During the fourth quarter of 2013, the Seafarer Overseas Growth and Income Fund gained 3.10% for both the Investor and Institutional share classes. The Fund’s benchmark, the MSCI Emerging Markets Total Return Index, rose 1.86%. By way of broader comparison, the S&P 500 Index rose 10.51%.

The Investor and Institutional classes began the quarter with net asset values of $11.39 and $11.40 per share, respectively. During the quarter, each class paid a semi-annual distribution: the Investor class paid approximately $0.395 per share, and the Institutional class paid approximately $0.405 per share. Both classes finished the year priced at $11.35 per share.

For the calendar year as a whole, the Fund’s Investor and Institutional classes returned 4.93% and 5.03% respectively, while the benchmark index declined by -2.27%.

[Please note: this portfolio review encompasses only the fourth quarter of 2013, and not the entire calendar year. The Fund operates on a fiscal year that concludes April 30; as such, Seafarer offers comprehensive portfolio reviews for its annual and semi-annual periods, which are published in the Fund’s Shareholder Reports in late June and December respectively. Previous Shareholder Reports are available in the Archives.]

Performance

During the fourth quarter, the Fund produced gains, and it outpaced its benchmark. However, investment conditions within the developing world were far more problematic than those positive results might suggest. Thailand and Turkey were both beset by severe (and unrelated) political unrest; China’s stock markets slumped on evidence that the country’s economy continues to decelerate; and emerging market currencies continued to fluctuate wildly, depreciating against the dollar.

Thailand’s political landscape has been deeply divided for the past seven years following a coup that overthrew the country’s Prime Minister. A few years ago, Thai factions loyal to the deposed Prime Minister elected his sister to the same office. Her government has done little to bridge the deep political divide, and a wave of protest swept Bangkok during the fourth quarter. Demonstrators in Thailand demanded that the current government abdicate power, and street protestors attempted to block an election that was intended to diffuse the political tension. Deadly violence has further marred the political clash, and no obvious resolution is in sight. Thai stocks slumped in response, though the Fund’s small exposure to the country allowed it to avoid the brunt of such losses.

However, the Fund fared less well with Turkey. A far-reaching corruption probe in that country ensnared large swathes of Prime Minister Erdoğan’s cabinet and his party (the AKP, or Justice and Development Party). The Prime Minister’s office responded aggressively in kind, accusing members of the judiciary and police of participating in a conspiracy to overturn his government. The resulting strife led to numerous arrests and dismissals of public servants, and the ensuing chaos has caused economic policy to grind to a halt. Stocks retreated sharply in December, and the Fund’s Turkish holdings detracted from performance by approximately 1% during the quarter.

Meanwhile, economic uncertainty weighed heavily on China. Data from the fourth quarter suggested that China’s economy continued its deceleration; that news in turn caused stocks in China and elsewhere to slump. At the end of 2012, China’s communist party installed a new government. Since that time, the new leadership has pursued two main objectives: to promote better-quality economic growth and to reign in the corruption that has polluted the party’s own ranks. For the most part, the ensuing political and economic reforms have been welcome – at least on the surface. However, we have material doubts about the efficacy of the anti-corruption campaign, and the new economic policies have yet to extricate the economy from its deceleration. Nonetheless, the Fund’s holdings within China and Hong Kong performed well during the quarter, and when measured in aggregate, contributed positively to performance. Still, we remain wary of economic and financial conditions within the mainland.

Currency volatility also returned with a vengeance during the quarter. Last May, the U.S. Federal Reserve Chairman suggested that the central bank might slowly withdraw its accommodative monetary policy, and that led to a pronounced bout of currency weakness in the developing world. Currency risks subsided during the latter portion of the third quarter, but they resumed in the final months of the year. The Brazilian real and the Turkish lira posed the largest problems for the Fund: the former cheapened on the perception that the Brazilian economy is mired in a low-growth, high-inflation condition reminiscent of “stagflation”; the latter fell due to fears that Turkey’s political instability would hinder its ability to finance its large trade deficit.

Both currencies fell approximately 6.5% during the quarter as a result; and in aggregate the two currencies detracted about 1% from the Fund’s performance during the period. The market’s assessment of the plight of the two nations is directionally correct; but nonetheless the currencies’ sharp retreat probably exaggerates the countries’ underlying problems. Still, emerging market currencies tend to overreact, and the real and lira may fall much further before this bout of currency weakness subsides once more.

Despite our concerns about China, the Fund’s holdings there performed quite well during the quarter. Chief among those positions was Beijing Enterprises, a diversified conglomerate with interests in gas distribution, beer, and wastewater treatment. The company completed a somewhat contentious acquisition during the quarter within the gas distribution industry: it attempted to buy a strategic stake in a separately listed entity (China Gas) from their mutual, unlisted parent. Minority shareholders contested the transaction; most, including Seafarer, felt that Beijing Enterprises was moderately overpaying for its target. The terms of the deal were eventually revised in a favorable manner, and when the revisions were announced, the shares of Beijing Enterprises surged higher. The stock has subsequently pulled back in 2014, but it was one of the largest contributors to the Fund’s performance in the fourth quarter.

Allocation

Looking forward, a number of major challenges confront the emerging markets. Thailand and Turkey continue to experience severe political unrest, with no clear resolution in sight. Turmoil has returned to the currency markets, and talking heads have begun to promote the concept of a “fragile five” (Brazil, India, Indonesia, South Africa, Turkey) – countries they deem especially susceptible to currency depreciation because of trade deficits, fiscal deficits, or a combination of both. Economic growth has decelerated in almost every developing country; Brazil’s economy has decelerated such that its recently-vaunted expansion is now at a standstill. The U.S. Federal Reserve’s decision to gradually withdraw its extraordinary monetary stimulus has placed pressure on bond markets within the developing world. At the center of it all, China’s growth has slowed considerably, and there are signs of financial distress there. As I commented in our Third Quarter 2013 Portfolio Review, I believe that the risk of a liquidity crisis or “credit event” in China (i.e., a default of a financial institution or major corporate counterparty) has undeniably risen. Combined, these risks have instilled a degree of panic within the emerging markets, and individual stocks have begun to trade in an erratic fashion.

As strange as it might seem, I am not overly concerned about most of the aforementioned risks. Maybe it is because I have experienced prior circumstances that were similar, and in my opinion, those past events were far more trying than present conditions. Maybe it is because valuations have grown increasingly attractive; in my view, they sufficiently discount nearly all the risks noted above. Maybe it is because I secretly enjoy financial panic. Panic is a brutal force, and it is unknowable. You cannot determine what damage it will do, or the extent to which stocks will fall in its wake; you can only make educated guesses about what might be susceptible. Yet panic is also beautiful, if only for the consistency of its effect: it always delivers better investment opportunities than existed previously. Like any investor, I am frustrated by panic, yet I thrive on it.

I find the current fears over the political landscape in Turkey to be exaggerated. I don’t pretend to be an expert on the country, and I have no crystal ball. I don’t know if Erdoğan’s government will prevail over its opposition; nor do I even know which outcome the market would prefer. At the same time, I am comfortable that the political and corporate institutions in Turkey will survive and gradually improve over time. Turkey is far from being a bastion of open, accountable and fair government; sadly, graft plays a major role within Turkish politics, and it may prove to be Erdoğan’s undoing. Yet I have travelled there enough to know that Turkey is no banana republic, nor is it likely to become one. I am confident that the country’s political and legal infrastructure, such as it is, will survive the current tumult. Even more so, I am confident that younger generations within the country will ensure that the government’s institutions modernize and grow more accountable. Thus I am drawn to the current panic.

I find the moniker of the “fragile five” to be superficial. There is no denying that currencies have been highly volatile over the past year, and that the “five” have born the brunt of the losses. As noted above, the Fund has not gone unscathed. Yet I am bemused by the knee-jerk reaction of the financial markets. I lived through the Asia currency crisis of 1997-1998, and current conditions are not as grave. Balance sheets were the terrible crux of that crisis; there was too much debt in Asia, and too much of it was dollar-denominated. Sub-par growth – not broken balance sheets – is the problem that now confronts the emerging world. Yet some market strategists are warning of “contagion” and suggesting that “we have seen this … before.”¹ Apparently everything you need to know about currencies is contained on the back page of The Economist – if a country runs a fiscal deficit and a trade deficit, it is “vulnerable,” and a candidate for a sharp sell-off. Absent is any understanding about the extent to which such countries have internal financial reserves (most do), or whether they have developed local bond markets to help finance their deficits (most have), or whether they have reduced reliance on the dollar (most have), or whether they have taken steps to extend the maturity of their foreign borrowing so as to avoid a short-term liquidity crunch (most have). It’s bittersweet that some of the pundits who are now decrying emerging market currencies also cheered the currencies not long ago – when most of them were 10% to 25% higher versus the dollar. (For the record, Seafarer was not among those cheering.²) It may be a rough ride ahead; but again, I am drawn to the panic.

The one major risk that I cannot dismiss or even diminish emanates from China. As noted in various Seafarer commentaries over the past several years, China’s growth is slowing. This deceleration coincides with a major shift in the country’s economic model, and that shift has given rise to significant economic uncertainty. The slow-down also happens to coincide with a great deal of accumulated bank debt that must be refinanced. Much of that debt was extended not based on the creditworthiness of the borrower, but rather based on implicit or explicit guarantees. Large debts, when combined with non-creditworthy borrowers and economic uncertainty, are usually a recipe for financial distress. The resulting financial risk is substantial, and there is some evidence that such distress is materializing within the mainland.

As a nation, and on paper, China is both liquid and solvent; in theory, it enjoys sufficient resources to manage the current set of financial risks. However, practice often bears no resemblance to theory.³ China’s financial system – which is dominated by state controlled banks – is deeply inefficient. There are many ways that inefficiency manifests itself. Most observers will quickly tell you that the banks are poor allocators of capital, steering loans to non-viable, state-favored projects. I would not argue this point much, except to point out that relative to the past, the banks are much improved. However, what concerns me is not the banks’ long-term lending ability; instead, I am worried about the banks’ short-term ability to manage liquidity gaps during a credit crunch. Relative to the U.S., China’s financial system is far less sophisticated and less diversified, particularly when it comes to managing such short-term liquidity pressures. China may be liquid in aggregate, but if that liquidity is not channeled to where it is best deployed, financial panic may ensue; and panic will rapidly undermine a financial system built on guarantees rather than capital and creditworthiness. The opacity associated with some of the darker corners of China’s economy will exacerbate any resulting distress. It is not a foregone conclusion that China will face a "credit event" – the country still has plenty of tools at its disposal to manage the elevated risks. Nonetheless: be wary of any disorderly defaults within the country's banking or corporate landscape, as the consequences might cascade.

Despite this warning, I am not panicking, nor is the Fund abandoning its long-term strategy. We are cognizant of the many risks that surround the emerging markets; as usual, some risks are ebbing, and others are escalating. I imagine that markets will be rough over the coming months. Risks may emanate from many different markets, but China should be investors’ primary concern. For the time being, the portfolio’s construct will remain largely unchanged: we are reasonably confident that the portfolio is prepared for financial distress, even as we cannot know where panic will manifest itself, or how far it will go. Valuations are favorable now, and support a long-term approach, even if the short-term outlook appears rocky. We will make modifications at the margin, reacting to price movements of individual securities, concentrating our favorite positions, and possibly selling off some of the chaff. Above all, we remain attuned to the long-term opportunities that panic might present.

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

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 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 12/31/2013, Beijing Enterprises Holdings Ltd. comprised 2.4% of the Seafarer Overseas Growth and Income Fund. The Fund held an indirect interest in China Gas Holdings Ltd. via its interest in Beijing Enterprises. The Fund did not hold a direct interest in China Gas. View the Fund’s Top 10 Holdings. Holdings are subject to change.

1. Bloomberg, “Developed Economies Seen Fighting Off Emerging-Market Contagion,” 27 January 2014; and Reuters News, “Analysis: Emerging markets as vulnerable to contagion as ever,” 27 January 2014.
2. Please see this essay on the Brazilian real, or these two essays on the Chinese yuan (part 1 and part 2), or this 2011 interview with Morningstar.
3. A favorite, and possibly apocryphal quote, from Yogi Berra: “In theory, there is no difference between theory and practice. In practice, there is.”