Dear Fellow Shareholders,
It is my pleasure to address you, our clients and shareholders of the Seafarer Funds, as this most unusual year comes to an end. Having communicated with some of you in my role as Co-Portfolio Manager of the Seafarer Overseas Growth and Income Fund, I am honored to be able to share some insights on how Seafarer Capital Partners is working remotely, and to offer you my thoughts on the current risks and opportunities in the emerging markets. For those of you who do not know me, I joined Seafarer in 2011 after three years of investment banking in the emerging markets followed by eight years of investing in the U.S. high yield bond market.
This semi-annual report covers the first half of the Funds’ 2020-2021 fiscal year (May 1, 2020 to October 31, 2020).
2020 and Update on Seafarer Capital Partners
2020 has been the most extraordinary year of my 20+ year career in financial markets, not just in terms of the public health crisis, but notably for the ways in which companies across the emerging markets have adapted to the challenges, rapidly digitalizing their businesses and recalibrating their future growth prospects.
This year has presented Seafarer with many challenges but working remotely has not been one of them. California’s wildfires and related power outages over the last couple of years spurred us to ensure that Seafarer personnel can effectively and efficiently work from home. Portable backup power banks, mobile hotspots and optional temporary office spaces are some of the business continuity arrangements Seafarer has set up to minimize disruptions to remote work. The investment team remains focused on our core task of in-depth bottom-up company research and security selection. Despite the unusual circumstances of 2020, our research process has stayed very much the same: we have the same weekly schedule (two investment team meetings), and we have the same collaborative process where ideas are presented to and debated by the entire investment team before a new security enters a portfolio. If anything, I have more time to conduct research as I am not on long-haul flights or sitting in choking emerging market traffic for dozens of hours each quarter.
A bright spot of our remote working arrangements is that access to management teams has been easier than anticipated, albeit virtual rather than physical. Companies around the globe have been willing to hold video conferences with our investment team, answering the same questions that would typically be addressed in on-site meetings. Nothing can take the place of on-site research and interaction in order to truly understand the culture and strategy of a company, or the motivations of a management team. However, the effectiveness of video conferencing has allowed our team to stay in close contact with our portfolio holdings as well as conduct in-depth research on prospective investments. As long-term emerging market investors, we are excited to get back to our markets when the borders are open and it is safe to travel. To be clear, we don’t know when travel for our investment team will resume or what the process will look like when it does. Still, I remain eager to again visit these markets that hold so much opportunity.
Heightened Risks in the Emerging Markets Emanating from China
While my confidence in the long-term benefits of investing in the emerging markets remains intact, there are many risks that warrant close monitoring. Two risks of particular concern for me are China’s indebted residential property developers and troubled banking sector. I will discuss each of these risks below.
In June, I published an update to a market commentary entitled China’s Indebted Residential Property Development Sector. In that commentary, I highlighted that a large percentage of China’s national budget is tied to the sale of state-owned land-use rights to the highly-indebted residential property developers. The International Monetary Fund projects government revenues from the sale of land-use rights to decrease in the coming years – a growing concern for the nation’s finances.1 Another problem for this sector is growing cross-currency risk: China’s residential property developers are expanding U.S. dollar-denominated debts at an alarming rate. With nearly all of property developers’ revenues and costs denominated in renminbi (RMB), this cross-currency liability represents a significant financial risk for these companies. Elevated yields for dollar-denominated bonds issued by several of the largest Chinese property developers offer a clear warning signal about these issuers’ financial health. Government funding shortfalls and defaults in the property sector could lead to systemic consequences for China – and the broader emerging markets. I will be closely monitoring the events that transpire in this vital sector of the Chinese economy.
The second risk that looms large in my opinion is the troubled banking sector in China. Chinese banks of all sizes remain under pressure to clean up their balance sheets, write off bad loans and raise capital, but this is hard to do when the government continues to use banks as tools to buttress economic growth. The country’s debt load remains concentrated on the balance sheets of banks, both large and small, a clear indication they are both beholden to and supported by the state. While concerted efforts and real progress have been made in developing China’s capital markets, as evidenced by the successful Stock Connect and Bond Connect programs, the banks remain a key provider of credit to China’s economy. This is where moral hazard creeps in: Chinese banks have grown accustomed to making risky loans, sometimes at the behest of the state, on the assumption that the government will bail them out if enough of these loans go bad. Beijing continues to demonstrate its capacity and willingness to intervene in order to prevent bank collapse, as shown by several recent bank bailouts, one of which is the May 2020 bailout of the Bank of Gansu. Gansu’s bailout is particularly concerning, as an already financially stretched state-backed entity was forced to raise its stake. As this stake is part of the bank’s capital, and the new equity holder is struggling with liquidity issues of its own, Gansu’s solvency issues hardly seem resolved. China’s dependence on – and support for – distressed banks for credit and growth may yet backfire if too many of them continue to operate in a speculative and unsustainable manner.
With these heightened risks in China adding to a great deal of uncertainty about the health of the global economy, our bottom-up fundamental investment process focused on security selection becomes even more important. It is through that process that we continue to find investment opportunities in the emerging markets amidst rapidly evolving risks and challenges.
Evolving Opportunities in the Emerging Markets
Disruptions caused by Covid-19 are forcing companies to reinvent their business models, alter workforce dynamics and change the way technology is used. Covid-19 has accelerated digitalization in most industries across the globe, notably in healthcare, education and payments. The healthcare industry has seen a boom in online medical consultation as well as related healthcare e-commerce. The education industry has seen intensifying competition and margin pressure as they address the many digitalization needs that have been pulled forward. And the payments industry is entering a new era of financial services where transactions and the many associated services are digitalizing before our eyes. I believe that these changes in the consumption of technology are likely to be permanent, anchored by the accelerated adoption of cloud-based services in both the public and private sectors. All of this creates investment opportunities in the developing world for the dedicated long-term investor: the pandemic has transformed the way industries function, cementing new digital and virtual processes with which we had only previously experimented.
Another opportunity I see is the continued formation of capital markets in the developing world. As mentioned above, China has acted decisively to broaden and deepen its capital markets in order to promote stable economic development. The speed and magnitude of China’s bond market boom over the last several years underscores these efforts. I think it is noteworthy that China’s bond markets have functioned well this year, maturing bonds continue to be refinanced – many with the much-needed longer tenors – and more issuers are accessing this market. Furthermore, the Chinese bond market may see more interest from the international investor with the recent announcement that foreigners will be allowed to access foreign exchange derivatives products, an essential aspect of bond market investing.
Equity market development continues at a robust pace in China, with over 300 initial public offerings (IPO) in Shanghai and Shenzhen this year representing close to 600 billion U.S. dollar (USD) equivalent in IPO listing proceeds. More listed companies mean a larger investment universe, and while valuations in the A-share market are inflated to put it mildly, we continue to scour this market for opportunities. China now has a vast universe of listed companies, so despite elevated valuations in many sectors, opportunities do exist, and we continue to add Chinese portfolio holdings, focusing on those with attractive valuations and compelling growth prospects.
China continues to open its capital markets to the world, but it must be highlighted that this is being done very much on its own terms. While I was drafting this letter, the Ant Financial IPO was suspended in both Hong Kong and Shanghai amid unexpected material regulatory changes. While China has made a great deal of progress in developing its capital markets, the suspension of what was to be the largest ever IPO just days before pricing is a damaging setback. To me, this event demonstrates that regulation in the country is not objective or rules-based. It also suggests that the Chinese regulators might not let Ant Financial or any other financial technology start up disintermediate the traditional state-controlled banking system that remains so essential to China achieving its economic goals. I believe this unprecedented move raises questions about the future of regulation in China’s financial sector, the reach of the Xi Jinping administration in the economy, and the future of capital markets in China.2 The emerging markets are rife with governments that hastily implement ill-conceived rules and regulations. Our job is to find companies that can thrive despite these difficult environments. Events like the Ant IPO suspension are frustrating but nevertheless inspire us to search harder for durable investment opportunities in these complicated markets.
While China dominates our investment universe, and we spend a great deal of our time looking for investment opportunities there, emerging markets elsewhere continue to provide fertile hunting ground. Brazil is one such country: it is home to a select group of well-run companies that have distinguished themselves over time through continued revenue and earnings growth as well as the fair treatment of minority shareholders. The recent depreciation of the Brazilian real (BRL), down -35.6% year-to-date as of November 12, makes these opportunities even more compelling from a valuation perspective when considered in USD terms. While China constitutes close to 42% of the MSCI Emerging Markets Index and at least that amount of the investment team’s time, other emerging markets continue to merit investigation and capital allocation. There are more than 4,200 listed companies located outside of China that together have a combined market capitalization of 12.9 trillion USD-equivalent.34 We continue to find opportunities outside of China in a variety of sectors, including information technology, consumer discretionary, health care and financials.
To conclude, I am proud of how our team has met the challenges of 2020, adjusting to remote work with the benefit of our advanced business continuity preparedness and staying connected with each other through regular video conferences. Seafarer’s investment team continues to manage our portfolios with the same process and philosophy that have been in place since the establishment of the firm nine years ago. With the promise of a vaccine on the horizon and a return to “normalcy” one step closer, it will be wonderful to again travel to our markets and meet with management teams in person. Progress and change in the developing world have happened at an impressive pace this year, and our investment team remains dedicated to discovering new investment opportunities across the globe.
Thank you for entrusting us with your capital. We are honored to serve as your investment adviser in the emerging markets.Kate Jaquet,
- The views and information discussed in this commentary are as of the date of publication, are subject to change, and may not reflect Seafarer’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 October 31, 2020, the Seafarer Funds did not own shares in Bank of Gansu Co., Ltd or Ant Group.
- “People’s Republic of China: 2019 Article IV Consultation,” International Monetary Fund, 9 August 2019.
- Jing Yang and Lingling Wei, “China’s President Xi Jinping Personally Scuttled Jack Ma’s Ant IPO,” The Wall Street Journal, 12 November 2020.
- This value excludes listed equities with market capitalizations below $250 million. Seafarer rarely considers equities below this threshold.
- Source: Bloomberg. Data as of 12 November 2020.