Pursuing Lasting Progress in Emerging Markets®

Letter to ShareholdersSemi-annual Report

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Dear Fellow Shareholders,

I am pleased to address you again on behalf of the Seafarer Overseas Growth and Income Fund.

During the first six months of the Fund’s 2012-13 fiscal year (May 1 – October 31), the Investor and Institutional share classes of the Fund gained 7.13% and 7.16%, respectively. By comparison, the Fund’s benchmark, the MSCI Emerging Markets Total Return Index, declined -1.01%. The team at Seafarer is pleased with the Fund’s performance to date; however, we are cognizant the Fund is very new, and that our work has only just begun.


A brief note on current market conditions: in the preceding letter to shareholders, I stated, “valuations on emerging equities are very appealing.” I draw your attention to that remark because conditions today are somewhat different. Valuations on many emerging market equities have risen, even if the index has not. In the meantime, the growth of profits, while still positive, has decelerated. In my own opinion, stock valuations are now broadly fair.

To be sure, valuations are not excessive when judged relative to history or the potential for future growth. Yet they are no longer especially attractive, in light of both well-known risks (e.g., slow growth in Europe and the possible dis-integration of the Euro; China’s slowing growth; and fiscal problems in the U.S.) and less-appreciated threats (e.g., the potential for conflict in Syria, Iran or the South China seas). More subtly, it is my opinion that the consensus forecast for profit growth in the emerging world has crept beyond reality. Disappointment will likely ensue, and if I am correct, stocks will gyrate. Investors who wish to safeguard a reasonable expectation of profits should be prepared to hold over a long horizon – at least three years – and through what may be considerable volatility.

China’s Future

In the preceding letter to shareholders, I discussed the changing nature of China’s economy. I made two points: first, the rate of growth in China is declining, and because the deceleration stems from structural causes (as opposed to cyclical ones), it will most likely be permanent. Second, the nature of China’s growth model is also changing, moving away from external and infrastructure sectors, and moving toward sectors that favor domestic demand, human capital, and especially services. I am going to revisit China’s evolution here, not only because it warrants your attention, but also because – to state the obvious! – it is highly complex, and challenging to navigate within the context of a long-term investment portfolio.

The pace of China’s growth is slowing amid transition, but its economy still has plenty of untapped capacity to grow, and perhaps in a more sustainable fashion. This latent potential is most visible in the country’s stunted and underdeveloped services sector, which in my view is leading the current transition. By “services,” I mean a broad spectrum of industries, comprising the consumer (e.g. health care, tourism and leisure); commercial (e.g. media, advertising, publishing, distribution, data processing, software and personnel management); and industrial (e.g. transport, logistics, pollution abatement, systems management).

Bright Prospects

China’s modern economy is decidedly pluralistic. However, over the past six decades, the country’s leadership has mostly favored a command-style system, and it has used its control over the economy to steer resources towards tangible, scalable manufacturing industries. The leadership’s intent was to induce growth and employment; yet it has resulted in an economic model that is unbalanced, as it is overly reliant on exports, construction, and investments in physical infrastructure. By contrast, China’s leadership has mostly overlooked (and perhaps even fears) the small-scale, intangible, information-intensive industries that comprise the services sector.

The consequence of this is that China’s modern service sector is puny by any reasonable measure. I estimate the private service sector comprises roughly one third of total output, whereas the equivalent ratio is 68% in the U.S.1 The low proportion of services within the economy means that if China can encourage growth in the sector – or at least not hinder it – it has plenty of room to expand.

In this respect, I believe present-day China is possibly analogous to the U.S. in 1947. Sixty-five years ago, private sector services accounted for only 48% of U.S. GDP.2 For the next six and a half decades, the service sector led our country’s growth, such that it now accounts for over two-thirds of output.3 I believe China’s evolution will follow a similar path, and indeed the evidence already suggests as much: data from China’s National Bureau of Statistics indicates that China’s tertiary sector (comprised mainly of service industries) has recently outpaced the country’s vaunted industrial sector. Since at least 2003, the former expanded at a compounded rate of 15.5% (measured in nominal terms), whereas the latter grew at a 15.1% rate. Meanwhile, China’s leadership also seems to acknowledge that the services sector will make an important contribution to future growth. The Central Committee’s current five-year plan (2011- 2015) prescribes long-term targets whereby the services sector would account for 70% of the country’s output.4 In addition, the plan elevates seven key industries – three of which are service-based – and “nurtures” them until they become “pillars” of the economy.5

Dark Clouds

Clearly, I remain enthusiastic about China’s economic prospects, especially its service sector; I only wish investing in the country was so simple! Obviously it is not. China faces myriad challenges, encompassing social, political, economic and environmental ills. Most are well known. There are, however, two threats to China’s future that I believe receive insufficient attention: the growing potential for military conflict; and the weakening grasp of the ruling party.

First, regarding the potential for conflict: I think it is unlikely China will go to war; but I cannot dismiss the possibility altogether. If China does engage in a major conflict, clearly it will pose a grave threat to the country’s future (to say nothing of stock markets around the world).

A casual survey of Chinese history suggests that most analysts perceive China as a peaceful power, at least with respect to cross-border conflict. History bears this out: China has occasionally fought lesser wars with its neighbors, but most of its conflicts and intrigues have been confined to its interior. China has always perceived itself as Asia’s central power – it is known as the Middle Kingdom – and historically it has held sway over a network of neighboring states that paid tribute to the center.

Many analysts appear comfortable with the assumption that China will remain a peaceful power amid its rise. I am not so sure: I don’t think the country’s past necessarily prescribes its future. Admittedly, my experience in China is limited, and is that of an outsider. Yet I worry about many things: I worry that the country’s hunger for resources will drive it to become overly assertive; I worry that a substantial portion of the country’s newfound wealth has been channeled into military spending; I worry that claims to seas and lands around greater China have complex and disputed origins; I worry that a large populace within China is restless, frustrated by a deep socio-economic divide and cut off from their roots, courtesy of the Cultural Revolution. Most of all I worry that China’s civilian leadership is struggling to retain its mandate amid economic challenges and scandalous corruption. I am concerned that the leadership will find it convenient to deflect criticism by cultivating chauvinist and bellicose politics.

I do not know whether the Diaoyu Islands will become the flashpoint for conflict. However, events there and elsewhere reveal a new actor: a powerful, modern state eager to assert its interests. Consequently, I assess the probability of conflict there or elsewhere as low, but well above zero. What surprises me is the seemingly relaxed stance of the global investment community. When I began my investment career fourteen years ago, the leading question I received from investors – ahead of every economic and financial issue – was whether war would break out between Beijing and Taipei. I rarely hear concerns about conflict today. Back then, I responded confidently that China’s growth meant it had too much to lose. Perhaps my old argument still holds; but I worry that the balance of power has grown far more complex. I do not advise retreat from China’s markets, but I urge investors to observe events carefully, and to proceed with caution.

Another matter plagues China today, and constitutes a more present threat to the country’s stability: the slipping grasp of the country’s leadership. As of the date of this report, China had nearly completed its once-per-decade transition in government. It did so under an astonishing cloud of scandal and venality. In my view, the country needs to cut a clear path toward reform and a greater degree of openness. However, the Communist Party of China (CPC) appears to be “circling the wagons” to protect its interests. Certain CPC members appear to have been shielded from scrutiny via patronage; meanwhile, the state-backed segment of the economy has literally been given a bigger seat at the table, as more captains of state-owned companies were “elected” to the 205-member Central Committee than ever before.

I find this shift in China’s direction worrisome, and the country’s top leadership is seemingly concerned, too. In one of his outgoing speeches, President Hu Jintao warned that if the party did not address its deficiencies head on, it could instigate “the fall of the state and the party.”6 Hu then used his influence to have his personal doctrine of the “scientific concept of development” enshrined in his party’s constitution, in a bid to ensure his legacy. There is a certain irony in the notion of the term “scientific development.” By it, President Hu means to favor the adoption of pragmatic policies that are unburdened by ideology. This is laudable. Yet what China’s leadership needs, now more than ever, is a truly scientific disposition: an abiding sense of curiosity; an openness to experimentation; a commitment to transparency; and a constant ability to adjust to reality, as informed by evidence.

I am told that President Hu and the leadership mean quite the opposite. They equate “scientific” with “systematic,” and they intend to curtail experimentation, not promote it. Several analysts have commented that Hu’s speeches during the handover effectively put his successors in the equivalent of a political straightjacket.7 Hu prescribed narrow limits for acceptable reform; much was left off the table, including the state-backed economy, along with the CPC itself. Unfortunately, it appears the leadership now associates political experimentation with the rogue dealings and cowboy-like leadership of the now disgraced Bo Xilai. The consequence is that rather than embrace change, the party appears set to pursue a closed approach that bears little resemblance to “science.”

For all my concerns, though, there is ample room for hope. I remain impressed that reform-minded factions within China continue to quietly win small but cumulatively meaningful battles, freeing up markets and relaxing central control over the economy. On balance, I still see more promise than pitfall – but the path forward is narrowing, and the footing treacherous. Investors must watch carefully where the country steps next.

Seafarer’s Present

Leaving aside China’s complex future, and moving to Seafarer’s simple present: we are happy to have gotten our business off the ground, and to have achieved a measure of progress. In launching our firm, we harbored no illusions: we knew it would be a challenging, long-term endeavor. I can report that the firm’s growth has surpassed our expectation, and we are pleased to have many new shareholders subscribe to the Fund. We are enthusiastic for the future, and we are honored by the trust each shareholder has placed in us. We will work to earn that trust.

The notion of progress is central to our investment philosophy at Seafarer. We invest in the developing world because it is steeped in growth and change. Individuals and families are striving to improve the conditions of their lives. That act – striving to meaningfully better one’s circumstances, and one’s society – is what begets progress. Some portion of that progress spills over to corporate profits, and to the value of companies. This is ultimately what we attempt to capture in our portfolios: the value that arises from the progress and growth of the developing world.

Thank you for entrusting us with your capital. We are honored to act as your investment adviser.

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 Index, Standard (Large+Mid Cap) Core, Gross (dividends reinvested), Total Return USD is a free float-adjusted market capitalization index designed to measure equity market performance of emerging markets. The MSCI Emerging Markets Index consists of the following 21 emerging market country indices: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey. Index code: GDUEEGF. 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.
  1. National Bureau of Statistics of China, U.S. Bureau of Economic Analysis (U.S. BEA) and Seafarer. Please note: statistics for both the U.S. and China intentionally exclude services provided by the government and / or the public sector. According to the U.S. BEA, U.S. total service sector activity comprises nearly 80% of U.S. GDP, about 13% of which is attributable to the public sector. China’s most accessible statistics on the tertiary sector do not distinguish between public and private sector services, but together they account for 43% of GDP. My intent here was to focus on private sector services only, and thus I have deducted an estimate for government-related services, which I believe comprise 12% to 13% of China’s GDP. Thus I estimate private sector services to constitute a bit less than one third of China’s output.
  2. U.S. BEA, Seafarer.
  3. U.S. BEA, Seafarer.
  4. Dan Harris, “China’s 12th Five Year Plan: A Preliminary Look,” China Law Blog, 3 March 2011.
  5. Xinhua, “China to nurture 7 new strategic industries in 2011-15,” 27 October 2010.
  6. Zhuang Pinghui, South China Morning Post, 10 November 2012.
  7. Verna Yu, South China Morning Post, 10 November 2012.