Dear Fellow Shareholders,
I am pleased to address you once again on behalf of the Seafarer Overseas Growth and Income Fund. This annual report encompasses the Fund’s most recent fiscal year, which ran from May 1, 2013 to April 30, 2014.
During the twelve month period, the Fund gained 2.12%, while the Fund’s benchmark, the MSCI Emerging Markets Total Return Index, fell -1.49%.1 By way of broader comparison, the S&P 500 Index increased 20.44%.
The Fund began the fiscal year with a net asset value of $11.91 per share. During the ensuing twelve months, the Fund paid two distributions, worth $0.552 in aggregate. Those payments brought the cumulative distributions per share, as measured from the Fund’s inception, to $0.674.2 The Fund then finished the fiscal year with a value of $11.59 per share.3
We are proud of the Fund’s performance during this period, whether measured relative to peers, relative to the benchmark index, or in absolute. Emerging markets were highly volatile during the past twelve months, and we are pleased the Fund dampened a bit of that volatility, in line with the Fund’s investment objective.
Frankly, though, it was a tough time to be an investor in the Fund, or the emerging markets more broadly. Equity markets swung around a great deal, and the Fund did not go unscathed. Sometimes the emerging markets and the Fund moved higher together, but mostly they moved either sideways or lower. In the end, the Fund’s returns for the fiscal year were meager, and while positive, hardly seem worth the intervening drama. It was a frustrating time, and we are happy it is behind us.
However, while we are looking back: what a year it was! The emerging markets were beset by myriad troubles, with very few positive events to offset. The woes were numerous:
- “Tapering,” or the end to the U.S. Federal Reserve’s quantitative easing policy.
- A mini-currency panic, led by the “fragile five” countries, which were deemed by some to be susceptible to funding gaps and therefore to financial crisis.4
- A rout in emerging market local currency bonds.
- A material deceleration in China’s economic growth, accompanied by several bouts of distress within that country’s rickety financial system, including the country’s first recorded corporate bond default.
- A collapse in commodity prices, which weighed heavily on Latin American and South African equities.
- The implosion and final death throes of a Brazilian magnate’s empire, in which Seafarer estimates over $30 billion worth of Brazilian equity and bond capitalization evaporated during the preceding 24 months.5
- Episodic bouts of aggression and hostility on the part of North Korea.
- Political instability in Brazil, Turkey, and Thailand, culminating in riots and protracted protests.
- Cross-border conflict, instability and secession in Ukraine.
When I review the list above, I am struck by the breadth and severity of the difficulties that have weighed on the emerging markets during the past twelve months. I am also struck by the performance of the benchmark index, when viewed in this context: a decline of only -1.49% is remarkable.
Last April, who would have imagined one year could deliver so many troubling events? And if you possessed such foreknowledge, would you have predicted the index would end the year roughly where it began? I, for one, would not have done so. If I somehow had advance notice of the list above, I would have cautioned clients to shelter from the market collapse that would inevitably follow. Yet the market was nearly flat! With the benefit of hindsight, it is natural to view the index’s return as disappointing; yet I would assert that it was remarkably resilient in light of what could have happened.
The resilience of the emerging markets, in the face of so much bad news, likely conveys a basic but important message: stocks in the developing world are inexpensive. I cannot conclusively determine whether stocks are truly “cheap,” or “cheap enough” – those are loaded phrases that hold different meanings for different investors, and anyway, the markets are too broad to offer a simple, binary assessment as to their “cheapness.” However, I can state that in my experience, when stocks absorb a great deal of bad news, and yet their prices are materially unchanged, the simplest (and most likely) explanation is that prices were already low enough to compensate investors for additional risks – even big, unforeseen ones. Expensive stocks tend to exhibit the opposite behavior: a reduced tolerance for bad news, with prices swooning after a minor negative shock. The one-year return from the emerging markets was nearly flat, despite all that occurred – and I submit it was probably because stocks were inexpensive, with valuations that could accommodate bad news.
Amid this challenging year, the Fund’s performance was bolstered by its exposure to China, Vietnam, India and Poland. Chile, Turkey and Thailand weighed on returns. The Fund benefited from banks, health care, industrials, and utilities; it made absolute gains in technology shares, but on a relative basis it underperformed the index, which did much better in that sector; and the Fund was especially impaired by its exposure to commodity stocks.
Latin America was particularly challenging for the Fund throughout much of the fiscal year; the Fund’s holdings in Mexico, Chile and Brazil were all weak during the bulk of the period. However, we were pleased to see most of the Fund’s holdings in Brazil recover much of their lost ground near the close of the fiscal year, such that the Fund position in Brazil finished nearly flat. The Fund’s holdings in Mexico declined a bit during the period, but this was mainly because the positions had been so successful during the prior year – effectively, the valuations of the Fund’s holdings “cooled off” a bit, after substantial prior gains. We remain comfortable with the Fund’s holdings in that market.
Chile was a different story, though: at the outset of the year, the Fund’s holdings there were mostly centered on the commodity sector. A collapse in prices for raw materials undermined the Fund’s chief holding there, and for a variety of reasons – both related and unrelated to the price decline – we had the Fund exit the position.6 The Fund retains one position in Chile – Corpbanca, a mid-sized bank that is currently merging with Itaú Unibanco, one of Brazil’s largest financial institutions.
Regarding banks, and other financial institutions: the financial sector made the single largest contribution to the Fund’s outperformance versus the benchmark index. The Fund generated gains from the sector in several markets – Poland, Brazil, South Korea and Vietnam – while the benchmark produced sharply negative returns. Seafarer’s focus on bottom-up stock selection helped during the fiscal period, as there was no common theme or geography to otherwise unite these positions. The banks in Poland and Brazil are large capitalization stocks, acquired when their shares were depressed; the Fund benefited from the subsequent recovery in the valuation of those shares. In Korea, the Fund acquired the heavily discounted preferred shares of a commercial insurance company; happily for the Fund, the discount subsequently eased. In Vietnam, the Fund benefited from its exposure to a small capitalization stock associated with the country’s largest commercial re-insurer.
As mentioned above, the Fund’s performance was weak, on a relative basis, within the technology sector – the Fund produced gains, but it was outpaced by the benchmark index. The index’s gains were spurred mostly by its exposure to internet stocks, particularly those based in China and Korea. Since its inception, the Fund has lacked exposure to internet-focused companies (e.g. social media, search engines, entertainment). The Fund’s strategy does not prohibit exposure to the internet; however, such stocks typically fail to meet the Fund’s valuation and dividend criteria. We recognize there are some excellent internet-driven businesses, and if valuations ever become sufficiently attractive, the Fund will likely seek exposure.
The Fund performed well within India, generating gains and avoiding the worst of the volatility that impacted Indian shares and the local currency last autumn. The Fund’s exposure to Poland also proved successful: the Fund’s holdings were relatively steady amid the gyrations of the past year, and the holdings experienced growth that outpaced market expectations, which lifted share prices a bit.
The most surprising source of returns for the Fund was China. The country suffered from declining stock markets and widely publicized fears over slow growth and systemic risks within its financial sector. So perhaps it is surprising, but nonetheless true, that the Fund’s exposure to China was one of the largest sources of its absolute and relative gains, and the majority of the Fund’s Chinese holdings had positive returns during the fiscal year. The Fund’s success was due to its avoidance of large capitalization banks and energy companies – those sectors arguably are most affected by China’s current problems; and it was aided by its exposure to small and mid-sized industrial, technology and health care companies.
If you wish to review a more detailed discussion of the Fund’s performance and holdings, Seafarer publishes four portfolio reviews per year. Each corresponds to a standard calendar quarter. Please visit the Archives for further information.
Peering Over China’s Great Wall of Worry
Returning to the topic of China: among investors focused on the emerging markets, the country is regarded with skepticism and trepidation. The global financial media is rife with reports of failings within the country’s financial system. Every release of economic data, no matter how trivial, receives a ridiculous degree of scrutiny, as if it were a tealeaf on which the Middle Kingdom’s future was written. I suppose there is a rational basis for this, as China is undergoing a major economic transition. The immediate outlook is not encouraging, and fraught with risk. There is plenty that can go wrong.
Yet if there is one surprising aspect to the current cloud that hangs over China, it is the near-total absence of discussion of all that could go right. The present debate around China’s investment merits is so unbalanced that it strikes me as absurd.
Please do not mistake me for a naive optimist about the country: for the past five years, I have written about the economy’s decelerating growth; its need for a revised economic model; troubles within its banking sector; potential imbalances that might undermine its currency, the renminbi; and the possibility that the country might instigate armed conflict with its neighbors. I am concerned about all of these issues, and more.
However, to dwell solely on the country’s well-known weaknesses is to ignore the important, broad-based reform efforts that are underway. China’s new leadership, installed in the fall of 2012, has launched a major overhaul of the country’s economic and political structure. Here is a partial list of what is taking place:
- A substantial (but unfortunately not exhaustive) anti-corruption drive.
- Liberalization of the local currency and of interest rates within the banking system. Both are “backdoor” reforms of the domestic banking sector.
- Recapitalization of the domestic banking system to address financial weaknesses.
- Major stock market reforms, including: enhanced access for foreign investors via the “through train” policy,7 new mechanisms for companies to issue capital, and a liberalized market for initial public offerings (IPOs).
- Major reforms to reduce excess capacities within state-owned enterprises.
- Modernization of provincial governments’ finances, possibly culminating in the authority to levy local taxes (i.e. property and sales taxes), and the authority to issue municipal-style bonds.
- Liberalization of most key input prices, especially energy and natural resources.
- Environmental regulation, targeting sharp reduction in carbon emissions, with severe penalties for polluters.
- Reformed property and land use rights.
- Reform of the hukou (“household registration”) system. Hukou is a set of identification documents, somewhat like a domestic passport. Hukou defines a household’s civil, economic and legal rights within a given local municipality. It confers access (or lack thereof) to various government services, health care, education, housing and employment. If a family attempts to move from the countryside to the city, it will not be entitled to such services in the new urban residence because the family’s hukou remains tied to the original rural home. In my opinion, the system is broadly analogous to social entitlements in the U.S. – and its reform is just as politically contentious.
- A major overhaul of the national healthcare delivery system.
- Relaxation of the “one child” policy.
Make no mistake: this is an impressive list. Apparently, China has listened to its external advisors, and to some of its detractors. The list makes it clear that China is not shying away from difficult change. No other developing nation has undertaken a reform program so comprehensive or bold. Imagine if the U.S. simultaneously tackled several sensitive issues. Envision a coordinated effort to reform healthcare, banking regulations, the tax code, and social entitlement programs. The project would be sweeping in its scale; it would meet with considerable resistance from vested interests; it would stand a significant risk of outright failure; and it would certainly rile every corner of our economy.
This is analogous to what is now taking place in China: the country is engaged in an extensive overhaul of the political and economic landscape. I cannot predict the extent to which it will be successful, but the country does not lack ambition. Nor does the leadership lack understanding about the urgency or nature of the challenges ahead. Admittedly, the most sensitive political reforms – those that might undermine the communist party’s authority – are absent. Nevertheless, any one of the initiatives above has the potential to impact the entire domestic economy for the better. If the reforms mostly meet with success, I believe China’s growth has the capacity to impress for many years to come. The team at Seafarer is eager to watch China’s progress unfold – and we will keep you informed regarding the results.
A Few Announcements
Please note: This section of the letter was written jointly by Andrew Foster and Michelle Foster, managing members of Seafarer Capital Partners, LLC.
The past fiscal year has been a good one for Seafarer Capital Partners, despite the difficulties that have weighed on the emerging markets. We have been privileged to welcome new shareholders to the Fund, and we have seen our relationships with clients grow. We made further investments in Seafarer’s resources – in personnel and technology – so as to ensure the firm’s steady growth and development. We recently expanded our investment team with the addition of Paul Espinosa, Senior Analyst, to our firm. Paul is a veteran investor in the emerging markets, and his arrival both broadens and deepens the team’s global research capabilities. We plan to further expand Seafarer’s team in the coming year.
Shortly after we founded Seafarer three years ago, we had the opportunity to write a brief essay on the firm’s goals. In that essay, we noted that our abiding goal as an investment adviser is to deliver superior long-term performance to our clients. However, we also noted three ancillary objectives: to increase the transparency associated with investment in developing countries; to mitigate a portion of the volatility that is inherent to the emerging markets; and to deliver lower costs to our clients, over time and with scale. We continue to work toward these three objectives, and we are happy to declare a bit of progress with respect to the third.
We are pleased to announce that effective September 1, 2014, the Fund will undertake an expense reduction on behalf of its shareholders. Seafarer Capital Partners, LLC (our firm) will contractually commit to lower the expenses of the Fund for the ensuing twelve months, with the intent to renew the same obligation for the foreseeable future. The Investor class net expenses will be reduced to 1.25% by way of this “expense cap,” and the Institutional class net expenses will be reduced to 1.05%.8 This new cap constitutes the second reduction in fees enacted by the Fund since its inception (the first reduction occurred in January 2013).
In addition, Seafarer Capital Partners will reduce its management fee for the Fund from 0.85% to 0.75%. Seafarer’s management fee constitutes a portion of the Fund’s overall expenses, and therefore such fees are subject to the aforementioned expense cap.
We are able to achieve these expense reductions because the Fund’s growth over the past year has afforded some basic economies of scale. Subscriptions from new and existing shareholders have increased the Fund’s operating efficiencies. The resulting economies, combined with the momentum we believe exists in our business, give us the confidence to drive expenses lower. We are pleased to achieve progress toward our goal of lower costs, though we are by no means finished. We will strive to further reduce expenses to shareholders, with additional time and with scale.
While we are pleased to be undertaking an expense reduction that benefits both share classes, it is our sincere wish that more shareholders could take advantage of the lower expenses afforded by the Institutional class. In truth, we would prefer to call it the “universal class,” because we hope that every shareholder could make use of it. We want to offer the lowest possible expenses to everyone. The problem is that certain distribution platforms (i.e., brokers, dealers, and other financial intermediaries) impose a minimum initial investment of $100,000 on the Institutional class. Those same platforms also restrict Seafarer’s ability to distribute the share class with a lower minimum on a direct basis – in other words, the $100,000 minimum applies everywhere, regardless of whether you purchase the Fund’s Institutional class directly from Seafarer, or from a platform or intermediary. This is not our preference. We are acutely aware that many shareholders cannot afford or would not choose to invest so much capital in the Fund. We are frustrated by the situation, as it drives a wedge between shareholders and the lower costs we would like to offer them.
Given that we would like to encourage broader usage of the Institutional class, we will describe three ways that certain shareholders might gain access to this share class, even if they are unable to immediately meet the investment minimum. First, financial advisers might discover that their platform will waive the minimum if the adviser invests with the intention to reach the minimum. Every platform evaluates waiver requests differently, and Seafarer has no influence over whether a particular platform will entertain such requests. Platforms that do grant waivers may require that Seafarer submit the request on behalf of the adviser. We are happy to help with such waiver requests. Advisers can contact us at (415) 578-9075 or email@example.com.
Second, advisers can meet the investment minimum for the Institutional class by aggregating Fund holdings across multiple client accounts, if permitted by the platform.9 If you are an adviser and you encounter difficulty with aggregation at the platform, please let us know; we will try to resolve the issue with the platform.
Third, our firm has some influence over the application of the minimum as it pertains to shareholders who subscribe to the Fund on a direct basis via an automatic investment plan (“AIP”). We will do our utmost to waive the Institutional class minimum for accounts that satisfy all of the following criteria:10
- The account must be established directly with the Fund, not with a platform or intermediary.
- The account must activate an AIP.
- The account holder must request the waiver on the Account Application or Account Options Form; when establishing a new account online; or by calling Shareholder Services at (855) 732-9220. The applicant must request the waiver in good faith, with the intent to eventually meet the Institutional class minimum via a program of sustained investment over time.
Also, we will do our best to ensure that existing AIP participants can convert from the Investor class to the Institutional class (known as a “share class transfer”), provided they satisfy all three criteria above. Ultimately, it is our hope that more shareholders make use of the Institutional class as a “universal” class, regardless of what its official name might convey. For our part, we will work to extend the benefit of lower expenses to those who undertake the extra effort required to invest directly with the Fund, on a sustained basis.
Thank you for entrusting us with your patience and your capital. It is an honor to serve as your investment adviser in the emerging markets.
- 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 4/30/2014, Corpbanca SA comprised 2.1% of the Seafarer Overseas Growth and Income Fund. The Fund had no economic interest in Itaú Unibanco. 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 1.93% during the fiscal year.
- The Fund’s inception date was February 15, 2012.
- The Fund’s Investor share class began the fiscal year with a net asset value of $11.91 per share; it paid two distributions, worth $0.540 in aggregate; and it finished the fiscal year with a value of $11.58 per share.
- The “fragile five” countries consist of Brazil, India, Indonesia, South Africa, and Turkey.
- Bloomberg, “Batista’s Losers Shout and Sue as OGX Meltdown Casts Pall,” 31 December 2013.
- For more details regarding the Fund’s exposure to the commodity sector, please see the Fund’s portfolio review for the third quarter of 2013.
- In April 2014 the China Securities Regulatory Commission (CSRC) and Hong Kong Securities and Futures Commission (SFC) announced the development of a pilot program called “Shanghai-Hong Kong Stock Connect” (informally known as the “through train”) that will establish mutual stock market access between mainland China and Hong Kong. The program will allow mainland Chinese and Hong Kong investors to access each other’s equity markets, and will enhance foreign investors' access to mainland listed stocks as well.
- Gross expense ratio as of the Prospectus dated August 31, 2013: 2.79% for Investor class; 2.69% for Institutional class.
- Similarly, individual investors can reach the investment minimum for the Institutional class by aggregating multiple accounts within the Fund, if permitted by the platform.
- In the case of the Institutional class waiver, the Investor class AIP initial investment minimum ($1500) applies.