This Shareholder Conference Call offered a retrospective of the Fund's first year, a discussion of Fund holdings, and a warning to be wary of inflated expectations for earnings growth from emerging market stocks.
Andrew Foster, Chief Investment Officer and Portfolio Manager:
Good afternoon everyone. This is Andrew Foster of Seafarer Capital Partners. Welcome to Seafarer’s Shareholder Conference Call.
This is the second Shareholder Call we’ve held since the launch of the Seafarer Fund in February of last year. We plan to hold these calls approximately twice a year. We value these calls as an opportunity to interact directly with both our shareholders and prospective shareholders. So we welcome your participation and encourage you to ask us questions.
On the call with me today are two of my colleagues from the investment team, William Maeck and Kate Jaquet. Today's call will be approximately one hour in length. I will begin the call with a presentation lasting about 30 minutes. A link to the presentation is available on our website, seafarerfunds.com, and also in the reminder email you received this morning with the conference call details. After the presentation, there will be an opportunity to ask questions.
With these introductions complete, I’d like to thank everyone for joining us today, and let’s get underway by turning to the presentation. Please note the Fund regulatory disclosures listed on page 1. View the Fund’s risk disclosures.
Now please turn to the agenda on page 2 of the presentation. We've divided the presentation into two sections. The first section is a brief retrospective that I'm calling, "What Sort of Fund Do You Own?" We will look back at the life of the Seafarer Fund from its inception to the present. We'll talk about some of the milestones that have been achieved along the way. We'll also take a dive into the portfolio, examining the composition, drivers of performance, and top holdings.
The second section of the presentation will focus on a brief outlook for the year ahead, which I'm entitling, "Walk On, but Tread Carefully." By this I mean the following: I believe that markets are still attractive at present for investors, but there are some challenges emerging at the horizon. I want investors to be aware of those risks and to approach emerging markets with caution. I'll give some explanation as to why that's the case during this section of the presentation. I will also comment on the investment landscape in some of the key markets in which the Fund invests: China, Brazil, Mexico, Poland, and Vietnam. I’m happy to address questions about those markets, or other markets, in the question and answer session, as well.
Section 1: A Brief Retrospective – What Sort of Fund Do You Own?
Let’s turn to the first section of the presentation, "What Sort of Fund Do You Own?" on page 3. If you pick up the Prospectus, you'll see that the Fund’s objective is long-term capital appreciation along with some current income. The Prospectus also lists a second objective, which is to mitigate adverse volatility in returns.
Beyond those objectives, the Fund is unique in that it has a wide-ranging geographic focus. At its core it is an emerging markets fund. It is primarily focused on the developing world. However, we have intentionally included a handful of developed markets in the Prospectus – in part because there are some key companies and countries that are growing in sync with the developing world, and especially because I don't want to be beholden to a benchmark's definition of what is, or is not, an emerging market. We are drawing the Fund along broader lines and finding opportunities as we do so.
With respect to asset classes, the Fund invests across several asset classes including dividend-paying common stocks and preferred stocks, with a small allocation at times to convertible bonds. There is the potential for fixed income, though we have not held any as yet. Our research process is focused on determining the quality of various listed companies and issuers, and the sustainability of their growth. Our process and our portfolio are predominately focused on common equities that pay dividends.
Before we move on to discuss the Fund’s composition, I will make one more comment about what we are trying to achieve with the Fund. The Fund’s goal is to offer a relatively stable means of participating in a portion of emerging markets’ growth prospects, while providing some downside protection along the way. I definitely have experienced a lot of volatility in my career, as I'm sure many of the investors on this call have experienced as well, so part of the goal is to mitigate some of that volatility, and yet still try to capture a portion of the growth, if not all of the growth, that is emanating from the emerging world. That's really the background story behind this Fund and its construct. Regarding the goal of providing some downside protection: it's important to note that I judge this relative to an ordinary basket of common equities from the emerging world and not relative to cash or fixed income. I do expect this Fund to fall when markets are moving in an adverse fashion. It's not as though we're attempting to make major rotational bets between asset classes so as to avoid market declines.
Let's move on to page 4 (“Portfolio Composition – Regions”), where we can see in a practical sense what's been going on with the Fund. This chart shows the Fund's allocations to various regions over time, a sort of “cross-section” of the Fund's geographical construct, if you will. In my view the main message of this chart is that since its inception the Fund has slowly but steadily moved out of East and South Asia, which is the very large red portion of this chart, and into Latin America and Eastern Europe.
We launched the Fund last February with a heavy weighting in Asia for three reasons. First, it is the region where the Seafarer team and I, in particular, have the greatest degree of experience. Therefore we felt strongly that we could add the most value in Asia, and we still feel this way. Second, on a more tactical level, at the time of our launch our research indicated that many of the companies we were seeing – and indeed, the markets overall in Asia – were a bit cheaper than the other major geographical zones and offered better growth versus value tradeoffs. So, tactically, we wanted to have a heavier weighting in Asia as we launched the Fund, and this has proven to be to the Fund's benefit because the Asian region has slightly outperformed the other constituents of the benchmark, the MSCI Emerging Markets Index, since that time.
Third and most importantly, Asia is the largest part of the Fund because it is by far the largest region among those presented here. By any fundamental measure – whether by market capitalization, economic output, or even population – Asia is the biggest piece of the emerging markets. By our own measurements, based on these underlying fundamentals, East and South Asia comprise at least two-thirds of the emerging world, even as the benchmark index suggests Asia is only about 60% of the emerging markets.
This last point is very important because we think the benchmark index structurally misrepresents the underlying fundamentals of many emerging markets. The index is skewed by many small biases and constraints that lead it to under-represent Asia. The notion that the index suffers from biases and shortcomings – surprising given that it is supposed to be “passive” – is a topic we covered in depth on our previous Shareholder Call, last summer. I won’t re-hash that argument here and now, but the transcript and presentation are available on our website. The upshot, though, is that Asia has long been under-represented in the global emerging market benchmarks. We intend to correct for that in the Fund’s portfolio, in order to offer a better, or more accurate, representation of the underlying fundamental reality in the emerging world. So the regional weights you see on the right side of this chart on page 4, as of the end of December, are likely to persist for the foreseeable future.
Regarding the other regions that we have moved steadily into since the Fund’s launch: I'm particularly excited about the opportunities in Eastern Europe. First and foremost, I would list Poland as a market where I see opportunities at this moment. We’ve also moved into Latin America, led by new holdings in Chile and Mexico. We have been less active in Brazil, though we see some signs that Brazil is beginning to turn a corner at the margin and we'll talk more about that toward the end of this presentation.
Overall, though, the portfolio construct that you see on the right side of this chart, as of the end of December of last year, is likely to be representative of the future: a fairly substantial allocation to Asia, reasonable size allocations to Eastern Europe and Latin America, and a smaller allocation to Middle East and Africa, with some small variations over time based on how we read tactical opportunities in markets. This is the construct that we're likely to carry forward because we think this offers the most faithful and accurate representation of the developing world.
Moving on to page 5 (“Portfolio Composition – Sectors”), this chart provides another view of the portfolio allocation over time, but now from a sector perspective. The Fund's sector construct has been relatively stable since its launch. The Fund has some fairly large allocations to financials and information technology, as represented by the thick blue and red bands, respectively. Overall, I believe the portfolio is quite diversified, especially relative to the benchmark, the MSCI Emerging Markets Index.
What you would not see from this chart is how different the Fund’s portfolio is from the benchmark index if you peer a level lower to some of the underlying detail. What we are doing that is noticeably different from the index is putting a very heavy emphasis on service sectors throughout the emerging world. Service sectors often get minimal representation, and in some cases are nearly nonexistent, in the benchmark index. I will provide two specific examples, related to information technology and health care.
The Fund has a fairly heavy weighting in information technology. This sector has been about 18% to 19% of the Fund since its launch. By contrast, the benchmark index has a 14% allocation to information technology. But if you peer a level lower than that and look at what comprises that 14% weighting in the index, all but 2% of it is associated with hardware makers, equipment makers, semiconductor makers, and chip makers, mainly producing products for export to the developed world. Only 2% of the 14% is associated with software and services within the information technology arena. Meanwhile, of the Fund’s 18% to 19% weighting in the information technology sector, 13% of it has been tied to software and services, and only about 5% to 6% has been associated with semiconductors and hardware. The Fund has a very substantial shift toward the softer services side of the industries that comprise the information technology sector.
In like fashion, the benchmark index has a weighting of slightly over 1% in health care, a key services sector for the developed economies of the world. The Fund has been averaging a 9% to 10% weighting in the health care sector since its launch, and I imagine that sort of allocation will continue, valuations and opportunities remaining constant.
It is this heavy emphasis on the services sectors that distinguishes the Fund from the benchmark index. We believe that service industries will produce the most sustained, steady growth over the ensuing decade.
Moving to page 6 (“Portfolio Composition – Capitalization Size”), this chart shows a third view of the portfolio allocation over time, now by company size. We're using the equity capitalization of the issuer of each security in the portfolio as a proxy for size. The important point to note here is that the portfolio is decidedly mid cap in its orientation, as represented by the thick green band on the chart. This orientation is not necessarily a product of deliberate design, but rather the consequence of the kind of growth we're searching for in our fundamental, bottom-up company research.
When we look for individual holdings, we are looking for companies capable of sustained, steady growth over the long term. As I mentioned a moment ago, we're seeing the greatest opportunities in the domestic services sector across the emerging world. This sector is under-developed within the emerging markets, and is rising steadily, in some cases faster than other parts of the economy. The kinds of companies that tend to be players in this sector are not necessarily the largest and most established companies that have been around 30, 40, 50 years. Broadly speaking, the largest companies have been associated with the historical growth drivers of the emerging world, which have generally been commodities and extractive industries, export-oriented industrial manufacturers, and to some extent, large government-owned commercial banks.
We instead have been looking for somewhat younger companies that are entering the nascent services sector in the emerging world. These companies are 15, 20, 25 years old, so they are well established and seasoned companies, but they are still young enough to be nimble. The companies have sufficient historical track records, so we can ascertain whether their business models are viable, and yet they are still young enough to command leadership positions in emerging service sectors. We find these companies often present the most sustainable source of growth and that's why we end up having a significant mid cap weighting.
We are intrigued by many small cap companies, and sometimes the growth is strongest there. However, the challenge presented by small caps is that the emerging world is a very volatile place in which to run a business. Some of the smaller, younger companies have more fragile financial situations and that means the growth they can offer is less sustainable. Growth among small caps can be short-term in nature, due to “churn”: small companies, with unproven business models, unseasoned management, or liquidity constraints, fail or slow down. We seek to invest in more sustainable growth, ideally. Nonetheless, we still have a fairly substantial overweighting in small caps vis-a-vis the benchmark, the MSCI Emerging Markets Index.
Before we move onto the next page, I will note that the three charts we have reviewed, which present different views of the portfolio allocation over time, are available on our website. They are included in the Historical Fund Data Spreadsheet, which is available for download at seafarerfunds.com. This spreadsheet contains a great deal of data on the historical composition and performance of the Fund.
Moving on to page 7 (“Portfolio Valuation Characteristics”), this chart presents some of the Fund’s valuation characteristics since its launch. These characteristics have been fairly steady over time. To put them in context here, the red line on the chart represents the price to book value for the Fund, drawn relative to the left axis. The blue line represents the gross portfolio yield, and it is also drawn relative to the left axis. The green line at the top of the chart represents the Fund’s price to earnings multiple relative to 12 month trailing earnings, and it is drawn relative to the right axis.
There are a couple of points I’d like to make in passing. The valuation metrics for the Fund, as I mentioned, have been fairly steady over time; we're not moving in and out of various holdings based on short-term price movements or trying to chase short-term perceptions of growth or value. Over the life of the Fund, the price to earnings multiple has been roughly in line with that of the benchmark, the MSCI Emerging Markets Index. In fact, at this moment, the Fund’s price to earnings multiple (based on trailing earnings) is a bit higher, at 14 versus 13 for the index. The distinguishing factor, I would note, is that the Fund’s gross portfolio yield has been considerably higher than that of the index – typically 0.75% to 1% higher, depending on when the gap was measured. I believe that this is an outcome of our bottom-up research. We're focused on companies that have strong cash flow and that are able to pay out a great deal of that cash flow in a dividend yield to shareholders in a reliable fashion. The Fund’s orientation toward dividend yield has generated a pickup, vis-a-vis the index, in terms of dividend yield.
Meanwhile, the Fund’s price to book ratio has been roughly in line with that of the index. The Fund’s price to book value has been hovering at about 1.7 to 1.8, as you can see from the red line. The index finished the year with a price to book value of about 1.7. The Fund and index are roughly comparable with each other on this measure, and I would stress that's because we see ourselves as growth investors. We are not seeking deep value or depressed price to book multiples. Instead, we are looking for growth that we can buy at a reasonable price. Primarily, we measure that by dividend yield and the ability to pay out current income.
Lastly, I would note that like valuations for the market overall, the price to earnings multiple for the Fund has risen fairly considerably since the lows of May and June 2012, around the time of our last Shareholder Call. On that call, I said that there were many things working against investors around the world; there were fears over Europe, slowing growth in China, and the U.S. fiscal position. At that time, I said there was one thing investors could count on: that valuations were their friend even if nothing else was.
Unfortunately, I have to suggest now that while I don't see valuations as necessarily being investors' enemy – in fact, valuations are reasonable in light of history and also in light of anticipated growth – they are no longer as friendly as they once were and are well off the bottom. I think valuations have become a slight headwind – rather than a tailwind, as they were not long ago. I'll express more on that idea in a moment.
Moving on to page 8 (“First Year Milestones”), let’s take a look at the major milestones the Fund has achieved since its launch. This page shows a chart of the Fund's NAV from the launch on February 15 of last year through January 15 of this year. The chart is demarcated with certain milestones of the Fund over time. The first major milestone was getting off the ground last February. We had a little less than two million dollars at our launch. Much of that capital was provided by the folks here at Seafarer and a few intrepid friends and shareholders who came with us from day one. We were grateful for their support.
As we moved forward, it turned out to be a tricky time to launch the Fund. I think most of you remember there was a mini bull market in all equities, especially emerging market equities, that ran between roughly the first of January and the end of February last year. We caught the very tail end of that, as you can tell from the chart, before markets started to get very choppy and move sideways throughout March and much of April. At the end of April markets took a sharp leg downward into May and June, and it felt like a pretty tough time to get the Fund off the ground. We tried to stay fully invested and focus on where we saw the best trade-offs between growth and value.
By mid summer, the Fund produced its first distribution of about 3.5 cents per share. That was the distribution for the Institutional share class (SIGIX); there was a slightly different distribution for the Investor class (SFGIX). Then by late summer, in August, the Fund reached the $10 million asset threshold due to steady inflow from some other clients who had joined us in the Fund.
By the fall we started to see valuations move steadily upwards, climbing that proverbial wall of worry about global growth, Europe, and the U.S. fiscal position. We paid a second distribution of 8.7 cents per share on the Institutional class in December. In general, it is the Fund’s policy to pay two distributions a year, one in June and one in December, as described in the Prospectus.
The Fund, like markets overall, experienced a fairly sharp upward movement through December to finish the calendar year off. As we moved into January, the Fund crossed the $30 million asset threshold within the first few days of the year.
Now, as we approach the one-year anniversary of the Fund, we are pleased to announce on this call that as of the 15th of this month, Seafarer has reduced the Fund’s net expenses. We have voluntarily waived an additional portion of the costs associated with the Fund, such that the net expense ratios for the Investor and Institutional share classes have decreased from the previous levels of 1.60% and 1.45%, respectively, to 1.40% and 1.25% today. We are reducing the Fund’s net expenses because both the Fund and the firm have obtained some modest economies and we wish to pass them along to shareholders as soon as possible. Also, we very much believe it is one of the firm's central duties to ensure that Fund expenses become more affordable with scale, and over time. We hope to pass on further economies of scale in the future.
That wraps up the overview of the Fund’s milestones over the past year. Moving on to page 9 (“Fund Performance”), William Maeck, one of my colleagues from the investment team, will discuss the Fund's performance last year.
William Maeck, Associate Portfolio Manager:
Since the Fund’s launch on February 15 of last year, and through the end of the calendar year at December 31st, the Fund gained 14.61% for the Investor class and 14.70% for the Institutional class, while its benchmark, the MSCI Emerging Markets Total Return Index, rose 2.52%. By way of broader comparison, the S&P 500 Index rose 8.31% over the same time period. View the Fund’s performance disclosure.
We are pleased with the Fund's performance to date, but we're also deeply cognizant that the Fund is new and that our work's only just begun. We appreciate your trust and support.
Moving on to page 10 (“Sources of Performance – Regions”), let’s review the sources of Fund performance in 2012. This chart describes the changes in the Fund’s NAV between the launch in February and the end of the calendar year, when the Fund finished up at $11.34. The green bars represent contributions to the NAV or items that increased the NAV – specifically, investment performance by various regions. The red bars represent items that reduced the NAV, mainly expenses and brokerage commissions, but there were also a few portfolio losses as you can see in the Other Markets section. Lastly, the gold bar that also caused a decline in the NAV represents the Fund distributions, which are taxable events for some shareholders.
There are many ways to interpret this chart, but I would like to highlight one. If you were to break down those items that contributed to the gross gains of the Fund by region – Asia versus Eastern Europe versus Latin America versus the Middle East and Africa – you would find that Asia accounted for 60% of the gross gains, Eastern Europe about 24% of the gross gains, Latin America about 13%, and Middle East and Africa about 4%. This contrasts with the Fund's time-weighted allocations in each of those four regions. Asia has been averaging about 70% of the portfolio since its launch, Eastern Europe about 14%, Latin America about 13%, and Middle East and Africa about 3%. I realize that was a lot of statistics to throw out, but the point is that, interestingly, even though Asia has been a large share of the Fund's allocation – 70% – it was only 60% of the Fund's gross gains.
Meanwhile, Eastern Europe contributed 24% of the gross gains, even though it's had an average weighting of about 14%. Latin America had an even contribution, contributing about 13% of the gains versus a 13% weighting.
I find this fascinating, in that I believe we come to the table with a lot of strengths in the Asian region, and yet it's actually been our work in the other parts of the world that has delivered outsized contributions to performance. If anything, Asia's been delivering a bit less at the margin than the rest of the portfolio to the gains we produced thus far.
Admittedly, this analysis is based on a very short time horizon, so I caution reading too much into it. However, we are proud of this performance nonetheless: even as we have done well enough with our Asian portfolio, we have done even better work with our investments in Eastern Europe and, to a lesser extent, Latin America. This gives us a great deal of encouragement as we continue to research other markets around the world.
Moving on to page 11 (“Top Ten Holdings”), this table presents the top ten holdings of the Fund as of the end of the year. I would like to address two of the holdings, to give you a sense of the broad spectrum of holdings in the Fund. Aselsan Elektronik, the fifth company listed on the table, has been the biggest contributor to the Fund’s performance since inception. Aselsan is a mid cap company based in Turkey. It is a producer of electronic systems predominantly used for military purposes, but increasingly used for civilian applications.
Our research indicates that Aselsan is growing nicely and in a sustainable fashion. What is interesting, behind this growth, is the company’s shift from a state-owned management style – due to the fact that the company was majority-owned by the Turkish Army – to much more of a commercial orientation over time.
The exciting development to watch with Aselsan – and what I believe is in large part fueling the company's performance – is the fact that the company is increasingly winning contracts outside of Turkey, away from the Turkish Army, and also with a number of civilian clients. This new set of growth drivers – this new commercial orientation that has transformed the company from a somewhat captive supplier to the Turkish Army, to a truly commercial enterprise – has been exciting for us to watch and I believe has fueled its performance.
At the other end of the spectrum, we have recently added a holding in a company called Ajinomoto, which is the eighth company listed on the table on page 11. Ajinomoto is a large cap food and food ingredients producer in Japan. It is a company that, like much of Japan, has struggled to grow for the last five years. Ajinomoto’s revenues have been basically flat for five years now. We're quite intrigued by this company because during that same time horizon, it has been able to produce very stable, sustainable, and even slightly increasing cash flow as it has worked to reduce costs and restructure its business lines.
Meanwhile, Ajinomoto is increasingly gaining exposure to emerging markets. About 20% of its revenues come from outside Japan, a growing portion of which is from the emerging world. The company has become incredibly disciplined in what has been a very caustic environment in Japan, associated with deflation and declining volumes. It has managed to survive due to this discipline, and meanwhile it is introducing a new growth driver from the emerging world. We think that these factors will lead to more sustainable growth in the future.
So our top ten holdings list includes companies at very different ends of the spectrum: a small, mid-sized company in Turkey that has been growing quite rapidly, and a larger Japanese company that's basically seen a flat line in its growth for the last five years, at the top line at least, but is pursuing new growth opportunities in the emerging world.
Section II: An Outlook for the Year Ahead – Walk On, but Tread Carefully
Let’s move on to the second section of the presentation, which I'm calling "Walk On, but Tread Carefully," on page 12. As it relates to my outlook for the year ahead in emerging markets, I'd like to stress that I'm not much of a macro investor and I don't generate a lot of major prognostications or sweeping views across markets. I don't have much to say in that regard. I tend to look at companies from the bottom up and formulate my views accordingly.
I think there are a lot of well-known risks out there, and I'm happy to address them in the question and answer session, but rather than regurgitate them on this call, I'd rather talk about one subtle risk that I see creeping into markets, and I especially see it from the bottom up. The emerging world may seem cheap at this moment. There are a lot of articles being written about how the multiples in the emerging world are lower than in the developed world, or at least some parts of the emerging world are cheaper, and that forecast growth looks pretty attractive. But I think these forecasts are a bit dangerous because I think they are increasingly become divorced from reality.
Meanwhile, the emerging markets, as I showed you earlier with the Fund's own valuations, have risen quite sharply from the lows of late spring/early summer. I don't think valuations are by any stretch problematic at present, but I am concerned that stocks are well off their lows and this may leave some room for pullback or correction, particularly if there is disappointment about the underlying fundamentals in emerging markets and especially their growth.
To show you what I am talking about, let's move on to page 13 (“Emerging Markets – Sales Growth”). This chart represents the annualized rate of sales growth for the 821 companies that comprise the MSCI Emerging Markets Index, for the past ten years. You can see it’s a fairly volatile measure, but you will also notice that sales growth has declined over the past year, which is the area that I have circled on the right. The top-line growth of these leading companies in the index is not particularly strong relative to history. Sales growth is bouncing around in the low teens range relative to the history that's been around 20% to 25%, outside of the crisis, of course, which you can see in 2008 and 2009.
Growth is still evident. Companies are growing in nominal terms, but I wouldn't say it's particularly robust growth relative to history. This is leading to some of my concern. This meanwhile contrasts against what I'm going to show you on page 14 (“Emerging Markets – Earnings Forecasts”): the nominal forecast growth in earnings per share for the same index going back ten years. You can see some fairly large swings around this index as well – the decline that happened around the 2008-2009 crisis, the resulting recovery in earnings, and the dramatic growth from the bottom that ensued.
What I find interesting about this is that as we left 2010 and went through 2011, we really had some unrealistic forecasts for growth courtesy of the analysts from Wall Street. There were forecasts for 25% to 30% growth during that period that were simply not in keeping with the impending slowdown in Brazil, China, Europe, or India, which was about to unfold.
I was quite happy in a certain respect to launch the Fund last year because by the beginning of 2012, those forecasts had become more tempered and, I believe, more in line with reality, offering about 15% forecast growth. As you can see, toward the end of 2012, the growth forecast is steadily creeping upwards again, to about 23%, and I think the explanation is the perennial enthusiasm of analysts. Stocks did well last year in the emerging world. There have been plenty of minor headaches along the way, but no major catastrophes. Analysts are getting more enthusiastic; they feel clients are getting enthusiastic. There's some optimistic bias creeping into those forecasts.
I really want to stress that I don’t see much evidence to support this creep upwards in expectations. This creep upwards is different from what I see researching companies from the bottom up, and it stands in contrast to the weak top-line growth we saw on the previous page. I think, unfortunately, that the decline in sales growth offers an accurate representation of what’s occurring in emerging markets.
Meanwhile, moving on to page 15 (“Emerging Markets – Price to Earnings Multiples”), the price that you pay for stocks, as evidenced by the price to earnings multiple chart shown here, has been steadily rising since the near term nadir in late spring of last year. This chart represents the trailing price to earnings ratio, based on actual earnings rather than forecasts, for the same MSCI Emerging Markets Index. What you have is multiples rising on the back of more enthusiastic earnings forecasts that I think are at least somewhat detached from reality, and this could leave room for disappointment as the year rolls forward. Do I think we're in danger territory? No, I do not. In fact, I think markets are reasonably healthy in looking forward to the year ahead, but there could be disappointment, and if so, it will probably rattle markets. I just want folks to be aware that we're in a different place than we were at our last Shareholder Call, in July of last year.
In light of my concern about valuations creeping upwards – without much evidence that the fundamentals warrant higher prices – I will make a few comments about the Fund’s positioning. We are happy with the Fund's construct at present. We are trying to introduce a barbell, as I call it, in our strategic orientation. We're simultaneously introducing a bit more risk in some cyclical sectors, but at the same time dialing back risk in some other sectors so as to provide more stability if markets see some sort of shock predicated by earnings disappointment. On the latter, we’re trying to dial back risk by pushing a little more into cash, but mainly into selected Japanese equities like the holding that I discussed earlier.
This approach – having a bit more risk in certain key sectors associated with recovery in China, and meanwhile dialing back risks in other parts of the portfolio – is how we are positioning the Fund for a year that frankly is going to be an interesting one to navigate. If markets do rise throughout the year, you'll see us get more defensive, though, and we'll become less of a barbell and more skewed toward the defensive end of the spectrum.
In the question and answer session I would be happy to address any questions about the outlook and Fund positioning that I have just described. For the moment, though, let’s move to the last page of the presentation, page 16 (“Around the World in 5 Minutes”), where we will make brief comments about the investment landscape in some of the countries in which the fund invests.
Regarding China, I'm still very excited about some of the growth prospects that exist within the country, particularly as the economy restructures. I see plenty of room for the services sector to grow. The services sector is very small in relation to most other developed economies around the world. I estimate that the private services sector in China is well less than a third of GDP (gross domestic product), compared to about two-thirds of GDP in the U.S. So I think there's plenty of room for that services sector to expand in China, and if so, China has plenty of room to grow ahead.
Meanwhile, China is at a tricky crossroads in terms of the challenges it faces. The natural environment there is in terrible disrepair. I'm particularly concerned that the government is facing challenges that it hasn't seen before. The society is advancing very rapidly, and even though the Communist Party has made several attempts at internal reform, I'm afraid that it's not keeping pace with how the Chinese citizenry is changing. I worry that this will put strains on the political system.
As I discussed in a shareholder letter last fall, I fear that some of the saber-rattling that's going on in China is more worrisome than in the past. It's something that shareholders should be paying attention to and taking seriously. I would say against that, valuations are quite favorable in China. China is turning a corner in terms of its growth and is getting its legs under it again, economically speaking. I think China has a narrow path to walk, but we're going to stay invested there at this time. We see opportunity, but it's a tricky market to navigate.
Brazil has been in the news overnight with President Rousseff continuing to introduce reforms to the economic landscape. The reforms that she launched in the second half of last year shocked the market and led it lower, causing Brazil to be one of the bigger underperformers within the MSCI Emerging Markets Index. I want to be clear that we absolutely applaud President Rousseff’s policies, almost across the board. Nonetheless, when I look at Brazil, I think the supply side constraints, infrastructure constraints, and the cost of doing business, which is known as the “custo Brasil,” are some of the bigger impediments to this economy's longer-term growth trajectory.
I think President Rousseff is targeting the right sort of reforms by weakening cartels and trying to introduce lower costs without necessarily implementing strict price controls across the board. I believe her policies will form the basis for a more stable future. The challenge is that in the short run, her reforms have really shocked the market. They have upset cozy profit structures and business models, and this has shocked people who were used to depending on certain sources of profit from listed companies. While this has caused a bit of tumult in markets that we're seeing even today, we believe that the reforms are setting a durable foundation for future growth, and thus we are positive about the future.
At this point I will turn it over to Kate Jaquet, one of my colleagues on the investment team. Kate, do you have any comments on Brazil?
Kate Jaquet, Senior Research Analyst:
The administration’s reforms, combined with the foreign exchange correction that we've seen in the local currency, the real – approximately 20% depreciation since March 2012 – lead us to believe that Brazil is beginning to turn a meaningful corner. The measures that the administration is taking are likely to benefit the domestic sector over the long term – specifically services to consumers – and this is where we are focusing our research in Brazil right now.
So that we can move on to the question and answer session, I'm going to quickly touch on the last three markets listed on page 16.
We’ve had a fairly substantial position in Mexico since nearly the outset of the Fund. We've been pleased by the performance of our holdings in that market this year. We see Mexico as an emerging powerhouse in the Latin American context. The problem is that the country has a relatively small stock market and valuations have run considerably last year. We think Mexico is going to be challenging in the near term outlook, but we plan to stay invested there over the longer term.
Regarding Poland, I hate to rely on a cliché, but I think this market is the baby that's being thrown out with the bathwater in Eastern Europe. Yes, the growth environment is challenging there, and Poland is quite reliant on Germany for its growth prospects. As Germany is struggling, so too is Poland. Nonetheless, we see plenty of growth opportunity in our holdings in Poland. The valuations there are quite attractive in my view. I wouldn't want to suggest that 2013 will be Poland's year by any stretch, but we see a lot of promise in this economy and we are going to stay invested there for quite some time to come.
Lastly, regarding Vietnam, I'm excited to announce that after a nine-month application and registration process, the Fund has been granted a license to invest directly in Vietnamese equities. As of the end of the year, we have begun to invest in some new holdings in Vietnam. We think that this is an economy that investors should pay attention to over the next decade within the Asian context. Right now the economy is in rough shape; it’s emerging from a small-scale banking crisis. The bad news is that Vietnam has some state-owned enterprises that are still casting a large shadow over the rest of the economy. We need to see greater reform amongst those companies. Meanwhile, I'm afraid the banking sector – which has been very compliant in lending to, and otherwise supporting, those same state-owned enterprises – may be in need of a recap or some sort of bailout.
The good news is that the private sector, excluding those state-owned enterprises, is in very robust health and is growing quite nicely. The country’s problems overall are very solvable. The problems in Vietnam are not so large that they can't be solved with the right kind of national policies and political will. If Vietnam undertakes the right efforts – and recent announcements suggest that this is occurring – better days may lay ahead for the country. We are excited to be investing there.
This concludes our presentation today. We will now move to the question and answer session.
Section III: Question and Answer Session
I'm going to lead with a couple questions that we received via our website in advance of this call. The first question is from Erryl in Texas. Erryl asks, what is the latest information on the size of the Fund, and is it growing as fast as you expected?
The Fund was about $34 million as of yesterday, and yes, it is growing as fast as we expected. In fact, the growth has slightly outpaced our own internal forecasts. Meanwhile, there are some other growth drivers at the firm, apart from the Fund, that lead us to be very confident for the future and prompted us to make the reduction in expenses for the Fund that we enabled on the 15th of this month.
A second set of questions has come from John in Alabama and Irv in Virginia. These questions are different, but closely related, so I'll try to answer them together.
John asks, how do you plan to manage the portfolio during periods in which you view emerging market companies to be overvalued, and how will you use various asset classes, such as cash, fixed income and convertibles, to avoid overvaluation in equities? Irv asks, what are you doing to protect against the downside with Seafarer?
I wish I could tell you that we have some macro strategy to time various asset classes within the Fund and switch out of, say, overvalued equities and into fixed income, convertibles or even cash. We don't do that. We really try to stay invested in individual holdings. We're very much bottom-up oriented. When we assess risk or the threat of overvaluation, we look at it through the lens of individual companies. When we seek to reduce risk in the portfolio, it's really a company by company decision. We try to get out of companies that we think have an excessive valuation, and move into companies that offer better growth versus value tradeoffs.
To an extent, we will tactically position the Fund a bit more in convertibles or fixed income if we see – on a company by company basis – a more tactical opportunity with those certain instruments. We may see greater defensiveness in a bond from a particular issuer, rather than its common equity. We're not making asset class level decisions within the Fund, but rather on a company by company basis.
Regarding cash, we're giving ourselves a bit of room to carry higher cash levels within this Fund compared to my past. I previously managed a very large fund with 1% to 2% levels of cash. The Seafarer Fund has averaged between 2% and 5% levels of cash since its outset, and I don't see us doing anything vastly different from that in the future. I think the Fund is unlikely to ever exceed a 10% level of cash.
A third question we received in advance of this call is, what might happen to emerging market equities in the event that bond yields rise substantially? What might it mean for emerging markets more generally if U.S. Treasuries face a setback or yields rise?
This is obviously the $64 trillion question at the moment. I am not a big believer in decoupling. I think that if bond yields rise sharply and there's a selloff in asset classes that are perceived as being low risk, it's likely to be damaging to the emerging world on all asset classes. On a more nuanced level, I do think that perhaps there's a bit more safety in equities than fixed income from the emerging world at present. I have been absolutely astonished at the low spreads that are available from fixed income instruments in the emerging world, and I feel that, relative to equities, there's a bit less safety there than at any other time in my career.
This is the reason that you don't see a very large allocation to convertibles or fixed income in the Fund at present. We're finding more safety at that bottom-up level in individual equities. I don't want to give a blanket endorsement to any particular market, but as I look for safety at the equity level, I am focusing my efforts on Japan at present. The Fund’s Japanese allocation has swung a bit; it is 5% today, it’s been as low as 2%, and at the launch it was about 7% or 8%.
We're slowly moving back into Japan at the margin because we're able to find companies that don't have inflated valuations; that have secure balance sheets that are stabilized by large holdings of cash; and especially that have underrated growth prospects for the future. When you have the sort of deflation and declining economic growth that Japan has lived through for two decades, it's about as caustic as it can possibly be on company financials. Yet, there are many companies within Japan that have learned to adapt and, to some extent, even prosper in this environment.
What I find so exciting about these companies is that they are, for the first time, beginning to find new growth drivers outside of Japan. This is a tier of mid-sized companies in Japan – not necessarily the large cap exporters with which we are all familiar, but rather mid-sized companies – that have learned to survive in this caustic environment, control their costs, produce stable cash flow even as the top line was declining, and now they are beginning to expand overseas. In my view, this is a recipe for margin expansion and for underappreciated growth.
We are excited to look at Japan as these companies expand into the emerging world with strong products and strong cash flow. This is how I hope to provide some defense at the margin, but as I mentioned at the outset, I think this portfolio will experience shocks if markets tumble. There will be very few safe havens if Treasuries get hit hard.
We have a question from Jon of Massachusetts. Jon, please go ahead.
Regarding the portfolio weightings in different parts of the world, can you give me a sense of how you and the team look at increasing or decreasing those weightings? Is it macro based, valuation based, or opportunity based? Obviously it's a combination of all of those approaches, but is it one more than the other? I understand that you are not a macro investor, so is your decision to move more into Latin America based on valuation, opportunity, or what?
We have a micro, bottom-up approach, but this is how the macro influences our process. It sets priorities. We look for ways that we can build a better representation of growth in the emerging world, particularly a better representation than is offered by the benchmark, the MSCI Emerging Markets Index. So we do spend some time looking at the macro picture from the lens of structural shortcomings or biases that might cause the index to be distorted. We identify those deficiencies, and these findings set the priorities in our bottom-up research process. From there on, the entire process is bottom-up. We don't sit around talking about the macro or politics. It's really about individual companies.
William, can you speak about the first research project you did on behalf of Seafarer, which was to research the structural shortcomings of the benchmark.
During our initial research project we identified sectors that were under-represented in the benchmark index, and those were service sectors predominantly. This has led to bottom-up company research within the service sectors.
In other words, when you look at the index, you say, this sector is underweighted and that presents an opportunity. If we overweight the sector, we'll do better than the index.
Yes. We ask, what does the world really look like? The MSCI benchmark says these are the weights in various countries, sectors, sub-industries, et cetera. That's a decent representation but not necessarily a perfect one. In fact, in my view, it suffers from many structural shortcomings. We try to exploit those shortcomings in the background over long periods of time. Those shortcomings do not get corrected overnight, and we are not talking about “is the market too expensive in China and too cheap in Turkey.” We are talking about the fact that the benchmark structurally underweights Asia and has done so for many years. The benchmark structurally underweights domestic service sectors and consumption sectors. Given this is the case, and given that we believe that over time the benchmark will come to follow the underlying fundamental reality, we're going to try to position ourselves ahead of the benchmark. We're going to prioritize our research queue, if you will, to look at those countries and sectors to which the benchmark is giving short shrift, but which also hopefully offer good long-term, sustainable growth prospects.
Our understanding of the benchmark’s structural shortcomings leads to the prioritization of the research queue and the research agenda. Then we do our individual company research. We find the names we want to own. We don't talk at length about interest rates in Brazil or macro politics in China. Sure we have some off-the-cuff discussions from time to time, but it does not influence the portfolio's construct in a material or measurable way. We are, instead, looking for individual names that produce the kind the sustainable growth that we're focused on.
At the very tail end of the process, when we determine the actual portfolio construction and weightings, I revisit our assumptions about the shortcomings of the benchmark. The final weighting in a name reflects, to some extent, a belief that overweighting a name that is not well represented by the index, or overweighting a sector that is not well represented by the index, will pay dividends over long periods of time. In any given year, that strategy doesn't necessarily pay off, but I think that over time, by offering a better representation of the emerging world in the portfolio, the strategy tends to outperform.
So you're not deep value oriented investors. You have a view of the index and how to beat it, combined with good analytics around companies, and this leads to the outperformance.
We hope so. We believe that roughly half of the performance will be driven by stock selection and roughly half of it will result from finding ways to exploit shortcomings in the benchmark. When I say half and half, I mean over long periods of time. In any given year, deviating much from the benchmark, as we all know, creates a lot of tracking error and potential risk. In any given year, if the larger holdings in the benchmark outperform, that could hurt this sort of strategy. But it's been my experience that over longer periods of time, the benchmark will gradually align with the underlying fundamentals, and we have a fair amount of data to substantiate this view. Effectively what you're able to do is position yourself ahead of where benchmark is ultimately going to end up. Simply put, I just refuse to believe that the emerging market benchmark index is going to have a 1% weighting in the health care sector in a decade's time. It will not. And yet that is what the index says today; that describes all health care in emerging markets today according to the index.
The Fund has a 10% weighting in health care. Where the benchmark will be in ten years, I don't know, but our research indicates that health care already represents about 4% of market capitalization in the emerging world and 5% to 6% of the underlying economic activity in the emerging world. The benchmark is vastly underweight the underlying fundamentals, and the Fund is – you could say – double overweight those fundamentals. We’ve done so by researching individual companies, but the weighting is based on an idea of how we might position ourselves ahead of the benchmark.
Understood. Let's say that there were two or three health care companies that you really like. There are funds out there that will take 10% weightings in two companies or something like that. You guys might overweight them a little bit, but you're going to essentially stay around that benchmark. Do I have that correct?
No, we are weighting according to the underlying fundamentals – that is to say, the natural scale and composition of the underlying market, whether measured via market capitalization or economic output. The market capitalization you see presented to you in the context of the benchmark index has gone through all sorts of filters and adjustments. By the time it winds up in an index it's actually, in my view, quite skewed.
We tend to look at the real raw unadjusted market capitalization, and we also use GDP as a major proxy for the underlying fundamentals. These are our pole stars, if you will. Within the portfolio we're pretty concentrated. I would say a big holding for the portfolio is a 4% to 5% weighting. We're not the kind of folks that would put on a 10% weighting in a single position, but we are fairly concentrated.
My last question relates to Poland. You mentioned that you really like Poland. Poland is 1% or 2% of your benchmark index. Would you double that? If you really like the specific area, what kind of weighting would you move to?
Poland has about a 1.5% weighting in the MSCI Emerging Markets Index as of the end of the year. The Fund’s weighting in Poland has been averaging about 11% since late spring, which represents a significant differential from the benchmark. My point is, when you get to a granular level of individual country weightings, the Fund could have substantially different weightings from that of the benchmark, and even from those of the pole stars that I mentioned a moment ago. Tactical views on valuation and growth will drive the differentials between the Fund and the pole stars.
I see valuation and growth opportunities in Poland that are quite attractive in the context of the Fund, and, therefore, the portfolio is substantially overweight what any measure of Poland would be, even on an unadjusted market capitalization or GDP weighted basis. However, when you step back and view the Fund from a 10,000 foot point of view on page 4 (“Portfolio Composition – Regions”), even though Poland represents an outsized proportion of the green strip which is Eastern Europe, the Fund’s aggregate weighting in Eastern Europe is roughly in line with the market cap and GDP that Eastern Europe represents within the emerging world.
All right, good. Thank you.
Thank you, Jon.
We are going to wrap up our discussion here today. I want to thank everyone for participating on the call. We look forward to having future conversations with you.
If you should have any questions about Seafarer or the contents of our presentation, please email us at email@example.com. Also, please sign up for our email list at seafarerfunds.com if you'd like to be notified of our next Shareholder Call.
Again, thank you for joining us and for entrusting us with your capital.
- 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. The MSCI Emerging Markets Total Return 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.
- As of 10/31/2012, Aselsan Elektronik Sanayi Ve Ticaret AS comprised 4.1% of the Seafarer Overseas Growth and Income Fund. As of 10/31/2012, the Fund had no economic interest in Ajinomoto Co. Inc. View the Seafarer Overseas Growth and Income Fund’s Top 10 Holdings. Holdings are subject to change.
- William Maeck and Kate Jaquet are Registered Representatives of ALPS Distributors, Inc.