During the third quarter of 2015, the Seafarer Overseas Growth and Income Fund returned -14.55%.¹ The Fund’s benchmark, the MSCI Emerging Markets Total Return Index, fell -17.78%. By way of broader comparison, the S&P 500 Index fell -6.44%. The Fund began the quarter with a net asset value of $12.10 per share, and finished with a value of $10.34 per share.²

Performance

During the quarter, the benchmark index (which is published by a firm called MSCI) declined nearly 18%. MSCI also publishes an “Emerging Markets Currency Index” that is comprised only of currencies, and is constructed such that its country allocations mirror those of the Fund’s benchmark. The implicit objective of the Emerging Markets Currency Index is to isolate the effect of currency movements and thereby measure their impact on performance. The currency index declined -6.28% during the quarter, suggesting roughly 35% of the benchmark’s decline during the quarter was attributable to foreign exchange movements. Calculating the equivalent statistic for the Fund with accuracy is difficult, however I estimate that currencies accounted for almost 40% of the Fund’s decline during the same period. Simply put, currencies weighed heavily on both the markets and the Fund.

In the portfolio review for the fourth quarter of 2014, I made a number of statements regarding my outlook for 2015. One of those statements pertained to emerging market currencies. I wrote the following:

I expect the conditions that induced weakness among the emerging currencies to continue, but ultimately moderate... Looking forward, Seafarer’s analysis and my instinct both suggest that most of the currency “pain” is in the past. Certainly, the [negative] conditions [that have caused currencies to decline versus the U.S. dollar] still exist, and consequently the [downward] trend may continue for some time. How long I do not know. Yet it is difficult to underestimate the magnitude of the adjustment that has already taken place.

As far as predictions go, that one was terribly wrong. In 2015, the weakness associated with the majority of emerging market currencies did not abate, but rather escalated. From January 1^st to September 30^th, the Brazilian Real fell 33% versus the U.S. dollar; the Turkish Lira dropped 23%; the Malaysian Ringgit was off 20%; the Indonesian Rupiah declined 15%; and the Mexican Peso was down 13%.³ The Brazilian Real’s decline was spurred by the downgrade of the country’s sovereign debt to a level equivalent to “junk.” Even the Renminbi, China’s currency – notoriously stable, and occasionally strong over the past decade – depreciated about 2.4% during the third quarter as the Chinese government materially altered the mechanism that sets the currency’s value versus the dollar.

Though it means little in the aftermath of such a costly error, I noted the following in the same essay:

First, whether their fortunes are waxing or waning at any given time, emerging market currencies are inherently volatile and risky relative to the dollar, regardless of what anyone says. Second, most currency forecasts are worth less than the paper on which they are written.

Obviously, the second statement applies to everyone, including me. As a general rule, I don’t believe emerging market currencies can become “cheap enough to be safe;” nor do I believe much in sweeping macroeconomic predictions. Yet I am convinced that emerging market currencies are overly depressed. Long-term assets⁴ denominated in emerging market currencies have become particularly attractive when evaluated from a dollar-based investor’s point of view (a topic that I will revisit in the Outlook section below). Admittedly, further currency depreciations might well occur; yet I believe most currencies have already fallen far enough to make further declines unwarranted – at least from a fundamental point of view.

Apart from currencies, a few positions made a notable impact on the portfolio’s performance. The Fund’s eight holdings on the Hong Kong Stock Exchange – all of which are denominated in Hong Kong dollars, and all of which are materially exposed to economic conditions in China – fell in unison amid a broader correction in Chinese stocks. The Fund’s Hong Kong-listed holdings accounted for slightly more than one quarter of the Fund’s losses during the period.

As the Hong Kong dollar is firmly pegged to the U.S. dollar, currency fluctuations played no role in the stocks’ losses. Instead, the positions experienced sharp price declines, falling approximately 20% during the three-month period. This result was bitterly disappointing, not least because it was only marginally better than the performance of the MSCI China index, which fell -22.67% during the quarter.

In the first half of the year, I had some sense that China’s stock market might experience a correction (see China’s Emergence, In Context from June 2015). I had no definitive knowledge as to when the correction might occur – the aforementioned video was recorded only a week before the sell-off began in earnest – yet I had recognized conditions that appeared sufficiently extreme as to warrant caution. I thought the best precaution was to ensure that the Fund’s China-related holdings had “defensive valuations.” By “defensive,” I mean security valuations low enough as to be reasonably confident that such securities might avoid full participation in a market-wide sell-off; and also valuations that feature current yields that could prove attractive in the event of a decline (and thereby offer a second line of “defense” against a potential correction). At the same time, I believed it paramount to avoid Chinese stocks that had been caught up in the frenetic surge that characterized the second quarter. I thought such stock gains would prove unsustainable, as they appeared to be financed by retail investors reliant on excessive amounts of margin finance.

Yet short of exiting Chinese securities altogether, I knew that entirely sidestepping the sell-off would prove impossible. However, I was entirely wrong in thinking the Fund’s holdings were “defensive” enough to buffer the blow. The Fund’s holdings were savaged along with the rest of the market. Xinhua Winshare, a publishing company in Western China, was one of the better-performing stocks within the Fund prior to the sell-off; and it is arguably the Fund’s most intriguing holding within China. This did not stop it from collapsing during the quarter – it fell -34.41%. Another holding, Hang Lung Properties, a seasoned property developer and commercial landlord with an excellent balance sheet, declined -24.69% even though it was valued at a 22% discount to book value before the sell-off began. Despite the stocks’ performance, I remain confident in both companies, and the Fund continues to hold sizeable stakes in both – indeed, the Fund did not sell any China-related holdings during the quarter.

Apart from the broad Chinese market correction, the Fund’s exposure to Latin America – and especially Brazil – weighed heavily on performance, accounting for about one-third of the Fund’s decline during the quarter. The Brazilian Real’s movement versus the U.S. dollar accounted for roughly half of that loss, with losses in the Fund’s Latin American stocks accounting for the other half.

During the quarter, Brazil’s economic woes deepened due to ongoing domestic political strife. The country has been burdened with poor economic and fiscal policy under the current government. President Dilma Rousseff signaled she would like to revise some of her administration’s policies, and introduce greater fiscal discipline; however, her political support has deteriorated to such extent that the Brazilian legislature overturned her efforts at change. Due to the country’s deteriorating fiscal and political situation, one international bond-rating agency chose to downgrade Brazil’s sovereign credit rating to “junk” status, sparking a sharp decline in the Real.

The currency’s rapid descent was a blow to the Fund, as it has carried a substantial “overweight” position in Brazilian equities since April 2015. The Fund’s allocation to Brazil is a direct function of the opportunities that Seafarer has discovered in that market. I believe that each of the current holdings presents unique merits – essentially attractive tradeoffs between present valuation, growth potential and current yield. Consequently, the Fund’s aggregate allocation to Brazil is unlikely to decline anytime soon, despite the losses induced by the Real.

Allocation

Despite the pronounced volatility and losses among emerging market equities, I made no major changes to the Fund’s regional or sector composition during the quarter.

The Fund’s allocation to larger-capitalization stocks (over $10 billion equivalent) has increased by design: I believe that greater value has begun to emerge among some of the Fund’s larger issuers as their share prices corrected during the quarter, and consequently I have increased the Fund’s allocation to such stocks by roughly 3% versus the end of the prior quarter.

By contrast, the Fund’s allocation to smaller-capitalization stocks (less than $1 billion) increased roughly 6% by happenstance: unfortunately a number of the Fund’s holdings were mid-sized stocks that saw their capitalizations shrink below the $1 billion mark due to a combination of price movements and currency depreciation. Though the short-term returns from these former mid-cap stocks have been disappointing, I am pleased to say that the fundamental health of the issuing companies is generally quite good, despite the difficult operating environment across most of the emerging markets. Consequently, I intend for the Fund to remain invested in this group of stocks, even as they have “slipped back” into small-cap status.

Perhaps the greatest change to the Fund’s construct has been its size: during the quarter, the Fund’s assets under management grew 60%, from $357 million to $572 million. Happily, this pronounced growth has not necessitated any major changes to the Fund’s construction. Presently, the Fund does carry a somewhat higher allocation to cash (around 8%) relative to past periods (typically 1% to 5%). I do not intend for the elevated cash holding to signal any particular message about the state of the markets, or the portfolio: rather, the extra cash simply reflects the fact that I have chosen not to rush when investing the Fund’s incoming capital amid falling markets. The Fund’s growth during a time of substantial volatility has afforded the luxury of investing slowly and carefully when others are selling hurriedly. I anticipate the Fund’s cash balance will decline when volatility declines and the Fund’s growth subsides.

The Fund has established one new position during the quarter, a holding in a Mexican Peso bond issued by America Movil, the largest telecommunication company in Latin America. The bond’s residual term is nine years; it has a 7.125% coupon; it has a “single A” rating; and it presently enjoys a yield to maturity of nearly 7.5%. The bond’s elevated yield is largely a function of the risk associated with the Mexican Peso: the same issuer enjoys substantially lower funding costs on its dollar- and euro-denominated debt.

However, even after adjusting for currency risk, there is residual credit risk embedded in the bond: over the past few years, Movil’s asset base has been restructured, and at the same time the company has grown more indebted. Both of these changes have materially weakened Movil’s creditworthiness. Meanwhile, the market seems to speculate that Movil might engage in an opportunistic, large-scale acquisition that would further strain the company’s cash flow. These risks cannot be dismissed. Yet our analysis of the bond suggests that default risk is low and manageable, despite such concerns – and consequently I believe the currency and credit risks associated with this bond are amply compensated by its present yield.

Outlook

As suggested in the first section of this review, I believe that apart from some notable exceptions, most emerging market currencies are substantially depressed versus the dollar. Unfortunately, I do not believe there is any strict fundamental mechanism that will support these currencies in the short run, or which will ensure their long-term alignment. I do not believe there is any theoretical model that can reliably predict “fair value” for a currency. To put it bluntly, the currencies have fallen far – too far in my view – but they may fall further, and there is nothing to ensure they will recover their value, even over the long term.

Seafarer has published a video that discusses the nature of the recent turbulence among emerging market currencies, so I will not repeat the discussion here. However, one important consequence of the currency volatility is that much of the developing world has experienced a sharp deterioration in market capitalization (as expressed in U.S. dollar terms). Consequently, one might question whether developing market companies have become excessively “cheap,” at least from the perspective of a portfolio that utilizes the U.S. dollar as its base currency.

I believe that some companies have grown too cheap under such conditions. I am drawn to those companies that possess high-quality, long-lived assets – particularly those assets that generate revenues from overseas (perhaps denominated in dollars), or assets that are difficult and costly to replace.

I believe the first group of companies (“dollar-earners”) should not experience a permanent impairment in capitalization simply because the local currency happened to decline versus the dollar. By definition, such companies earn dollar revenues and dollar profits. Why should such companies’ market capitalizations shrink in dollar terms, simply because their stock prices are denominated in foreign currencies? Yet for some companies in the developing world, this is exactly what has occurred, possibly creating a mismatch between price and value.

I hold a similar belief for the second group (“replacement values”), which is comprised of companies with assets that are unique or hard to replace – especially assets that are typically denominated in dollars. Like the first group, these companies might experience dwindling capitalizations (expressed in dollars) simply because their stock prices are denominated in weak currencies. Yet the value of such companies’ assets should be little affected: after all, anyone seeking to replace or replicate such assets would be forced to pay the same dollar-based price that the companies once did. This condition has the potential to make such companies attractive assets for acquisition. Imagine a new company seeking to enter an established industry in a given country. Why would the new entrant bother to expend dollars for new assets at full price when it could acquire an existing company at a discount, and thereby gain control of the same assets? This sort of incentive should ensure that companies do not experience capitalizations that fall permanently below replacement costs. Yet I believe this condition has occurred recently – at least temporarily – in markets where currencies dropped precipitously over the summer.

Neither “dollar earners” nor “replacement values” will necessarily make emerging market stocks perform well. However, the materialization of such situations suggests that value has begun to emerge, even amid the pervasive currency weakness.

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

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 MSCI Emerging Markets Currency Index sets the weights of each currency equal to the relevant country weight in the MSCI Emerging Markets Index. Index code: MXEF0CX0. 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 September 30, 2015, Xinhua Winshare Publishing and Media Co. comprised 2.8% of the Seafarer Overseas Growth and Income Fund; Hang Lung Properties, Ltd. comprised 4.2% of the Fund; and the America Movil SAB Corporate Bond 7.125% 12/09/24 MXN comprised 1.1% of the Fund. 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 -14.57% during the quarter.
2. The Fund’s Investor share class began the quarter with a net asset value of $12.08 per share, and finished with a value of $10.32 per share.
3. Source: Bloomberg.
4. For example, high quality companies, with solvent balance sheets, capable of sustained growth.