Seafarer semi-annual: China remains selectively investable, as ever

David_Snowball

Seafarer's semi-annual report was just released. The main essay is written by Paul Espinosa rather than Andrew Foster. It makes three arguments are EM investing that folks might want to reflect on. I'll offer just my synopsis of the arguments and a snippet from the letter for each.

"Beating the market" is a popular but spurious goal. I mention this because it's my own prejudice. Mr. Espinosa's statement of the case:

While investors may feel comforted by the thought of their investment return not falling behind the market during their working lives, the question of whether the market will deliver what they need requires a leap of faith ... a decade of extraordinary returns for the S&P 500 Index (16.20% annual rate of return between October 31, 2011 and October 29, 2021) ... has left many with the presumption that the equity market will fulfill their future needs.

Similarly, over the same decade, the Morningstar Emerging Markets Index delivered a 5.45% annual rate of return, leaving the same investors wondering if an allocation to the emerging markets (EM) can fulfill their future needs even if they performed in-line with that index. Even if many investors got what they wanted in terms of not underperforming the benchmark, they did not get what they needed. Subtracting the 1.72% average annual rate of U.S. inflation over the recent decade, the real rate of return for U.S.-based EM investors was 2.23%

I find it interesting to share with U.S.-based investors that in other countries, equity markets are referred to as “variable return markets,” in contrast to fixed income markets, a useful and timely reminder of the nature of equity investments.

China is investable but passive investing there is more dangerous than elsewhere At base, investing in China has always involved juggling hand grenades. The difference is that, just now, many more investors are obsessing about the distinctive risks that a superpower with a cult of personality embodies. In Mr. Espinosa's mind, that's an argument for active, flexible risk management since normal metrics that work for passive strategies (market cap or whatever) can be upended in an afternoon by Mr. Xi's petulance.

As a hybrid of a command economy with pockets of free market pricing, and with a President self-appointed to the role for life and intent on regulating the economy and individual behavior according to his personal beliefs (Xi Jinping Thought), investment risk must be managed actively, in contrast to the rest of the world where investors have already demonstrated a preference for a passive approach.

Seafarer believes that the distinction between emerging and developing markets is the level of risk they inflict on investors, not the size of the component economies. By that standard, China should remain in the EM asset class rather than being arbitrarily singled out because of its size.

Corporations in the emerging world are practicing better governance than US corporations, and have been punished for it. US corporations poured money into buying investor approval through dividends and buybacks; EM corporations reinvested in their businesses. Paul Espinosa's statement of the case:

between 2010 and 2019, while EM corporates may not have grown earnings rapidly, they have accumulated them in the form of retained earnings, while concurrently growing dividends relative to the previous decade. [Those reflect] strengthened balance sheets (retained earnings) and improved corporate governance (higher dividends) ... U.S. corporates focused on dividends and buybacks at the expense of strengthening their balance sheets through retained earnings. In hindsight, this behavior may explain the attractive returns of the S&P 500 Index over the period."

Andrew Foster's summary:

Pundits, caught off guard, sought to describe the interventions as little more than the ordinary activity of a “regulatory cycle" ... What a gross and costly mischaracterization of events! The policy interventions bore no semblance to regulation ... Instead, China’s leadership undertook interventions by executive fiat that were capricious and sweeping in scope...

China remains “investable,” albeit only very selectively – as has always been the case. Among all the countries in the developing world, China remains uniquely qualified to produce more competitive companies capable of succeeding globally.

Over the past 10 years, for both China and diversified EM, the Lipper benchmark indexes trail the peer group average (i.e., active has outperformed passive, on average), 9 of the 10 China funds that have outperformed the peer group average were active funds (iShares Taiwan is the other), 9 of the 10 diversified EM funds are active (First Trust Chindia is the 10th). It's hard to generalize about the bottom of the heap because it's dominated by quirky single country or single asset funds.

The creme de la creme for the 10 year group are three EM small cap growth funds: Matthews, Wasatch and Driehaus. They qualify as both Great Owl and Honor Roll funds.

Seafarer is a month short of its 10th anniversary so it didn't make the 10 year list. Based on 9.8 years, it's top quarter by Sharpe and top third by annual returns.