Dear Fellow Shareholders,
I am pleased to address you once again on behalf of the Seafarer Overseas Growth and Income Fund. This report addresses the first half of the Fund’s fiscal year (May 1 to October 31, 2014).
During the semi-annual period, the Fund gained 2.38%, while the Fund’s benchmark, the MSCI Emerging Markets Total Return Index, rose 3.96%.1 By way of broader comparison, the S&P 500 Index increased 8.22%.
The Fund began the fiscal year with a net asset value of $11.59 per share. In June, the Fund paid a semi-annual distribution of $0.075 per share. That payment brought the cumulative distribution per share, as measured from the Fund’s inception,2 to $0.749. The Fund finished the semi-annual period with a value of $11.79 per share.3
The first half of the fiscal year was marked by substantial swings in the value of both the Fund and the benchmark index.
Initially, both surged higher together: between the close of the prior fiscal year (April 30) and September 3, the Fund and the index gained 7.16% and 12.29%, respectively. However, early September proved to be the near-term peak in the emerging markets. By the end of October, both the Fund and the index had retreated substantially from the highs of September, and each finished the semi-annual period with only modest gains, as noted above.
When markets were rising prior to September, the Fund’s performance lagged its benchmark in part because of what the portfolio held (its Vietnam positions slumped), but mostly because of what it chose to omit (Taiwan technology firms surged, along with China banks, and China and Russia energy companies).
The Fund’s Vietnam holdings had enjoyed a modest degree of outperformance in the first several months of the calendar year, but over the summer, their prices crumbled as hostilities between China and Vietnam escalated. During the past several years, China has grown more assertive in its efforts to explore for oil in the South China Sea. This summer, China declared sovereignty over a section of what had been recognized as the East Vietnam Sea, and promptly inserted an oil rig in the contested waters. Vietnam’s coast guard retaliated by cutting the rig loose from its mooring, and Chinese warships circled. The conflict spilled onshore as Vietnamese protested Chinese presence on the country’s soil, and violent protesters burned or destroyed properties and factories they perceived to be of Chinese ownership. The local stock market plummeted in response, and the Fund’s Vietnam holdings detracted from performance. Seafarer continues to monitor the conflict; at this time, though, I do not believe this event constitutes sufficient grounds to exit the portfolio’s positions, given their strong growth prospects and reasonable valuations.
Meanwhile, the Fund’s lack of exposure to small and mid-size technology companies – mostly located in Taiwan – caused it to lag the benchmark during the market’s run-up. While interesting investments occasionally surface among the sea of smaller technology firms located in and around Taipei, this group of companies in general is not distinguished by sustainable growth. Most companies make components for consumer electronics or computers, and while some grow quickly for a while, often their good fortune is not sustainable, as their products are rapidly commoditized, or as technological evolution renders their products obsolete. Their share prices can jump rapidly higher for a time when their products are in vogue. Nevertheless, I rarely find much that is worthwhile or sustainable in this segment of the market, though there are sometimes exceptions.
Chinese equities were spurred higher over the summer for several reasons. First, stock prices had become overly depressed in the spring, and were therefore perhaps poised for a modest recovery, which indeed occurred. Second, the Chinese government had ample cause to provide mild stimulus to the economy, not only to offset slowing growth, but also to facilitate the recovery and recapitalization of the state-backed domestic banking system. Third, markets were cheered by news in early August that a former member of China’s elite politburo had been arrested. Investors took this as a sign that a long-running and wide-ranging anti-graft campaign was near an end – and consequently that politics and economics “as usual” (i.e. growth-oriented policy-making) might soon resume. Together, these three factors sustained Chinese stocks through the late summer.
September’s arrival ended the markets’ run. Early in the month, a series of economic reports indicated that the U.S. economy was growing faster than was broadly anticipated. Economic strength prompted investors to re-evaluate their expectations regarding the pace and magnitude of future interest rate increases, even as the Governors of the Federal Reserve cautioned that “conditions may . . . warrant keeping the target federal funds rate below levels [viewed] as normal” for some time to come.4 The resulting change in expectations brought about a sharp decline in global stock and foreign currency markets.
Around the same time, a number of unwelcome events struck the emerging markets simultaneously. First, economic reports revealed that the Chinese economy was unexpectedly weak, despite the aforementioned stimulus measures introduced over the summer. Second, Brazil’s incumbent president, Dilma Rousseff, won re-election by a narrow margin – and the Brazilian currency (the real) and stocks declined out of fear that Rousseff’s victory would beget further fiscal stress and economic stagnation. Third, geopolitical concerns regarding Russia’s involvement in Ukraine resurfaced, and currency markets weakened after the release of new reports that Russia’s government was contemplating closing its capital account to foreign exchange. All of these events combined to eliminate the gains of the Fund and the index such that both slumped toward the end of the semi-annual period.
The bulk of the Fund’s holdings were unable to escape September’s downdraft, though the Fund fell less rapidly than the index. The Fund’s holdings in Brazil and Turkey weighed heavily on performance: both countries’ stock markets reacted badly to the prospect of higher interest rates, and their respective currencies fell very sharply, too. Of the two markets, Brazil was especially hard-hit, swooning on the re-election of President Rousseff. I acknowledge that both countries’ currencies are somewhat vulnerable in the short run to changing interest rate conditions, yet I am not particularly concerned about currency risks in the context of the Fund’s construction and long-term investment horizon.
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.
The Rise of Value
Note to readers: this section of the Letter to Shareholders is largely repetitive of a similar commentary published in Seafarer’s Third Quarter 2014 Portfolio Review. We are re-publishing the contents here because we believe the underlying ideas are important to convey to all shareholders. If you have previously read the aforementioned review, you may wish to skip to the next section of the letter, “Some Brief Announcements.”
The recent turmoil in global stock markets places the near-term outlook in sharp focus: where are markets headed next?
In my judgment, valuations within the emerging markets are generally favorable to long-term investors. Offsetting this is the precarious state of the Chinese economy, tepid growth in Europe and Latin America, severe instability in Eastern Europe and the Middle East, and the prospect of substantially higher interest rates in the U.S. Uncertainty prevails.
Unfortunately – but as usual – I have no means to determine the near-term direction of markets with any precision. Despite prevailing risks, the Fund’s portfolio holdings are attractive, and thus the Fund remains near full investment – very little cash is held in reserve right now. Yet even as the near-term is murky, I believe the longer-term outlook has recently come into sharper focus. A very important structural change – one that I think has been a long time in coming – has just begun to reshape the investment landscape within the developing world. I think the consequence of this change will play out over the next decade, at a minimum.
Before I explain this change, I need to provide some background. For the past sixteen years, I have subscribed to an investment philosophy that stresses “growth” over “value.” By “value,” I mean an investment approach that places its primary emphasis on the inherent cheapness of a company’s balance sheet, and which places secondary weight on the growth prospect of the company’s income statement. Such cheapness usually stems from an excessive amount of cash on the balance sheet; or assets whose liquidation value exceeds the company’s market capitalization; or operating assets that would become substantially more productive (and therefore more valuable) if in the hands of a more capable owner-operator.
When pursuing “growth,” I have never shunned “value.” On the contrary: I know price matters a great deal. I know that long-term investment success hinges on the pursuit of securities with reasonable prices, and the avoidance of securities with excessive valuations. In abstract, I prefer the concept “value” to “growth.” However, I have built the Fund’s investment strategy around a conservative “growth and income” strategy out of practical necessity. In the past, I have had substantial doubts as to whether a classic “value” strategy could be effectively implemented within the developing world – “value” seemed destined to become a “value trap.” Pursuing a “growth and income” strategy was a viable alternative. The strategy’s exposure to growth would ostensibly generate an underlying, compounding rate of return. The strategy’s focus on generating a reasonable measure of current income was intended to ensure the portfolio of stocks exhibited satisfactory value, and would be less prone to the volatility inherent to the emerging markets.
While I might prefer “value” in abstract, my doubts about it in practice stem from the many structural impediments that the emerging markets present to the pursuit of a classic value investment approach. Most of those impediments are a function of the rudimentary state of the protections afforded passive minority investors, especially foreigners (such as the Fund). In order to realize the value embedded in a cheap balance sheet, a minority investor must often invest patiently for an extended period, awaiting the catalyst that will ultimately unlock the value.
The problem with waiting in the developing world is that most countries lack sufficient legal, financial, accounting and regulatory standards to protect minority investors from abuse by “control parties.” A control party is the dominant owner of a given company. Without appropriate safeguards, minorities have little hope of avoiding exploitation while they wait; nor do they have sufficient legal clout to exert pressure on the control party to accelerate the realization of value. Thus in the past, a prospective “value” investment was more likely to be a “trap” than a source of long-term return. A passive, minority investor in common stock might be forced to wait a very long time before realizing the “value” underpinning the investment – if they realized anything at all.
Other challenges exist for a “value” strategy in the developing world. “Change-of-control” investors – either private equity firms, or operating companies attempting to consolidate their industry – are typically thwarted in their attempts to wrestle control from negligent control parties, thus precluding an important means by which investors might realize “value.” Change-of-control investors usually face legal and cultural barriers that impede their ability to execute hostile takeovers. Incumbent control parties are often secure in their status, benefiting from political patronage, legal systems that hamper takeovers, and guanxi. Another historical impediment to takeovers has been the stunted nature of debt capital markets. Capital markets in the developing world have historically been small and shallow. Obviously, leveraged buyouts and other “take private” transactions will struggle if local currency debt markets are not deep enough to provide the requisite capital.
Perhaps the most significant impediment is the relatively minimal presence of large, domestic institutional investors (i.e. pension funds, endowments, and other asset managers) within developing markets. The absence of such institutions can hamper the realization of “value”: institutions with vested economic interests are often critical to ensuring a basic standard of economic discipline and corporate governance within a given market. Furthermore, such institutions usually enjoy as much or more local political clout than the control parties they might seek to discipline; this allows them to exert pressure for better governance in a way that very few foreign investors can. Historically, though, domestic institutional investors have been most notable for their minimal presence, or outright absence. Where such institutions exist, they have been mostly unable or unwilling to exercise their economic power to improve governance and corporate performance. Structural impediments such as these – common throughout the developing world – meant that a classic “value” approach had little chance of success in the past.
Now to the present day: all of this is changing. I believe that the prerequisites for realizing a “value” strategy in developing markets are materializing, slowly but steadily. Accounting standards, for example, have undergone enormous improvements in the past fifteen years. The resulting transparency means that it is much harder for control parties to abuse their position. Legal systems, while still imperfect, enforce much greater equality between shareholders than in the past. This means that minority investors and foreigners are on better footing relative to local investors and incumbent control parties.
Change-of-control investors are beginning to emerge. Private equity, while still small, is much better organized and funded than in the past. Local currency debt markets have mushroomed; they now seem large enough to support takeovers and buyouts efficiently. Perhaps most importantly, large domestic institutions have begun to credibly execute their investment mandates. Political reality has caught up with them: fiscal pressures and looming pension liabilities have forced such institutions to get serious about achieving better returns from their investment portfolios on behalf of their constituents. This in turn has prompted institutions to demand more from wayward companies and their management teams; they expect improved profitability and higher dividends. All of the aforementioned changes suggest the investment landscape has been altered – subtly, but irrevocably. Moreover, I believe the natural evolution of these markets will only magnify and sustain the structural change. The future holds further improvements in accounting and legal standards, the proliferation of change-of-control investors, and the rise of domestic institutional investors.
Taken together, all of these changes suggest the time for “value” has finally arrived in the emerging world. You will see Seafarer explore this approach in the future – though in doing so, the Fund will not deviate in any material way from its “growth and income” strategy. From the Fund’s inception, I have experimented with positions that were heavier on “balance sheet value” and somewhat lighter on “growth and income” than was normal for the strategy. Happily, most of those experiments have borne fruit, and consequently, I plan to expand the Fund’s exposure to “value-heavy / growth-and-income” positions. I believe the rise of “value” will be an important feature of investment in the emerging world for the decade to come.
Some Brief Announcements
I am pleased to report that Seafarer Capital Partners, the investment adviser for your Fund, continues to invest in its own capabilities, as well the cost structure of the Fund itself.
On September 1, Seafarer Capital Partners undertook an expense reduction (known as a “contractual cap”), such that the Fund’s net expenses were reduced to 1.25% for the Investor class and 1.05% for the Institutional class.5 This is the second such expense reduction since the Fund’s inception. In addition, and at the same time, Seafarer Capital Partners reduced 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. For further background on these fee reductions, please see the Letter to Shareholders from the Fund’s Annual Report dated April 30, 2014.
Seafarer’s team continues to grow. In August, we welcomed Sameer Agarwal to the firm. Sameer joins us as a research analyst. His background spans the developing world, with particular emphasis on India, and he is well versed in many valuation techniques and fundamental analyses. He is an excellent complement to our research team.
In September, Daniel Duncan joined the Seafarer team as a Vice President. Daniel leads the firm’s business development and client service efforts. He is the first person within Seafarer to engage in a client-facing role. Daniel and I worked together previously, and over the years he has earned my trust and respect. I am so pleased by the opportunity to work with him again.
Amid the continued volatility that has characterized the emerging markets, we wish to 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.
- References to the “Fund” pertain to the Fund’s Institutional share class (ticker: SIGIX). The Investor share class (ticker: SFGIX) returned 2.27% during the semi-annual period.
- The Fund’s inception date is February 15, 2012.
- The Fund’s Investor share class began the fiscal year with a net asset value of $11.58 per share; it paid a semi-annual distribution of $0.072 per share in June; and it finished the semi-annual period with a value of $11.77 per share.
- Federal Reserve Board of Governors, Federal Open Market Committee, Press Release, 17 September 2014.
- Seafarer Capital Partners contractually committed to lower the expenses of the Fund for the ensuing twelve months, with the intent to renew the same obligation for the foreseeable future.