Video Transcript
Natalia:
Hello. Thank you for joining us for the second quarter 2024 portfolio briefing video for the Seafarer Overseas Value Fund. I'm here with Paul Espinosa, lead PM on the fund, and Brent Clayton co-PM on the fund. Thank you both for joining us. Paul, could you tell me what the performance was for both the fund and the Bloomberg emerging market Index for the second quarter?
Paul:
Thank you, Natalia, for the second quarter of 2024, that is from March 28th till June 28th, the Seafarer Overseas Value Fund returned minus 3.5%, whereas the benchmark, the Bloomberg Emerging Markets Benchmark returned plus 4.1%.
Natalia:
The fund does seem to be lagging performance-wise quite a bit, so perhaps we could talk about some of the drivers of that performance.
Brent:
Sure, yeah, it was a disappointing quarter for the performance of the fund, both in a relative sense as well as in absolute terms. And we really focus on absolute return, but offer a few comments regarding the performance of the Bloomberg Index. And I would also suggest that those viewers who are interested should take a look at the Seafarer Overseas Growth and Income Fund portfolio briefing video for some additional color and more in-depth discussion on what transpired more broadly in the emerging markets during the quarter.
So starting with the Bloomberg Emerging Market Index, it really was driven by some of the more growth-oriented parts of this index. Namely, I'd start with Taiwanese chip-making stocks, which were really led by Taiwan Semiconductor or TSMC, which was up about 24% in US dollar terms for its local shares, which really seemed to be driven by excitement for artificial intelligence.
Second, I'd point to India, which tends to be one of the more expensive emerging markets, at least from a multiple standpoint, which returned about 8% for its Sensex index in US dollar terms during the quarter.
And then third, China tech stocks mounted a comeback or rebound during the quarter, really led by Tencent, which is one of the index giants and a large tech company in the country, which itself was up about 24% in US dollar terms. While we do own a handful of Indian stocks in general, these are segments of the market that we've struggled to find many opportunities as value investors. And while it's painful to underperform in the short term, we're not going to start chasing market thematics or the latest hot sector. We're sticking to what we do and our value approach, which really pursues value in the emerging markets through the seven sources of value, which is detailed in the white paper on our website.
Shifting to the performance of the fund itself on the positive side of the ledger, the fund saw gains in its India holdings that was on a geographic basis the largest positive contributor to performance, which these holdings partly benefited from the broader rally in Indian stocks as well as some company-specific developments. In particular, I'd highlight Petronet LNG, which is India's largest LNG or liquefied natural gas import terminal company, which was up about 25% in US dollar terms during the quarter. This seemed to be really be driven by an expectation that India will grow its importation of liquefied natural gas in the years to come as global liquefied natural gas prices have moderated in recent months. And second, the company provided an update on the expected completion timeline for a pipeline in the south of the country that may serve to increase the capacity utilization of one of its southern terminals.
The fund also benefited from its holdings in China, which were another source of positive return for the fund. In particularly, performance was led by some of the more hard asset-intensive holdings. In particular, China Yangtze Power, which is a hydroelectric power producer and owner of the Three Gorges Dam as well as Shangri-La, which is a hotel owner and operator, neither had particularly meaningful company-specific announcements during the quarter. So this may just be the market starting to recognize some of the value on offer in some of these more hard asset intensive businesses, which is something we touched on in last quarter's portfolio briefing video, and particularly regarding Shangri-La.
Unfortunately, the gains in these names were overshadowed by losses elsewhere in the portfolio, which really seemed to concentrate in Brazil and the Republic of Georgia. I would say at a top level, these were much more driven by macro drivers or top-down factors as opposed to bottom-up company developments. Starting with Brazil, this was the single biggest detractor to portfolio performance during the quarter. We started the quarter with about an 11% weighting to Brazil spread across four positions. Currency movements was a big part of their underperformance during the quarter with the Brazilian Real depreciating about 10%, which seemed at least for three of the four positions to explain most of their loss. For the fourth position, which was down a bit more, was XP Inc, which is a Brazilian investment platform company. It's kind of akin to Charles Schwab, but focused on the Brazilian market. The stock was down 31% during the quarter, which I think was really driven by expectations over Brazilian monetary policy.
And what I mean by that, the Central Bank of Brazil has been in the process of cutting its interest rates in the past year. It's cut its interest rates about a little over 300 basis points to a level of about 10.5%. And for XP interest rates impact its business in a couple of ways, but more specifically, I would highlight that investors tend to divert their savings to fixed-income products when interest rates are high over its more profitable equities business, although it makes money on both segments of this business and it may slow the pace of new client additions to their platform.
I think this earnings downgrade or impact of slower growth may overshadow or is maybe overly focused by the market and the sell off and underappreciate the underlying profitability of this business as well as its already discounted valuation.
Shifting last to Georgia, the fund owns two positions in Georgia, a leading bank and a leading conglomerate. Both are listed on the London Stock Exchange. These positions were some of the biggest positive contributors to performance in the first quarter ending in March, but lost the gains that they had in the first quarter in the second quarter, which seemed to be related to the passage of a controversial law in Georgia, which requires that media organizations as well as NGOs that receive more than 20% of their funding from foreign sources register as so-called Agents of Foreign Influence. Critics of this law have concerns that this may hamper free speech in the country and the ability for NGOs to operate without harassment, and some have even speculated that this may indicate a geopolitical shift for the country away from Europe and towards Russia.
On this latter point, I think the speculation may be a bit premature. Georgia's population is overwhelmingly pro-Western, and I'd say anti-Russian as well with polling indicating more than 80% of the population's support of EU integration. The country has an election, a national election coming up in October, and I think this will probably serve as an effective referendum on this bill. I would also note that the party that pushed through this bill also has been the driving force for a number of steps that the country has taken towards EU accession. In 2014, they signed a free trade agreement with EU. In 2017, they made the goal of joining both the EU and NATO, enshrined in the Georgian constitution. And then in December of last year, the country receive EU candidate status again under the same control of the same party.
We're obviously watching the developments in Georgia very closely, but really through the lens of how it may the individual holdings that we have. And in this light, I don't see a huge fundamental impact at this point. Both stocks are professionally managed with independent boards, have very profitable underlying businesses and trade at very inexpensive valuations, both trade under four times trailing earnings and both have ongoing share buyback programs. So we'll see how things develop, but at this point, I think both positions have a risk-return profile that may be skewed to the upside.
Natalia:
Thank you Brent for walking us through all those details and all those specific companies. Paul, in the past you've spoken about companies going through their own cycles to generate profit growth detached from more macro events. As Brent pointed out earlier, the fund does own XP, which seems to have been hit pretty significantly by interest rates. Can you talk to us a little bit more about that?
Paul:
I'd be happy to. There's a difference between the market using changes in interest rate expectations to buy and sell the stock, and the reason we own the stock through that volatility. As Brent alluded to XP is indeed impacted by macro in terms of the movement of assets in Brazil savings, from fixed income to equities and vice versa. However, we own the stock for the penetration of the platform within the wealth management industry in Brazil and the growth of that industry.
Now, as rates have moved, that platform, the assets under custody of XP have grown throughout this whole period, both as rates were going up from 2% to almost 14%, and as the rates came down to around 10.5% now. So through that whole interest rate cycle, the penetration of the platform, the growth of the platform has increased, revenue has increased, earnings have increased. So the impact of interest rates is really around whether that penetration grows faster or slower and the market may well trade on that, but we hold the stock through that, and in fact use the volatility to our advantage in the sense that we usually add to our position as the stock comes down.
So again, if you're willing to hold the stock for its fundamental reasons as opposed to the market expressing a macro view through the stock, then you can use that to your advantage and buy it for the real reasons that actually produce earnings now.
Natalia:
Thank you. To continue talking about specific names, have there been any additions or deletions in the portfolio this quarter?
Paul:
There have been, we've added Hongkong Land, and we've sold Petrovietnam Fertilizer and Chemical. Hongkong Land is a subsidiary of existing holding, Jardine Matheson, and this subsidiary specializes in office and retail space ownership and leasing thereof. It has a small development business, but that is not to be confused with a Chinese developer by any means, it's not. But it is located in China, and I think the stock has sold off because of its location in China and the negative sentiment surrounding the country, as well as the negative sentiment surrounding Hong Kong where it does own a significant and a significant asset base there. And the reasoning behind this holding is really what I'm interested in is really the asset buying a hard asset in China that you can buy cheaply now.
This stock is trading at 0.2 times book. And it is not just about that expected capital gain from buying really an asset at a distressed valuation that I think is rare to find that kind of valuation anywhere in the world, but it does produce current income. And that's the whole irony here, that the asset itself is producing cash flow and the company is sharing that cash flow with shareholders. The dividend yield on Hongkong Land is currently 6.8%. And then the last variable to consider is growth. That's where you can also explain the 0.2 times price to book valuation is not just that it owns assets in Hong Kong and in the mainland, by the way, it owns assets in Southeast Asia as well, but China and Hong Kong dominate.
But the other argument could be, "Well, look, it's a low growth stock over the past decade. It's grown in the low single digits." And my point here is that, and the reason we own it is that that variable, I also expect it to change over the next five years. The net leasable area for this company is going to grow around 61%. So I don't think the market is focused on that at all. The market tends to focus on the next two quarters, maybe the next year, not much more than that. But even beyond that, the market is really distracted by macro news once again surrounding China and Hong Kong. So I think this is an opportunity again, to buy a real asset with current yield. We're selling Petrovietnam Fertilizer chemical to fund this purchase. We've made a nice return on the stock we’ve held since inception.
So for many years now, and I will say this, there's nothing wrong with the company. It was simply, I think it was time to sell it. I consider the management of Hong Kong land to be significantly superior to the management of Petrovietnam Fertilizer and Chemicals. So we are upgrading the portfolio, we're harvesting gains in the portfolio as well. And I will point out, and I think this is important, the total return per annum on this stock for the fund has been in the double digits. That's not the important data point. The important data point is that around three quarters of that total return have really come from dividends.
And that's the point I'd like to emphasize, which is to say that emerging markets tend to be a hunting ground for growth investors. And this stocks, this stock proves at the micro level that one, there are stocks in the emerging markets that do pay significant dividends and furthermore than one can profit handsomely from set dividends. So yes, we harvested our gains there and substituted really a strong income stream from PetroVietnam Fertilizer and Chemical. And we invested it in also an income stream for Hong Kong Land 6.8% dividend yield. But more than that, I expect the future total return of the stock to really depend more on capital gains given the low valuation of their hard asset as I just discussed. And that's how the portfolio is shifting and it makes sense to find that kind of valuation in China, given everything that's going on there.
Natalia:
Thank you. Before we wrap up today, Paul, you and Brent took a trip to China and South Korea recently over this past quarter. Can you share some of your feedback from your travels?
Paul:
Sure. I'll just say the following before passing the mic to Brent. The primary motivation for the trip was to visit Hong kong Land. We spent significant time with them. We visited their assets in Hong Kong as well as Shanghai and spent time with management. Now, beyond that, we also wanted to go to China to find new ideas. That market has underperformed for over two years now, and it has done so significantly. So in theory, as value investors that we are, we should find new ideas there. So we went to check on that and then we traveled to Korea also to look for ideas. And it coincided with the value up program in Korea, which again is designed to release the value that is presumably trapped. Their Korean companies suffer from the infamous Korean discount. And there's presumably value and offer there. I think there is, and the value of program is designed to release that. And we wanted to check on that, but with that said, I'll let Brent expand more.
Brent:
Sure. Well, just starting with China, given how many stocks have underperformed over the past two years, as Paul noted, it was a good time to start looking for more value opportunities there as well as a checkup on some of the existing holdings that we have in the country. And I think from an opportunity standpoint, we've met a couple of companies that in the past have always been way too expensive and have gotten a lot cheaper, very high quality businesses that are on sale now because seemingly more due to the China macro factor. That being said, we also came across a number of value traps as well. A couple of stocks that were flush with cash, but no real intention to share those balance sheet liquidity sources with minority investors and no real good use for why they need to hoard the cash. We also met some world-class manufacturers, very impressive businesses, but that seem to be facing some of the challenges of expanding into the US and Europe from a geopolitical standpoint and may have some latent risks there.
So I think it's a market that certainly offers value and there's opportunity there, but I'd be very choosy about which individual stocks to go into because there are some pitfalls in the country.
Turning into South Korea. I think my broad takeaway from the ground up learning about how companies are reacting to the proposed corporate value up program, which again is a voluntary program. I think I left maybe a little more skeptical that the market will lead to substantive change, at least in the short term. And why do I say that? IR teams we met with we're receptive to the program. We're still waiting to see what the corporate announcements are, but I think that when these come out, we'll see what they are, but I think it may be a little more incremental in nature rather than more drastic change. So perhaps companies paying out slightly higher dividend payout ratios as opposed to large one-off special dividends of cash resources or large corporate restructurings.
Why do I say that? I think it comes down to control party incentives and at Seafarer we talk a lot about control parties and understanding them. The control parties in case here are the controlling Chaebol families that own and run a lot of the large listed stocks in Korea. And I don't think the corporate value up program at this stage is necessarily offering enough incentive for them to change their behavior. And the two areas I'd really point to are the inheritance taxes in South Korea as well as the dividend tax. The inheritance taxes for most people can run as high as 50% depending on the size of the inheritance. For Chaebol families or controlling shareholders, they can run as high as 60%, which actually create an incentive to keep share prices low and reduce the inheritance bill. It also may explain some of the convoluted holding company structures that you see in Korea, where it could be that corporate value is shifting from one holding company to another because of an inheritance tax considerations.
The second area, dividend taxes above a very low nominal level for these controlling families dividends are taxed as personal income tax at a rate of as high as 45%, which may create an incentive for these companies to hoard cash and not pay it out as dividends. There was some hope that the corporate value up program would lead to some tax changes, but with the opposition party winning the elections in the country in April, it doesn't look like that's necessarily a high likelihood at this stage. Longer term, I think I'm still hopeful for change. We met with one analyst who made the point that the national pension system will become depleted over the next 20, 30 years if it doesn't achieve higher rates of return. So at a certain point there may be political pressure from pensioners to see high returns, which may create more of a political will to bring the necessary tax changes. But for the time being, I think, it's positive that this is happening in the country, but I think I would caution investors not to expect the Korea discount to disappear overnight.
Natalia:
Thanks, Brent, and thank you as well, Paul. And thank you to our viewers for joining us for this second quarter recap of the Overseas Value Fund. Please visit our website for all of our other communications.
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