During the second quarter of 2014, the Seafarer Overseas Growth and Income Fund gained 4.16%.¹ The Fund’s benchmark, the MSCI Emerging Markets Total Return Index, rose 6.71%. By way of broader comparison, the S&P 500 Index rose 5.23%.

The Fund began the quarter with a net asset value of $11.43 per share. During the quarter, the Fund paid a semi-annual distribution of $0.075 per share. This payment brought the cumulative distribution per share, as measured from the Fund’s inception,² to $0.749. The Fund then finished the quarter with a value of $11.83 per share.³

During the six month period ending June 30, the Fund returned 4.90%, whereas the benchmark index climbed 6.32%.⁴

Performance

During the second quarter, the Fund’s performance lagged its benchmark in part because of what the portfolio held (its Vietnamese positions slumped), but mostly because of what it chose to omit (Taiwanese technology firms surged, along with Chinese banks, and Chinese and Russian energy companies).

The Fund’s Vietnam holdings, which had enjoyed a modest degree of outperformance during the first three months of the year, saw their prices crumble amid geopolitical threats. In recent months, China’s oil exploration efforts have led it to assert sovereignty over a section of what has otherwise been recognized as the East Vietnam Sea.

During the quarter, China inserted an oil rig in these contested waters, and Vietnam sought to confront China over its maritime rights. The conflict spilled onshore as Vietnamese protested Chinese presence on the country’s soil, and violent protestors burned or destroyed properties and factories they perceived to be of Chinese origin or ownership. The local stock market plummeted in response, and the Fund’s Vietnam holdings detracted about 0.5% from the Fund’s 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. The Fund’s holdings in Vietnam are distinguished by their strong growth prospects and very reasonable valuations, and absent a severe escalation in the conflict, I intend for the Fund to remain invested there for some time to come.

Meanwhile, the Fund’s lack of exposure to small and mid-size technology companies – mostly located in Taiwan – caused it to lag the benchmark. While interesting investments occasionally surface among the sea of smaller tech firms located in and around Taipei, this group of companies in general is not distinguished by sustainable growth. Most 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. In general I find little that is worthwhile in this segment of the market, though there are notable exceptions.

Meanwhile, a surge in large capitalization stocks – especially Chinese banks, and Chinese and Russian energy companies – took place because investors were apparently less worried about the risks associated with these countries than they were during the first quarter. Such large capitalization stocks are substantial constituents of the benchmark index, so their performance during the quarter left the Fund behind a bit. While the Fund has no immediate intention to invest in either of these market segments, I believe that valuations across much of China are appealing, and there may soon be opportunities to invest in the banking sector (more on this idea below).

Allocation

No major changes were made to the construct of the Fund’s portfolio during the quarter.

No new positions were added during the quarter, though three new positions were added just after June 30. The Fund is actively building up the three new positions, so I will postpone their disclosure until a subsequent review. However, I can offer basic details about each: the Fund added a Chinese publishing house, a Chinese packaging company, and a South African insurance firm. The former two positions are small capitalization stocks (i.e. under $1 billion each), whereas the latter has a capitalization in excess of $10 billion. The publisher is most attractive for its steady growth and low valuation, whereas the packaging company and the insurance firm are distinguished by their growth prospects combined with reasonable valuations.

The Fund exited one position during the quarter, Kimberly-Clark de Mexico (KCDM). KCDM is a consumer products company: it is the largest producer of diapers and other sanitary products in Mexico. The Fund established a position in KCDM shortly after its inception. Seafarer’s research suggested that the company’s steady growth was underappreciated, and that its cash flow would allow it to maintain a steadily rising dividend for many years to come. Since that time, the Fund has enjoyed substantial dividends and capital gains from KCDM’s shares. However, the Fund exited the stock because I perceived better opportunities to re-deploy capital elsewhere in the portfolio. Our analysis suggests that KCDM’s performance has deteriorated at the margin. Growth has moderated, in part because of cost pressures, and most importantly, the company appears reliant on borrowed funds to sustain its dividend. KCDM’s valuation, which was once attractive, is no longer particularly favorable, especially in light of the aforementioned decline in its fundamentals. Consequently, the Fund has moved onward.

Reflecting on the Fund’s current positioning, I have made a slight shift in the portfolio toward higher growth stocks than was the case 18 months ago, at which time the portfolio was marginally more defensive. This shift has been accomplished without any great cost from a valuation perspective. The Fund’s price to book ratio for its equity holdings is unchanged (it is now 1.8, as it also was then), and the gross portfolio yield has declined a small amount (3.1% now versus 3.5% then).⁵ Meanwhile, the consensus forecast for the portfolio’s earnings per share growth over the next two fiscal years has risen from 7.6% to 11.8%.⁶

I have altered the Fund’s exposure in this manner because at the moment, I believe growth prospects for certain stocks are mildly under appreciated (and conversely, some “defensive” stocks appear mildly overvalued). Emerging market stocks have underperformed their developed market peers for the past few years on the premise that growth was decelerating in the developing world, and consequently, the lofty valuations attached to some stocks (rightly) deflated.

However, I wish to emphasize that this recent shift is small in absolute; it is a “tilt” within the portfolio, not a fundamental re-working of its design. The Fund is not out to “chase” growth on the premise that stock markets are about to become ebullient. The portfolio’s investment strategy remains necessarily conservative: the Fund’s secondary objective is to seek to mitigate adverse volatility in returns. If stock markets continue to generate quick, sharp gains, the Fund’s strategy means it might lag its benchmark to an extent. Still, I am pleased to have made this minor shift in the portfolio’s construct, and I think it will serve the Fund well if stock markets continue to climb higher.

Outlook

Over the past month, Chinese stocks have benefited from improved sentiment and better performance. I believe there are two explanations as to why Chinese stocks have demonstrated more life as of late. I suspect both explanations are relevant, and probably operating in tandem.

The first explanation is a straightforward one: Chinese stocks have rebounded because global investors have begun to realize that while the Chinese economy is under some strain, the situation is not as dire as has been suggested by investment strategists or the media. Meanwhile, average valuations on Chinese stocks are low, if not depressed, suggesting that much of the “bad news” about the Chinese economy is likely “priced in” to most stocks. Low valuations and better-than-expected economic conditions together set the stage for better performance. I believe this explanation has some merit, and I tried to indicate as much in Seafarer’s most recent shareholder letter, dated May 12, 2014.

The second explanation is a bit more obscure, and certainly more Machiavellian. To put it bluntly, China’s financial services sector – comprised mainly of banks and insurance companies – needs to recapitalize itself, soon. Excessive levels of credit growth have strained capital adequacy, and an unknown amount of the country’s financial debt has begun to sour. “NPAs” (non-performing assets) are the result, and such bad assets must be restructured or written off, all of which dampen profitability and place further strains on the financial sector’s capital adequacy.

Whether or not they publicly admit as much, I believe China’s authorities harbor no illusions about the looming NPA problem. Consequently regulators have begun to revise capitalization standards, giving financial services firms more flexibility to issue new forms of capital. China’s financial firms have historically been unable or unwilling to issue preferred shares, but now they can do so, and the newfound flexibility has prompted a number of large institutions to announce intentions to issue new stock. Planned issuance of roughly 300 billion renminbi (RMB) (about $47 billion) has been announced over the past 12 weeks, and more is likely to come – the recapitalization bill may well surpass RMB 500 billion ($81 billion) in the end.⁷ Though no plans are definite as of yet, I understand that the banks intend to place roughly half of the new stock overseas, and half domestically, among Chinese investors.

Irrespective of whether the final bill is $47 billion or $81 billion, it’s obviously no small sum. It is so large that price discovery during issuance will be (reasonably) fair: while it might be possible to fool a small group of parochial investors for a bit of money, it is altogether a different thing to part a global, skeptical investor base from tens of billions of dollars. Thus the valuation of these preferred shares might make them interesting to the Fund, and revelatory in any case.

Even as I doubt anyone will play the fool, I do not believe it is a coincidence that the central government recently authorized a “mini-stimulus” package intended to boost the economy. Happily for the authorities, the stimulus has borne fruit just before the recapitalization drive begins in earnest.⁸ Share prices have risen too, which certainly doesn’t hurt the central government’s plans. Still, whether you believe in the straightforward or the Machiavellian explanation for China’s recent rebound – personally, I believe both are true – there are ample grounds to remain invested in China. The Fund will most likely increase its exposure there during the coming quarters, particularly if a forthcoming program entitled “mutual market access”⁹ (informally known as the “through train”) grants foreign investors (such as the Fund) the ability to invest in A-shares. Our preliminary research suggests there are a few diamonds among the A-share ashes. However, be wary of the upcoming preferred share issuance from China: the sheer scale of it has the potential to unsettle the emerging markets over the next few quarters.

Thank you for entrusting us with your capital. We are honored to serve as your investment adviser in the emerging markets.

The performance data quoted represents past performance and does not guarantee future results. Future returns may be lower or higher. The investment return and principal value will fluctuate so that an investor's shares, when redeemed, may be worth more or less than the original cost. View the Fund’s most recent month-end performance.

The MSCI Emerging Markets Total Return Index, Standard (Large+Mid Cap) Core, Gross (dividends reinvested), USD is a free float-adjusted market capitalization index designed to measure equity market performance of emerging markets. Index code: GDUEEGF. It is not possible to invest directly in this or any index.

The S&P 500 Total Return Index is a stock market index based on the market capitalizations of 500 large companies with common stock listed on the NYSE or NASDAQ. It is not possible to invest directly in this or any index.

The views and information discussed in this commentary are as of the date of publication, are subject to change, and may not reflect the writer's current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. It should not be assumed that any investment will be profitable or will equal the performance of the portfolios or any securities or any sectors mentioned herein. The subject matter contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation. Seafarer does not accept any liability for losses either direct or consequential caused by the use of this information.

As of June 30, 2014, the Seafarer Overseas Growth and Income Fund had no economic interest in Kimberly-Clark de Mexico. View the Fund’s Top 10 Holdings. Holdings are subject to change.

1. References to the “Fund” pertain to the Fund’s Institutional share class (ticker: SIGIX). The Investor share class (ticker: SFGIX) returned 4.14% during the quarter.
2. The Fund’s inception date was February 15, 2012.
3. The Fund’s Investor share class began the quarter with a net asset value of $11.42 per share; it paid a semi-annual distribution of $0.072 per share; and it finished the quarter with a value of $11.82 per share.
4. The Fund’s Investor share class returned 4.78% during the six month period ending June 30.
5. Source: Bloomberg and Seafarer. Presented in Seafarer’s Historical Fund Data Spreadsheet, “Portfolio Characteristics” tab, comparing characteristics at 12/31/12 versus 6/30/14.
6. Based on consensus estimates, as derived from Bloomberg. Two-year compound average growth rate (CAGR), as calculated from data presented in Seafarer’s Historical Fund Data Spreadsheet, “Portfolio Characteristics” tab, comparing forecast earnings per share growth at 12/31/12 versus 6/30/14.
7. Bloomberg News, “ICBC Plans to Raise as Much as $12.9 Billion in Capital,” 25 July 2014.
8. Bloomberg News, “China Needs More Stimulus to Meet Growth Goal,” 23 July 2014.
9. In April 2014 the China Securities Regulatory Commission (CSRC) and Hong Kong Securities and Futures Commission (SFC) announced the development of a program called “Shanghai-Hong Kong Stock Connect” that will establish mutual stock market access between mainland China and Hong Kong. The program will allow mainland Chinese and Hong Kong investors to access each other’s equity markets, and will enhance foreign investors' access to mainland listed stocks as well.