November 8, 2022

Dear Fellow Shareholders of the Seafarer Funds,

I am pleased to address you on behalf of Seafarer Capital Partners (“Seafarer”), the adviser to the Seafarer Funds (the "Funds"). This semi-annual report covers the first half of the Funds’ 2022-2023 fiscal year (May 1, 2022 to October 31, 2022).

I write to you at an important moment for China, and by extension the emerging markets asset class as a whole. Seafarer has consistently advocated for a balanced approach to the risks of investing in China. Members of our investment team have for years sounded the alarm on stimulus-driven asset bubbles, an overleveraged property market, the impact of a deteriorating U.S.-China relationship, and the Communist Party’s efforts to exert control over Chinese companies.

However, over the past several years, there appeared to be a major disconnect between the lofty valuations many investors were assigning Chinese companies and the long list of risks that could impact their growth. At the height of this trend, some of the analysis of China’s leading technology firms seemed completely divorced from the difficult and complicated operating environment they face.

This disconnect between perceptions and reality is now rapidly unwinding because of two key developments. The first is that the market has belatedly realized that Xi Jinping has reshaped China’s political and economic objectives. For the past few decades, investors have viewed China’s leadership as relatively flexible and pragmatic. The country’s overriding economic goal was rapid growth and integration into the global trading system. Under Xi Jinping, however, China’s priorities have changed. National security now plays a larger role in shaping economic policy and the state is more willing to intervene to influence market outcomes. Perhaps even more concerning is that policymaking in China has become more rigid and less adaptable. The Chinese economy is currently being dragged down by the weight of several policies badly in need of reform, including “zero-Covid” and the crackdown on the real estate market. As Xi Jinping enters an unprecedented third term in office, it’s clear that China’s political trajectory is not about to change anytime soon.

The second factor bringing market expectations back to reality is the impact of the strained U.S.-China relationship. As ties have deteriorated, policymakers in both countries have taken actions to target each other’s economies. Chinese companies now face tariffs, restrictions on access to key technologies, export bans, sanctions, forced delisting, and investment blacklists. Moreover, U.S. policymakers are now explicitly calling for action to prevent key industries from developing in China.¹ Under some extreme scenarios, such as a conflict over Taiwan, capital flows into and out of China may be dramatically restricted. For investors in Chinese stocks, these policy risks can no longer be ignored or downplayed. Given hardening viewpoints in both Beijing and Washington, it is unlikely that the relationship will meaningfully improve anytime soon.

While these two developments – China’s changing priorities under Xi and the deterioration of the U.S.-China relationship – are hugely significant, they are not new. As mentioned above, Seafarer’s investment team has written extensively about developments as they have unfolded. However, as the market has finally caught up to the new reality on the ground, it has been accompanied by volatile moves in the prices of Chinese securities. Market participants are now struggling to value Chinese assets in this new and more difficult investing environment.

As investors reevaluate their approach to China, I would like to offer a few items for consideration:

First, I don’t believe that the Chinese economic miracle of the past few decades was the result of a predictable and market-friendly government in Beijing. The view that China before Xi Jinping was a bastion of support for the private sector is historically inaccurate. A closer examination of the past reveals that Chinese entrepreneurs have faced policy discrimination and ideological backlash from the government almost continuously since China began opening up in 1978. China’s economic transformation is as much a story of private enterprise thriving in difficult circumstances as it is the government leading through top-down policy reforms. There’s no guarantee that China’s entrepreneurs will manage to overcome the unprecedented challenges of the Xi Jinping Era, but I wouldn’t count them out yet.

Second, despite policy retrenchment in other areas, China’s capital markets have generally become more open and better governed over the past decade. Through the Stock Connect and reforms to the Qualified Foreign Institutional Investor (QFII) program, it’s never been easier for foreign investors to access China’s domestic equity markets. Moreover, China has made meaningful improvements to its rules that govern trading on its stock exchanges, reducing suspensions and improving listing rules.² Last year, a Chinese court approved the country’s first ever shareholder class action lawsuit.³

Third, Chinese companies are beginning to attach greater priority to shareholder return. The number of firms paying a cash dividend in China’s A-share market increased from 1,981 to 3,241 between 2015 and 2021.⁴ During that same period, total annual dividends grew from $120 billion to $254 billion, with the average payout ratio increasing from 35.5% to 39.2%.⁴ Buybacks in the A-share market have grown quickly, although they are still far less common than in the U.S. and European markets. To further promote this trend, Chinese regulators recently relaxed the relatively strict rules governing buybacks.⁵ China’s Hong Kong and overseas-listed companies have announced record buybacks and special dividends in 2022.⁶

Fourth, the very best Chinese companies will not be confined to China’s domestic market. In 2021, there were more than 150 A-share stocks with at least $1 billion in overseas revenue.⁴ As China’s economy slows, more Chinese firms are now making a concerted push to expand abroad. While growing international restrictions are an unavoidable headwind, Chinese companies are finding ways to access the American and European markets through overseas subsidiaries and joint ventures. Furthermore, the barriers to Chinese businesses are considerably lower in much of the developing world. In these countries, many Chinese companies (or their affiliates) are market leaders in industries such as electric vehicles, batteries, e-commerce, clean energy, and mobile payments.

My expectation is that the Chinese economy will not return to the rapid growth of the past, the country’s policy environment will continue to be difficult, and the U.S.-China relationship will remain strained. However, given the factors listed in the paragraphs above, I’m also optimistic that through careful, bottom-up analysis, Seafarer will continue to find a handful of attractive companies in China. In fact, despite our concerns about political and economic developments in China over the past few years, we’ve continued to research new investment opportunities in the country. As market sentiment on China has oscillated between euphoria and despair, Seafarer has maintained a steady path between these two extremes.

Borrowing a phrase from the late Deng Xiaoping, we will continue to “seek truth through facts” when investing in China. That involves developing a deep understanding of the businesses we invest in through thorough analysis of their earnings, balance sheets, and governance structures. It also entails a clear-eyed examination of the operating environment these companies face that neither minimizes nor exaggerates risks. There’s no guarantee of success when investing, but I believe that Seafarer’s approach of disciplined active management is best suited for the challenges and opportunities presented by China in this new era.

Expansion of Seafarer’s Team

Seafarer continues to invest in its portfolio management and operational capacities, particularly through additions to the team. During this semi-annual period, I am pleased to report that Seafarer hired two individuals.

Lydia So joined Seafarer as a Portfolio Manager. Effective August 31, 2022, she was named a Lead Portfolio Manager of the Seafarer Overseas Growth and Income Fund. She joins Andrew Foster and Paul Espinosa, who remain Lead Portfolio Managers of the Fund. Lydia is responsible for the Fund’s growth-oriented securities. For more information, view the Message to Shareholders – Portfolio Manager Update.

Hannah Woolley joined the firm as a Business Manager. Hannah helps manage several key business functions, focused on fund administration, technology, business continuity, and human resources. Prior to joining Seafarer, she worked as an administrative lead at Wellington Management.

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

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.

1. “Remarks by National Security Advisor Jake Sullivan at the Special Competitive Studies Project Global Emerging Technologies Summit,” The White House, 16 September 2022.
2. “China A Shares Future Outlook,” Asia Securities Industry & Financial Markets Association, July 2021.
3. “Chinese Court Rules Against Kangmei in 'Milestone' Case’,” Reuters, 12 November 2021.
4. Source: Wind Information. Data as of 2 November 2022.
5. “China to Ease Share Buyback Rules Amid a Sluggish Market,” Reuters, 14 October 2022.
6. Sources: (a) Wind Information. Data as of 2 November 2022. (b) Clarence Leong, “Chinese Companies Boost Returns to Shareholders,” The Wall Street Journal, 9 May 2022.