’s investment strategies will mitigate at least a portion of this volatility, so that clients may invest with less frustration and more confidence over time.

Thank you for entrusting us with your capital. We are honored to act as your investment adviser, and we look forward to serving as such for many years to come.

Andrew Foster,
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 4/30/2012, Infosys Ltd. ADR comprised 3.7% of the Seafarer Overseas Growth and Income Fund. Holdings are subject to change.
  1. Source: Factset. Growth rates measured in U.S. dollar terms, on a year-on-year basis, using year-end market-based exchange rates between the Indian Rupee and the U.S. dollar. When measured in Rupee terms, or when measured using a static exchange rate, the company's growth rates are considerably higher. Regarding the annual ordinary dividend growth calculation: in fiscal year 2010-11, Infosys paid a “30th Year Special Dividend” on a one-time basis. If this dividend is included in the measurement of Infosys' dividend growth for fiscal year 2010-11 to 2011-12, gross dividends fell 39% year-on-year.
  2. Source: Factset.
  3. Tax efficiency: under certain circumstances, exchange traded funds (ETFs) may be able to avoid realizing capital gains. This feature of ETFs may render them more tax efficient than a traditional mutual fund that employs the same strategy. For more advice on this topic, please consult your tax advisor. You may also find background information on the Morningstar website under the topic Untangling ETF Tax-Efficiency Myths.
  4. Costly distribution: under certain circumstances, the distribution of traditional mutual funds may be costly relative to the distribution of exchange-traded securities. Mutual fund distribution may entail “loads” (commission-like fees), 12b-1 fees (fees paid by a fund to ensure its distribution), or ongoing payments by a fund’s advisor to ensure distribution. The aforementioned payments may or may not be transparent to a fund’s shareholders. By contrast, transactions in exchange-traded securities (such as a stock or an exchange-traded fund) typically incur a more limited (but still substantial) set of costs, arising from brokerage commissions and price “spreads.” For more information on this topic, please see the Securities and Exchange Commission’s discussion of mutual fund fees.
  5. Perceived benefits of open-end, no-load mutual funds: it is Seafarer’s opinion that mutual funds offer certain benefits to shareholders that are absent from or diluted in other investment vehicles. Those benefits include (but are not necessarily limited to): daily valuation of a fund’s investment holdings; daily redemption and subscription privileges by shareholders, priced at the fund’s net asset value; regulations that proscribe the liquidity of the underlying portfolio holdings; semi-regular, public disclosure of portfolio holdings; oversight by an independent Board of Trustees; external audits, and separate custody of the investment portfolio; asset based fees, in lieu of performance fees; and fiduciary standards proscribed in the body of law and regulations that defines public mutual funds.