Dear Fellow Shareholders,
I am pleased to address you on behalf of Seafarer Capital Partners (“Seafarer”), the adviser to the Seafarer Funds (the "Funds"). This semi-annual report covers the first half of the Funds’ 2021-2022 fiscal year (May 1, 2021 to October 31, 2021).
Investors’ Wants Versus Investors’ Needs
What do investors want? Judging by the popularity of passive index funds and the benchmarking of active manager performance, one may surmise that many investors seek to do no worse than the market.
What do investors need? In my opinion, at a minimum most investors need the preservation of the purchasing power of their savings, which would otherwise erode over time if accumulated in a savings account. However, many investors seek to grow their capital in real terms, i.e. after the cumulative impact of inflation, to retire in comfort.
While investors may feel comforted by the thought of their investment return not falling behind the market during their working lives, the question of whether the market will deliver what they need requires a leap of faith.
The reason I draw attention to the distinction between wants and needs is that, in my opinion, a decade of extraordinary returns for the S&P 500 Index (16.20% annual rate of return between October 31, 2011 and October 29, 2021) has afforded some investors the luxury of avoiding the question.1 For those that confronted the issue, this past decade of returns has left many with the presumption that the equity market will fulfill their future needs.
Similarly, over the same decade, the Morningstar Emerging Markets Index delivered a 5.45% annual rate of return, leaving the same investors wondering if an allocation to the emerging markets (EM) can fulfill their future needs even if they performed in-line with the index.1
I find it interesting to share with U.S.-based investors that in other countries, equity markets are referred to as “variable return markets,” in contrast to fixed income markets, a useful and timely reminder of the nature of equity investments.
A Shifting Foundation Supporting Prospective Investment Returns
This reminder is timely because the foundation supporting prospective investment returns, both for the S&P 500 and for the emerging markets, is visibly shifting. To put it in technical terms, the risk-free rate underlying global allocations to variable return markets may rise relative to the past decade as the Federal Reserve has already announced the tapering of Quantitative Easing and has guided to likely interest rate increases thereafter, even if not for the first time. Likewise, the discount rate for global emerging market equities is already rising as many EM central banks, such as those of Mexico, Brazil, the Czech Republic, Poland, and South Korea, have begun raising interest rates ahead of the Federal Reserve, itself a rare occurrence. Furthermore, even if the People’s Bank of China (PBOC) has not increased official rates for the largest country in the EM universe, in my opinion, the Chinese discount rate for equities is effectively rising as of the date of this letter, as the country struggles with the consequences of slowing the rate of debt growth.
One recent measure to accomplish this goal is the “three red lines” borrowing regulation conceived of by the PBOC to control financial leverage in the real estate sector, which has resulted in several developers missing debt payments.2 The same way that the absence of market-determined interest rates encouraged irresponsible debt growth at Chinese developers, the arbitrary manner in which bankruptcy rules are implemented has reminded equity investors of the difference between official interest rates for the country and the effective risk embedded in Chinese equity discount rates.
The seemingly arbitrary policy (the three red lines) for managing the financial leverage of a particular sector (real estate) and its consequences (missed debt payments) extended to other sectors during 2021 with new public policies aimed at private after-school tutoring companies (banning profits) and at corporates operating in the internet space (largely focused on anti-trust, data security, and financial risk). It is this extension that is arguably raising the effective discount rate for Chinese equities during 2021.
As important as it is to highlight the real time increases in the effective equity discount rates for the largest country in the EM universe (China) and for the global emerging markets (central banks raising rates in many countries) – and the increase in the global risk-free rate (determined by the Federal Reserve) – this idea is a preamble to a more important one.
How Investable is China?
Consider that as arbitrary as Chinese public policy may seem at any given point in time, said policy changes are arguably unsurprising, if not necessarily predictable, from a medium-to-long-term perspective. Over the past decade, Beijing has clamped down on the most polluting industries (as it has on the internet industry recently); issued policy dictates to reduce overcapacity in industries reticent to do so given their dependence on political interests over market prices to regulate themselves (as it has done to control financial leverage at property developers); and taken measures to reduce the cost of healthcare (the same way the PBOC controls the cost of money). Thus, the risk of rule by edict in China is not a new phenomenon. In my view, China remains as investable as ever. The fact that the effective discount rate for the country’s equities appears to be rising at present does not mean that something has suddenly changed in China making its markets uninvestable. What has changed is investor awareness and willingness to price the risks that were ever-present in the country.
That change is the most important lesson of the current Chinese zeitgeist. Why? Because it means that during periods of time when investors blindly bid up the price of high-growth Chinese companies, a more risk-aware investor had a better chance of avoiding the denouement faced by Chinese ADR investors during 2021, who were exposed to education and internet corporates, which tend to list shares offshore. Conversely, when the general market tenor questions the investability of Chinese equities – as it is doing now – one may search for opportunities in the country, not for the sake of being contrarian, but on the basis of a more considered awareness of the risks involved and the valuations paid for such risks.
Seafarer’s Chief Investment Officer, Andrew Foster, has for years written about his evolving thoughts regarding China in his market commentaries and portfolio reviews. Despite his generally negative assessment of China’s policy evolution throughout the years, Seafarer remained continuously invested in the country. At the risk of coming across as self-serving, I would characterize Seafarer’s approach to China investments as being perhaps more risk-aware than industry average over the past few years. Conversely, now that investors appear to question allocations to the country, I would argue that from Seafarer’s perspective, the market perception of the country has shifted more than our own assessment of the risk. As always, China is selectively investable. There may be sharp drawbacks to investing in the country on a passive basis, since in our estimation, diversification alone is probably insufficient to minimize the risks previously discussed. Rather than own everything in China (index funds) or own nothing (write off China as uninvestable), Seafarer believes a selective approach to investing in the country is more likely to build lasting wealth for clients over time.
If selectivity is more effective than diversification to manage equity risk in China, is the country the exception that proves the rule that in the rest of the world diversification (passive investing) is more effective than selectivity (active strategies)?
Should China Be Separated Into Its Own Asset Class?
The first part of the question, whether China is an exception within global markets, dovetails to a recent topic that has gathered traction within the general emerging market (EM) discourse of whether China should be treated as its own asset class, separate from the emerging markets. The only argument I have encountered in support of such a view relates to size, as the country’s equity market capitalization represents approximately a third of the EM universe. Let me opine on the issue by asking a question: since when does size determine anything, much less investment return considerations? Remember that the investment return measure is unitless; it is a percentage figure. Size itself does not come into the equation at all. The parallel with the story of David and Goliath comes to mind.
While I have yet to hear a sensible reason for segregating China into its own asset class, I will offer my own fundamentally-based possible reason for doing so. As a hybrid of a command economy with pockets of free market pricing, and with a President self-appointed to the role for life and intent on regulating the economy and individual behavior according to his personal beliefs (Xi Jinping Thought), investment risk must be managed actively, in contrast to the rest of the world where investors have already demonstrated a preference for a passive approach. In other words, one could argue that China should be separated from the rest of the EM universe because the nature of the risk it represents is sufficiently unique to warrant a different approach, not because it is “large.”
In spite of the above, I would argue that China belongs within the EM universe. In my opinion, the term “emerging markets” partially refers to the emergence of socialist command economies to the realm of economies regulating themselves through the price mechanism (as opposed to ideology), with prices determined by each individual actor who participates in the economy (as opposed to a group of individuals in a room). On this basis, China is clearly still emerging, with Xi Jinping having regressed the country on this scale. Not only are there more developed economies than China within the EM universe, but safer ones with regards to property rights and the rule of law. In my opinion, the recent travails of Chinese private education investors who were suddenly, if not unpredictably, expropriated of their right to profit, brought these long-ignored risks to the fore.
Likewise, the uncertainty surrounding the potentially differing treatment of onshore and offshore bond holders of China Evergrande, a real estate developer in the midst of a liquidity crisis, serves to question the rule of law and property rights in the country. In short, risk determines whether a country belongs in the emerging or developed market universe. On this basis, China belongs squarely in the EM category, is much farther from graduating to developed market status than other countries, and – in my view – the idea that it deserves its own asset class demonstrates an underappreciation of the underlying investment risks.
In effect, the argument that China deserves its own asset class due to its size is the equivalent of passive funds buying more of a security the larger its market capitalization grows. I will leave it to the proponents of scaling up exposure to a country or security as its price rises to explain how that will yield attractive future investment returns.
Is China the Exception to the Rule?
Coming back to the second part of the question above, whether China is the exception that proves the rule that in the rest of the world passive strategies appear to deliver higher risk-adjusted investment returns relative to active strategies, I will answer with a question once again. Does the investor shift to passive strategies over the past decade mean that index-based investing will prove more effective than an active approach over the next ten years? Has the previously noted underperformance of the EM universe relative to the S&P 500 Index over the past decade mean that investors will better meet their needs by allocating more to the S&P 500 at the expense of the emerging markets over the next ten years?
Based on my own experience, these two questions lay at the core of investor concerns.
The same way Chinese public policy developments during 2021 exposed the lack of risk awareness of investors in specific Chinese ADRs – as well as that of proponents of larger and independent allocations to the country within global portfolios – there is a strong probability that those arguing for the continued relative underperformance of the emerging markets over the next ten years may be forced to reassess their views.
Rather than stake my argument on macroeconomic or strategist-type predictions about the future, I prefer to focus on the foundation of future EM investment returns to answer the question. In my opinion, the realm of macro / strategist predictions is a graveyard of failed prognostications that suffered a miserable death at the hands of the grim reaper known as reality. I find it much more useful to focus on bottom-up stock analysis, Seafarer’s specialty, to address the next decade’s prospects (not the final outcome) for EM investment returns.
As a matter of the historical record of cumulative earnings over the recent decade ended December 31, 2020, the constituents of the MSCI Emerging Markets Index grew earnings at a modest 3.74% annually versus the prior decade ended December 31, 2010. This fact may go a long way to explain the paltry 3.99% annual rate of return of said index over the decade ended December 31, 2020.3 Even if many investors got what they wanted in terms of not underperforming the benchmark, in my view they did not get what they needed. Subtracting the 1.72% average annual rate of U.S. inflation (as measured by the Consumer Price Index) over the recent decade, the real rate of return for U.S.-based EM investors was 2.23%.4
The issue with arguing that the future will differ from the past is that EM economists / strategists always resort to the same arguments: the rate of gross domestic product (GDP) growth is higher in the emerging markets than in developed ones, as is the rate of population growth, and the rate of productivity growth can be higher as well. The problem with these arguments is that they were equally true and valid over the last decade as well, and yet here we are. Furthermore, bottom-up investors are keenly aware of the difference between GDP growth and corporate profit growth, a distinction that strategists seldom acknowledge.
A “Lost Decade” for EM Investors, but Not for EM Corporates
The reason Seafarer continues to invest in the emerging market universe as a means to deliver what investors need is that, based on our stock research, we realize EM corporates have not been complacent over the past decade of modest earnings growth. As Figure 1 below shows, between 2010 and 2019, while EM corporates may not have grown earnings rapidly, they have accumulated them in the form of retained earnings, while concurrently growing dividends relative to the previous decade. In other words, while the investment community wallows in the “lost decade” of emerging markets, Seafarer seeks valuable gems within the rough in the form of strengthened balance sheets (retained earnings) and improved corporate governance (higher dividends). In hindsight, this emphasis on stronger book values and dividends makes sense from the perspectives of many EM corporates having lost access to U.S. dollar funding after the 2008 Great Financial Crisis and facing challenging growth prospects.
Said corporate experience stands in stark contrast to that of U.S. corporates, which as Figure 1 shows, focused on dividends and buybacks at the expense of strengthening their balance sheets through retained earnings. In hindsight, this behavior may explain the attractive returns of the S&P 500 Index over the period.
In my opinion, based on the above, the past decade was far from lost for EM corporates. On the contrary, instead of making macroeconomic guesses regarding growth over the next decade, it is more valuable to ask how companies will deploy their strengthened balance sheets to fund and create their own growth path over the next ten years (independently of GDP growth), and to place a value on the possibility of even further corporate governance improvements.
In summary, the past ten years may have been a “lost decade” for EM investors, but not for EM corporates. Understanding the implications of that idea, and only that, is more than enough to warrant consideration of investing in the universe for the next decade. Now the work of finding the individual EM corporates that will deliver the investment return needs of investors begins.
Thank you for entrusting us with your capital during these difficult times. We are, as always, honored to serve as your investment adviser in the developing world.Paul Espinosa,
- 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 September 30, 2021, the Seafarer Funds did not own shares in China Evergrande Group.
- Source: Bloomberg. Data as of 8 November 2021.
- “What China’s Three Red Lines Mean for Property Firms,” Bloomberg, 8 October 2020.
- Sources: Bloomberg, Seafarer. Data as of 8 November 2021.
- Sources: Bloomberg, U.S. Bureau of Labor Statistics, Seafarer. Real rate of return calculated using geometric mean calculation. Data as of 8 November 2021.