During the second quarter of 2024, the Seafarer Overseas Value Fund returned -3.47%.¹² The Fund’s benchmark indices, the Bloomberg Emerging Markets Large, Mid, and Small Cap Net Return USD Index and the Morningstar Emerging Markets Net Return USD Index returned 3.96% and 5.16%, respectively. By way of broader comparison, the S&P 500 Index returned 4.28%.

The Fund began the quarter with a net asset value of $14.12 per share. It paid no distributions during the quarter and finished the period with a value of $13.63 per share.³

Performance

The second quarter of 2024 was a difficult one for absolute and relative performance. Rather than dance around the facts in this portfolio review, I will use the opportunity to illustrate what the Value Fund is and what it is not. A deeper understanding of the Fund’s nature by existing and potential investors as a result of this review would be a positive outcome from a bad quarter.

The Value Fund and the Bloomberg Emerging Markets benchmark are two different beasts. On the concentration and diversification front, it is notable that out of the 4,892 constituents of the Bloomberg index as of June 28, 2024, the highest-weighted stock, Taiwan Semiconductor Manufacturing Company (TSMC), had an allocation of 6.62%. It is also unusual, and therefore notable as well, for the stock with the largest weighting to perform so well as to also account for close to a third of the index’s performance. Indeed, TSMC’s contribution to the Bloomberg EM Index total return of 3.96% was 1.24%, or 31.31% of the benchmark’s performance.

The Value Fund by contrast owned 41 positions at the end of the quarter with the highest weighting of 3.88% allocated to Petronet LNG, a stock with a benchmark weighting of 0.03%.

The Bloomberg benchmark seeks diversification across nearly 5,000 stocks in order to diversify away stock-specific risk and thus derive investment return from market risk. The Value Fund, on the other hand, seeks to derive returns from stock-specific risk while minimizing market risk – thus the 41 holdings and allocations based on the seven categories of value, which represent criteria distinct from market capitalization and growth considerations.

This last point on market capitalization and growth criteria is the reason why the nature of risk that the Value Fund pursues tends to differ from that pursued by the benchmark and by most emerging market growth investors. Most indices determine representation by market capitalization, adjusted by stock liquidity considerations. Many emerging market investors, of the growth persuasion or not, benchmark their portfolios to indices, determining allocations by overweighting or underweighting stocks relative to an index. As a result, many portfolios implicitly use market capitalization as an allocation directive, while explicitly using mostly growth criteria to pick specific companies.

The result is that while benchmarks and growth investors would naturally gravitate to TSMC as an investment given its large market capitalization and growth prospects, it would be uncharacteristic for the Value Fund to do the same. More than an excuse, this is a recognition of a reality with which any investor in the Fund, current or future, should be aware.

Finally, to add more depth to the reader’s understanding of the Value Fund, I will add that not only does the Fund’s nature differ from that of the benchmark as explained above, but the source of TSMC’s return this quarter is one that the Fund hardly ever pursues.

TSMC’s stock price is anticipating earnings that consensus expectations have yet to quantify. As such, TSMC’s price to earnings (P/E) multiple has expanded to 27.13x as of June 28, 2024, from 15.47x as of June 30, 2023.⁴ The market is effectively anticipating future cash flow related to a technology in development – artificial intelligence (AI) – that corporates have yet to define how to monetize. It is the nature of markets to discount the future, even when it suffers from unusually low visibility, albeit with high promise, as is the case with AI. Thus, it is perfectly sensible for the market to take what may be considered a “fair or high” price to earnings multiple and raise it to a “higher still” level in the case of TSMC.

So, I would argue that the market is directionally correct in its price action relating to TSMC, even if the accuracy of its future profit estimate remains to be seen.

What the reader should take away from the foregoing is that as correct as the market may be, the Value Fund does not court this type of risk – extremely low cash flow visibility and ever higher earnings multiples with little information to ground them in terms of valuation. There is a role for that type of risk in the market and for certain investors that specialize in pricing that risk. It is not the type of risk that the Value Fund specializes in pricing, and arguably, is inappropriate for a fund of this nature.

In summary, existing and potential investors in the Value Fund should understand that unlike the benchmark and many growth investors that dominate the emerging markets, the Fund bases investment decisions on the seven categories of value. The Value Fund actively eschews allocations prioritized by market capitalization, speculative growth, and indefinite or ungrounded multiple expansion.

Again, I do believe the market is broadly correct in its treatment of TSMC. Thus, my message to investors is that that source of risk is uncharacteristic to the type of work the Value Fund concentrates on.

A Seafarer Overseas Value Fund investor needs to know that the Fund seeks to outperform the benchmark over a long time horizon measured in years, using sources of investment return that relate more to undervaluation and income generation, than to ever-higher multiple expansion and high growth.

After that long, though hopefully useful preamble, what risks dominated the Value Fund’s performance during the second quarter of 2024?

While the market focused on the technology sector, the Fund’s top two contributors to total return were the same as last quarter and far removed from the AI-related optimism: Petronet LNG (Asset Productivity source of value; the “source of value” for a Fund holding is hereafter referenced in parentheses), India’s largest liquified natural gas (LNG) import terminal operator and Qatar Gas Transport (Deleveraging and Segregated Market), an owner and operator of transport vessels for LNG. The former’s stock price appreciated in recognition of India’s strong energy consumption, and therefore growing need for LNG imports, which have moderated in price from their peak two years ago. Qatar Gas Transport, on the other hand, rose on the back of a second fleet expansion announcement this year. This ongoing asset expansion brings visible growth to the company through the contracted nature of its long-term charters with the national energy company developing Qatar’s vast natural gas reserves.

It is ironic that two other top performers during the quarter were (1) Chinese companies, given the sustained dismal performance of Chinese equity markets over the past two years, and (2) diametrically opposed in terms of fundamental drivers. Both companies, China Yangtze Power (Structural Shift), the world’s largest hydroelectric utility, and Shangri-La (Breakup Value and Asset Productivity), a hotel owner and operator in Asia, share a similar dividend yield of close to 3% as of the end of the quarter, but for different reasons.⁴ The stock price of China Yangtze Power has continued to appreciate, anticipating higher earnings from recent acquisitions, recognizing improved rainfall compared to the prior year, and compressing the dividend yield following lower bond yields in China. Shangri-La’s stock price appreciation and dividend yield originates from the opposite end of the earnings spectrum: the stock price reflects an ongoing resurgence of domestic travel and tourism in China, restoring the company’s profitability, and the dividend yield reflects the resumption of dividend payments after a hiatus during the pandemic. In other words, one stock (China Yangtze Power) enjoys highly visible earnings with a robust payout ratio, while the other (Shangri-La) is characterized by cyclical earnings and a low, but rising, payout ratio.

The market recognized the value offered by two very different stocks. It wasn’t all about AI. And ironically, it happened in China.

On the negative side of the ledger, I would highlight XP, Inc. (Structural Shift), a Brazilian investment management platform, as the primary detractor from Fund performance. This is an interesting case, in that the stock has been a good long-term performer for the Fund based on the structural growth of the online asset management industry in Brazil. However, the stock has also proven to be volatile based on macro factors. During the quarter, the Federal Reserve’s “higher-for-longer” change of tact weakened several emerging market currencies – including the Brazilian real – whose central banks were in the process of lowering interest rates. The potential for an interruption to Brazil’s lower interest rate trajectory prompted the market to re-evaluate XP’s earnings growth momentum, and reversed the appreciation in XP’s stock price that took place in late 2023 in anticipation of lower interest rates. The Value Fund continues to hold XP on the basis of its valuation relative to its structural growth. Unlike the market, the Fund does not trade the stock based on changing expectations around earnings momentum. The Fund will continue to use changes in the market’s perception of XP’s growth opportunistically, and hopefully to its advantage.

Lastly, the Fund’s two holdings in the Republic of Georgia were the second and fourth largest detractors from performance. Bank of Georgia (Asset Productivity and Segregated Market), a leading bank, and Georgia Capital (Breakup Value and Segregated Market), a conglomerate, gave up their gains from the first quarter during the second quarter. Strong first quarter results announcements by both companies were overshadowed by Georgia’s passage of a controversial “Transparency of Foreign Influence” bill. This law requires media and non-profit organizations that receive more than 20% of their funding from foreign sources to register as so-called agents of foreign influence. Georgia’s parliament overrode a Presidential veto to push through the bill despite mass protests and concerns expressed from the E.U. and U.S. Critics worry the law may hamper freedom of speech and stigmatize NGOs operating in the country.

While a disappointing development for the Georgian people, at present, the fundamental impact on the businesses of these two companies looks to be muted. At the margin, it may dampen some of their future growth upside should the law impede Georgia’s aspirations to join the E.U., which might moderate the country’s pace of economic growth. However, it seems premature to declare these E.U. ambitions as definitively over. Polling indicates over 80% of Georgia’s population supports E.U. integration, and national elections in October may serve as an effective referendum on the bill.⁵ Likewise, it bears noting that the political party that pushed through the bill has also been the driving force behind Georgia’s past moves toward E.U. accession – having signed a free trade agreement with the E.U. in 2014, enshrined the goals of E.U. and NATO integration into Georgia’s Constitution in 2017, and received E.U. candidate status in December 2023. The management teams of both companies seem unperturbed; both have continued their share buyback programs throughout the quarter, taking advantage of the cheaper stock prices on offer.

Allocation

During the second quarter the Fund established a new position in Hongkong Land (Breakup Value and Management Change), a property investment, development, and management company with assets located primarily in Hong Kong and mainland China, in addition to Southeast Asia. Through Hongkong Land (HKL), the Fund is investing in real assets valued at distressed levels (0.2x price to book value (P/BV)), without the assets or the company being financially distressed.⁴ Conservatively financed, HKL’s stock does not suffer from the leverage-related distress of many of its peers, but rather from the pessimism associated with the location of its office buildings in Hong Kong. The pessimism surrounding China’s geopolitical place in the world, as well as its property market woes, may also cloud the market’s assessment of HKL’s new and sizable development project in Shanghai, which together with a new CEO appointment this year, will inject renewed growth and vigor into the company after a decade of virtual stagnation. A 6.81% dividend yield, as of the end of the quarter, underscores the valuation.⁴

The Fund exited Petrovietnam Fertilizer and Chemicals (Management Change and Asset Productivity), a Vietnamese fertilizer manufacturer. The Fund has done well with this holding, deriving the majority of its total return in the stock from dividend accruals. By selling this company and purchasing Hongkong Land, the Fund is substituting a lower – though still substantial – dividend yield for a higher one, but acquiring greater potential for future capital appreciation, while gaining more exposure to real assets over simply cash flows, as well as upgrading management quality.

Outlook

Is growth everything? By definition, growth investors earn an investment return from future corporate profit growth in excess of what is captured in the present share price. As the dominant investment strategy in the emerging market universe, changes in growth expectations at the macroeconomic level can result in meaningful price action for an entire stock market. Arguably, the relative underperformance of China and South Korea in recent years has much to do with this dynamic.

As value investors, my colleague Brent Clayton and I recently traveled to China and Korea with a very different set of eyes. We were curious to discover if a growth investor’s discarded market may be a value investor’s gold. Many roads lead to Rome, and the Seafarer Overseas Value Fund pursues investment returns in many ways other than growth, among them value trapped in the balance sheet.

It is highly symbolic that the Seafarer Value Team traveled to China and Korea searching for trapped value in corporate balance sheets, since both countries epitomize the concept at the macroeconomic level as well.

The value trapped in China hides in plain sight in the form of foreign exchange reserves exceeding $3 trillion. The country’s history of targeting the foreign exchange rate against the U.S. dollar means that the People’s Bank of China (PBOC) restricted the growth in the domestic money supply, and directed it to infrastructure projects and state-owned enterprises (SOEs) at the expense of domestic consumption and private enterprises. The absence of a freely tradeable Chinese renminbi means that China’s current account surplus lasted longer and grew larger than it would have otherwise.

The issue at hand for bottom-up investors is whether change is afoot in the monetary management of China, and whether it may release latent value at the corporate level. The evidence that China is in the process of re-arranging its monetary policy is evident in the absence of an infrastructure spending boost (to the chagrin of growth investors) to counter decelerating gross domestic product (GDP) growth, and in the controlled depreciation of the Chinese renminbi to 7.2 to the U.S. dollar from 6.2. The former means slower credit growth and potentially less crowding out of the private sector, and the latter equates to higher domestic inflation, or a nominal GDP boost. Both measures are designed to help reverse the country’s ever rising debt to GDP ratio.

In practical terms, the foregoing means that our meetings with Chinese SOEs focused on identifying a change in their reinvestment versus dividend decision. Overall, we detected no meaningful change. A specific SOE, which shall remain unnamed, had no plans to pay out a significant cash balance despite operating in a lower growth industry. It did not have meaningful expansion plans either. And the company had no clear answer to the quandary posed by its attractive return on equity with ever accumulating excess cash on its balance sheet. Still, this SOE made a discernable effort to increase its standing in the capital markets with many of its corporate managers attending our meeting, including a very senior company official. However, the effort proved richer in form than in substance. Only one of the cast of managers participated in the majority of the discussion, with the senior one solely chiming in on the more difficult questions. Even then, statements of intention and conceptual answers rather than hard data characterized their responses. Nothing useful to a fundamental investor.

While we noticed an effort by SOEs to communicate with the market, macroeconomic policymaking developments have yet to translate to microeconomic change, at least at the SOE level. The question of releasing value trapped in the balance sheet pervaded many of our meetings, including several nominally private companies whose control party is the government, as well as truly private enterprises. I would argue that, while allowing for exceptions, the overall status of cash trapped in corporate balance sheets resembles the standing of China’s foreign exchange reserves. No change.

Korea is at once different and similar to China regarding the release of trapped value. Unlike China, where the state accumulated – at the expense of households - the lion’s share of the profit / savings accrued since it began reforming and liberalizing its economy around 1978, Korea allowed its conglomerates to accrue said wealth during its industrialization. Our trip to Seoul was opportune as it followed the government’s recent announcement of the so-called Value-Up Program. This program is a national initiative to improve the capital efficiency and the return of profit and capital to investors by listed corporates, and thus improve the historically low valuation of the Korean stock market. The former is of relevance to the National Pension Service, the country’s public pension fund, now that the country’s population is rapidly aging, while the latter is more relevant to households who increasingly invest and store wealth in the stock market.

The question before the jury is whether the Korean Value-Up Program will propel the stock market, following in the footsteps of Japan’s own successful effort on the same front, or whether it will follow China’s path of form over substance. Our meetings with Korean corporates benefitted from the announcement of the intention behind the Value-Up Program, but suffered from the lack of concrete detail to date. The most common response to our queries was that corporates are in the process of evaluating the extent of their participation in the voluntary program. Note the phrasing used in the preceding sentence. No corporate dismissed its participation. The only ones to suggest they are unlikely to participate in a meaningful way were high growth companies, for whom the program is less relevant.

I find justified optimism in the positive stock price reaction of many Korean companies following the program’s announcement, though I would caution against impatience. Indeed, while the general acceptance of the program by corporates during our discussions is reason for short-term confidence, I draw long-term comfort from other ideas discussed during meetings. The first one is the expectation that should this voluntary program prove fruitless, the government will follow-up with legislation to coerce better treatment of minority shareholders. The second one is the acknowledgement of the root cause of poor corporate governance by Korean enterprises: a punitive inheritance tax rate of up to 50% (60% for Chaebol families), which incentivizes families to minimize their tax bill by keeping the market value of their wealth as low as possible. This is where China and Korea overlap. Whereas the Chinese state appropriated the majority the country’s savings from the beginning, the Korean government let private conglomerates accrue said savings only to appropriate them on a generational timeline. Both China and Korea appear to underestimate the power of incentives.

The discussion of whether Korea will address directly the pernicious effects of its inheritance tax law, or simply place a band-aid over its self-inflicted wound is steeped in Korean political complexities worthy of a Ph.D. The pragmatic investor would do well to steer clear of an investment decision based on a view regarding a political outcome. Thus, my earlier warning against impatience. The Korean Value-Up Program is well received by corporates, a degree of valuation re-rating in the stock market is justified, and the ultimate impact is uncertain as of today. Incremental improvement is the most succinct take-away from our conversations.

Indeed, selectivity and incremental improvement summarize the conclusions from our most recent visit to China and Korea. I find no meaningful change in the prospect for the release of value trapped in Chinese balance sheets, and find more form than substance in the outreach by SOEs. Conversely, I do find justified optimism for the incremental release of value trapped in Korean corporates. However, in both cases, selectivity must remain the investor’s best friend. There are thousands of listed companies in China with much room to find exceptions to the rule, while in Korea selecting those corporates more amenable to the principles behind the Value-Up Program should prove profitable.

It goes without saying that in my opinion stock selection, as opposed to passive investing, is of paramount importance to avoid the value traps that pervade the landscape of balance sheet-related value in China and Korea.

Finally, at a time of decelerating Chinese GDP growth, concerns over whether Korea is in the middle income trap, and more generally poor emerging market equity returns over the past decade, I urge investors to think outside of the growth box, and consider the very real value stored in the corporate balance sheets of these two emerging countries and corporates.

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

As of June 30, 2024, securities mentioned in the portfolio review comprised the following weights in the Seafarer Overseas Value Fund: Petronet LNG, Ltd. (3.9%), Qatar Gas Transport Co., Ltd. (3.7%), China Yangtze Power Co., Ltd. (2.8%), Shangri-La Asia, Ltd. (3.2%), XP, Inc. (2.9%), Bank of Georgia Group PLC (2.5%), Georgia Capital PLC (2.7%), and Hongkong Land Holdings, Ltd. (2.1%). The Fund did not own shares in Taiwan Semiconductor Manufacturing Company or Petrovietnam Fertilizer and Chemicals. View the Fund’s Top 10 Holdings. Holdings are subject to change.

Source: ALPS Fund Services, Inc.

Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). Bloomberg or Bloomberg’s licensors own all proprietary rights in the Bloomberg Indices. Neither Bloomberg nor Bloomberg’s licensors approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

The Seafarer Funds are not sponsored, endorsed, sold, or promoted by Morningstar, Inc. Morningstar, Inc. makes no representation or warranty, express or implied, to the shareholders of the Funds or any member of the public regarding the advisability of investing in the Funds or the ability of the Morningstar Emerging Markets Net Return U.S. Dollar Index to track general equity market performance of emerging markets.

1. References to the “Fund” pertain to the Fund’s Institutional share class (ticker: SIVLX). The Investor share class (ticker: SFVLX) returned -3.48% during the quarter. All returns are measured inclusive of Fund distributions paid (in relation to Fund performance) or dividends paid (in relation to index performance), reinvested in full (exclusive of any U.S. taxation) on the pertinent ex-date.
2. 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.
3. The Fund’s Investor share class began the quarter with a net asset value of $14.07 per share; and it finished the quarter with a value of $13.58 per share.
4. Source: Bloomberg.
5. “IRI Poll Shows Strong Support of Georgian Citizens for EU and NATO Membership.” Civil Georgia, November 16, 2023.