Aberdeen Latin American Income Fund — Income without compromising on capital growth

Over the last five years, within Latin America, equities have outpaced the performance of government bonds; they have also outperformed UK equities over this period in sterling terms (Exhibit 2, LHS). IMF economic growth forecasts are for above-average growth in the region in 2021, at 2.3% versus 1.6% for advanced economies (1.6% for both in 2020). Drivers include a favourable interest rate environment, population growth and a more affluent middle class.

Looking at forward P/E valuations (Exhibit 2, RHS), in aggregate, Latin American equities are c 21% less expensive than the world market. They are trading at a 6% discount to their five-year average, while global equities are trading on a 6% premium. Although Brazil’s valuation looks somewhat extended, Mexico is looking more attractive, at a 13% discount to its five-year average. With above-average growth prospects and below-average valuations, investors may wish to consider an allocation to Latin America.

ALAI was launched on 16 August 2010 as a Jersey-incorporated closed-end investment company and is listed on the Main Market of the London Stock Exchange. The fund is managed by ASI, aiming to generate a total return with an above-average yield, primarily via investing in Latin American securities. ALAI’s performance is benchmarked against a composite index comprising 60% MSCI EM Latin American 10/40 index and 40% JP Morgan Government Bond Index EM Global Diversified (Latin America carve-out); both are sterling adjusted. The portfolio is not constructed with reference to the composite index, meaning there will be periods when ALAI’s performance deviates from that of its benchmark.

The manager invests in equity, equity-related and fixed income securities; at end-January 2020, the fund held c 61% in equities and c 39% in government bonds. In order to mitigate risk, at least 25% of gross assets must be held in equity and equity-related investments, and at least 25% in fixed income investments. There are no restrictions on geographic, sector or market cap exposure. At the time of investment, a maximum 15% of gross assets may be held in a single company, with up to 25% in non-investment grade government debt (rated BB+/Ba1 or lower). The manager may employ derivatives for efficient portfolio management and to mitigate risk (up to 50% of gross assets). Gearing of 20% of net assets is permitted at the time of drawdown; at end-January 2020, net gearing was 12.4%.

We met with two of ALAI’s managers, Viktor Szabó (a member of the emerging market debt team) and Brunella Isper (a member of the global emerging markets equities team), who gave their perspectives on Latin America. Szabó says that 2019 was quite a disappointment in terms of economic growth, although the stock market performed very well, helped by macro developments. At the beginning of the year there were fears about higher US interest rates, but the Federal Reserve adopted a more dovish stance, the US did not tip into recession, there was progress on the US-China trade dispute and then in late January 2020, the US approved the new trade agreement with Canada and Mexico (the USMCA). The manager is encouraged by the growth prospects for Latin America this year given benign inflation and declining or already low interest rates. As an example, Brazilian rates are at a record low: the Selic has declined from 14.25% in 2016 to 4.25%. Szabó expects more investment in the country, although there may be capital outflows from domestic investors, which could put pressure on the Brazilian currency. Given low interest rates, he says bond yields in Brazil are no longer as attractive and there has been a large rotation from fixed-income securities into equities.

Szabó explains that some of the smaller Latin American countries experienced protests towards the end of 2019, namely in Chile, Colombia, Bolivia and Ecuador. The manager says the most surprising and violent unrest was in Chile, one of the wealthier and most developed economies in the region; tensions started following a rise in the Santiago Metro's underground fare. The government’s knee-jerk reaction to the protests was to increase 2020 fiscal spending by 4.5%, which is above the rate of inflation, to be spent on programmes such as pensions and healthcare. There is also a proposed change to the Chilean constitution, which the manager suggests will be a very protracted and unsettling process. Szabó also highlights Peru, where there are significant political changes in progress following the dissolution of Congress, and Uruguay, where the 2019 general election saw the appointment of a market-friendly president, which the manager suggests is positive for ALAI’s Uruguayan fixed income exposure.

Offering his thoughts on the impacts of the COVID-19 coronavirus on Latin America, Szabó says Mexico is the only economy that is manufacturing based, as all others in the region are mainly commodity exporters. The manager notes that while over the last 20 years, Latin America’s Chinese exposure has increased, China’s contribution to GDP in the region is still not that significant and he believes the shock from the virus will be much larger for Asian countries depending on the Chinese manufacturing supply chain and tourism. While oil prices have declined meaningfully since the virus outbreak, Szabó suggests this is largely sentiment driven, and he does not expect Latin American exports to collapse.

The manager says Mexican economic growth in 2019 was a real disappointment, with Q2–Q4 GDP data indicating a recession. He observes a divergence in local sentiment – consumers remain optimistic, but business sentiment is weak. President Obrador has taken steps to build bridges with the business community, but so far has been unsuccessful. On a more positive note, production declines at state oil company Pemex seem to have stabilised. If there is an increase in production, it would be positive for the Mexican economy, while the resilience in consumer sentiment bodes well for demand for services and consumption growth. Szabó says that despite the lack of growth in Mexico, the peso has remained relatively strong, which provides scope for the central bank to reduce interest rates further, which should be supportive for future economic output.

Isper says that in Brazil, the long-awaited pension reform bill was passed in October and is one of the main achievements of the Bolsonaro administration, as it should provide significant cost savings. The government acknowledges that pension reform on its own is not sufficient and is working on other programmes such as administration reform, tax reform and a reduction in public sector spending. The manager suggests that tax reform could be particularly significant given the current onerous and very bureaucratic system. She says the Brazilian government is making good progress with its privatisation agenda, which is continuing in 2020 and while low interest rates are putting pressure on the currency, they provide the impetus for companies to invest and promote credit creation. GDP growth was modest in 2019 and the big recovery following the 2015/16 recession is yet to materialise. Isper says that while government stimulus drove the economic improvement following the global financial crisis, this time a recovery must be driven by the private sector. Although this could be a more subdued pickup, she believes the recovery could be healthier and more sustainable. There are some encouraging signs for improved growth, in terms of lower unemployment and higher job creation; the manager says she is ‘cautiously optimistic’ on the prospects for Brazil in 2020.

ASI employs a team-based approach, focusing on quality and value. ALAI is managed by ASI’s global emerging markets equities team and emerging market debt team, who communicate regularly to consider portfolio positioning (including the level of gearing), combining macro and micro inputs and discussing findings from recent trips and company meetings. They seek investments that can be held for the long term. Risk management is integral to the investment process; ASI has an independent performance and risk team to ensure funds adhere to their respective guidelines and managers are aware of their risk exposures.

In terms of equities, the manager seeks companies with strong management teams, good fundamentals and pricing power that tap into the more robust parts of the Latin American economy and are trading on reasonable valuations. Potential investee companies undergo thorough bottom-up, proprietary research. Regularly meeting company managements is a key element of the investment process and there is a keen focus on a company’s environmental, social and governance track record. Isper notes that generally, firms are increasing their levels of disclosure. ALAI’s portfolio turnover is relatively low at c 15% pa, which implies an average seven-year holding period, although many equity investments have been held for more than a decade.

In terms of fixed income, the manager seeks high-quality securities that generate a sufficient level of income. Analysis is undertaken on a bottom-up basis, focusing on the perceived prospects of each individual country. For liquidity reasons, ALAI invests in government or quasi-government issuers rather than corporate debt. Investments are generally made in local rather than hard currencies, but the manager can hedge or take forward currency positions. ASI’s fixed income team is responsible for generating the bulk of ALAI’s income, so investments are biased to higher-coupon issues. This ensures the fund’s equity managers can focus on selecting companies for their total return potential rather than just focusing on income.

At end-January 2020, ALAI’s top 10 positions made up 44.5% of the portfolio, which was in line with a year earlier; nine positions were common to both periods. Over this time, the fund’s equity exposure increased by 5.2pp, while the number of holdings declined by three to 62. The equity exposure is at the high end of the historical range (see Exhibit 3), reflecting the managers’ bullish outlook on the prospects for Latin America.

In terms of ALAI’s geographic breakdown, the largest changes were higher weightings to Mexico (+2.6pp) and Brazil (+2.1pp) and lower exposure to Argentina (-2.7pp).

Szabó highlights ALAI’s lack of fixed income exposure to Argentina: the last bond was sold in Q319, before the introduction of capital controls. The manager suggests the country is now ‘untradable’; it is on the brink of default as its level of debt has ballooned in recent years. Argentina has been removed from the bond index used in the fund’s composite benchmark. ALAI’s sole Argentinian equity position is IT and software development company Globant, which generates the majority of its sales outside of the country and is benefiting from the migration to digital strategies.

Isper highlights ALAI’s most recent new equity positions:

The manager is mindful of diluting ALAI’s performance by having too many holdings, so has been selling lower-conviction positions:

Within ALAI’s fixed income portfolio, Szabó has been reducing the overweight to longer-dated Brazilian debt as he believes the country is close to the end of the rate-cutting cycle. However, he notes the coronavirus outbreak means interest rates could stay lower for longer. The manager is long duration risk in Mexico, as he believes there are real prospects for further interest rate cuts. The fund had no fixed-income exposure in Chile for a long while, but the manager recently took a short-term tactical currency position following the market sell-off as a result of the protests in the country. This proved successful and the position was closed, with the proceeds used to reduce the fund’s underweight exposure to the Peruvian sol.

ALAI’s relative returns are shown in Exhibit 8. It has outpaced the benchmark over the last year in NAV and share price terms, while its share price has also slightly outperformed over the last three years. Latin American markets have been somewhat weak over the last six months and the fund’s share price has outperformed, while its NAV is modestly weaker. Looking at ALAI’s equity exposure, over this period the largest contributors to relative returns were Mexican airport operator ASUR (+68bp), Brazilian software company TOTVS (+48bp) and Mexican bank Grupo Financiero Banorte (+45bp), while the largest detractors were not holding Mexican telecoms operator América Móvil (64bp), holding Banco BBVA Argentina (-53bp) and not holding Brazilian retailer Magazine Luiza (41bp). On the bond side, the largest contributors to returns were a lack of exposure to Chile and issuance selection in Mexico, while the exposure to Uruguay detracted from performance.

Over the last three years, ALAI has generally traded within a range of a c 10% to a c 16% discount. Its current 12.5% discount to cum-income NAV compares with the 8.4–16.8% range over the last 12 months. Over the last one, three and five years, ALAI’s discount has averaged 13.5%, 13.4% and 12.6% respectively.

Renewed annually, the board has the authority to repurchase up to 14.99% and allot up to 10% of issued shares to manage a discount or premium. In FY19, 2.2m shares (3.6% of the share base) were repurchased at a cost of £1.5m, which enhanced NAV by 0.46%.

ALAI is a Jersey-registered investment company with one class of share; there are currently 57.1m ordinary shares in issue (with a further 6.1m held in treasury). It has a three-year £8m (£6m drawn), multi-currency, revolving credit agreement with Scotiabank (Ireland) – the fund may not have fixed long-term borrowings. At end-January 2020, net gearing was 12.4%.

Aberdeen Standard Fund Managers is paid an annual management fee of 1.0% of ALAI’s NAV. It is charged 40% to the revenue and 60% to the capital accounts, reflecting the prospective split between future revenue and capital growth. The fund’s ongoing charge ratio (OCR) is capped at 2.0%, and any excess fees are rebated. In FY19 the OCR 2.0%, which was in line with FY18.

ALAI pays quarterly dividends in January, May, July and October. The annual distribution was rebased in FY16 from 4.25p to 3.50p per share due to the depreciation of Latin American currencies. It has remained at this level for the last four financial years and the board expects this to continue. In FY19, the dividend was 1.2x covered. At the end of FY19, ALAI had revenue reserves of £2.7m, which is c 1.3x the last annual dividend payment. Based on its current share price, ALAI offers a 5.1% yield.

There are just two funds in the AIC Latin America sector and they pursue different strategies, as ALAI has a significant exposure to government bonds whereas BlackRock Latin American Investment Trust invests only in equities. ALAI’s NAV total return is ahead of its peer’s over one year, while trailing over three and five years. The fund has a wider discount and a higher ongoing charge, which is a function of spreading fixed costs over a smaller base. ALAI is geared, while its peer currently has a modest net cash position and it has a lower, albeit still attractive, dividend yield of 5%. To enable a broader comparison, in Exhibit 11 we also highlight a range of open-ended equity funds that invest in Latin America. ALAI’s NAV total returns are above their average returns over one and five years, while lagging over three years. Its dividend yield compares very favourably with all those of the open-ended funds.

Following the retirement of George Baird at the December 2019 AGM, ALAI’s board now has three independent, non-executive directors. The chairman, since the company’s launch in 2010, is Richard Prosser. Hazel Adam joined the board on 27 April 2018, while Heather MacCallum joined last year on 24 April.