BlackRock Latin American IT — Update 27 May 2016

For reference, the MSCI EM Latin American Index is heavily weighted to Brazil (>50% at the end of April 2016). Looking at Exhibit 2 (left-hand side) in sterling terms, Latin America has underperformed world stock markets since 2010. This is partly due to the strength of the US market, which represents c 60% of the MSCI World Index. Also, there have been political issues in Latin America such as the Petrobras corruption scandal in Brazil; in addition, weak commodity prices have had a significant impact on growth in the region. In its latest economic outlook in January, the International Monetary Fund reduced its estimate for 2016 economic growth in Brazil by another 0.3pp; for the year it expects output to contract by 3.8%, in line with the provisional figure for 2015. However, political developments in the country since then provide a potentially more optimistic outlook. The impeachment of President Dilma Rousseff and the replacement by Vice-President Michel Temer potentially paves the way for an improvement in the economy and market-friendly reforms; the country already has a normal monetary policy with positive real interest rates. As shown below, there has been a noticeable outperformance of Latin America versus world markets over the short term.

With regards to valuation (Exhibit 2, right-hand side), in terms of forward P/E multiples, Latin America is currently trading at 12.9x, a modest premium to the five-year average of 12.6x. On a relative basis, it is trading at a 13% discount to world markets, which is meaningfully below the five-year average of 3%. For investors looking for equity exposure to a region with a relatively attractive valuation and recent positive newsflow, an actively managed specialist fund may appeal.

BRLA was launched in 1990 as F&C Latin American Trust; BlackRock took over management in March 2006. The fund manager is William Landers, who is based in New York; he has been investing in Latin American assets at BlackRock since 2002 and has 25 years’ investment experience. The manager is assisted by four other investment professionals who have individual country and sector expertise. They are based in New York and Sao Paulo, Brazil. BRLA is an actively managed fund with 50-75 holdings in Latin American companies aiming to deliver capital growth and an attractive total return. The portfolio is diversified by sector, geography and market cap and does not take extreme bets versus the benchmark MSCI Emerging Markets Latin America Index. BRLA is listed in London and its shares are quoted in sterling. However, its financial statements are reported in US dollars and its NAV is quoted in both sterling and dollars.

The manager is as positive in his outlook as he has been for quite some time. Following the suspension of Brazilian President Dilma Rousseff for allegedly hiding the scale of the budget deficit, he believes that for the first time in two years, the country has a clear path to return to growth. With a new president, cabinet and central bank governor, there is the potential for fiscal discipline and lower inflation. The expectation is for rising confidence and a return to infrastructure investment. The political reset button has been pressed; the manager believes the president will have a good dialogue with Congress and will be able to pass reforms. Current valuations of Brazilian companies are not seen as compelling due to a trough in economic activity, which has depressed earnings. However, the manager expects positive earnings revisions over the next 12-18 months, which should make company valuations look more attractive.

In Mexico, the manager sees a continuation of a gradual improvement in the domestic side of the economy. The US is its biggest trading partner and imports had slowed in recent months. However, Mexico has been gaining market share and exports to the US are now on an improving trend. A stabilising or a rising oil price would also be beneficial to the economy, as crude oil is the largest export. See ‘current portfolio positioning’ below for comments on smaller countries in the region.

The manager aims for long-term outperformance versus the benchmark with below-average volatility, using a combination of top-down and bottom-up analysis. From a top-down perspective the manager assesses factors such as politics, inflation and currency and suggests their importance varies. From a bottom-up perspective, the first stage of the process is a liquidity screen. There are more than 400 listed companies in the region that the manager narrows down to c 175, having taken country and sector views into account. When assessing a potential investment he focuses on the quality of management, company fundamentals and valuation. A high-quality management team has the ability to deliver value to shareholders over the long term and has regard for minority shareholders. Fundamental analysis involves an assessment about future growth potential, the strength of the balance sheet and cash flow generation. The manager seeks undervalued stocks where consensus earnings expectations appear realistic. The team has an extensive network within the region, which assists in the formation of their fundamental insights.

Portfolio holdings are constantly monitored and may be sold if there is a significant change in fundamentals or valuation. Informal risk controls limit large-cap stocks to 500bp above or below the index weighting; the limit for mid-cap stocks is 200bp, while small-cap stocks usually have at least a 50bp position in the portfolio; in practice, these controls rarely restrict stock selection. The BRLA team has the ability to draw on the insight of other BlackRock managers such as those in Asia-Pacific, a key trading partner of Latin America, as well as deep resources in other departments such as product strategy, sales, trading and risk management.

At the end of April 2016, the top 10 holdings accounted for 47.8% of the portfolio; a modest decrease from 50% a year before. The manager invests across the capitalisation spectrum; at the last month end, 69% of the portfolio was in large caps (>$10bn), 21% in mid caps ($2-10bn) and 10% in small caps (<$2bn). The smallest company in the portfolio is c $400m; several countries in the region have a shortage of large-cap companies in which the manager can invest. As BRLA is a closed-ended fund with stable share capital, the manager is able to maintain a higher exposure to mid- and small-cap securities than in his comparable open-ended SICAV.

The manager is comfortable with his country weightings, modestly overweight Brazil and Mexico, which together dominate the benchmark with a combined 84%. There had been an underweight exposure to Brazil; however, in mid-March when it looked like impeachment of the president was likely, the manager moved 600bp in a day into large-cap companies, predicated on the fact that conditions in the country could improve now rather than having to wait for an election in 2018. The investment has led to strong absolute returns but the stock market moved very quickly, which led to BRLA underperforming the benchmark in the short term although it is outperforming its peers who may have made the switch more slowly. The increased exposure to Brazil included additions to Itaú and Banco Bradesco and buying back into Petrobras, where the prosecutor expects the investigation into the corruption scandal to be concluded by the end of the year. The manager is confident that there will be a longer-term benefit as foreign investors return to Brazil. Financial stocks are seen as particularly attractive as they tend to benefit when a country’s risk premium reduces. During the recent economic crisis, banks have been conservative in their lending practices and should prosper in an improving economy.

BRLA retains an overweight position in Peru. There are elections in June; both candidates are viewed as market friendly. As reflected by their underweight positions, the manager is less positive on the outlooks for stocks in Chile and Colombia. Argentina is not represented in the benchmark, but the manager has added portfolio exposure to the country as he believes that the new president, Mauricio Macri, has moved quickly on reforms including debt agreements, currency controls and export taxes. The big obstacle now is to bring inflation down, which is key to the economy improving. In early 2000, before the country was reclassified as a frontier market, it was 8-9% of the benchmark and could be included again in the future. The manager comments that Argentina is a large economy with good companies that can provide investment opportunities.

The manager explains that near-term underperformance versus the benchmark is due to the Brazilian stock market rallying strongly in mid-March, when it became apparent that the president was likely to be impeached. He was already increasing his exposure to the country and has since moved to a modest overweight in Brazil versus the benchmark.

BRLA’s NAV total return has outperformed the benchmark over one year and is in line over three years. Latin American markets have lagged world stock markets in recent years, partly due to the strength of the US market as well as political issues within the region, coupled with the impact of weak commodity prices.

The current 11.0% share price discount to cum-income NAV compares to the average of 11.9% over the last 12 months (range of 6.4% to 18.1%). This is a modest increase from the averages of the last three, five and 10 years (11.0%, 9.5% and 6.9% respectively). The widening has occurred during a period when Latin American stocks have been out of favour with investors (see Exhibit 2).

The BRLA board is able to repurchase up 14.99% of its ordinary shares and to allot shares up to 5% of the issued share capital to manage the discount or premium. However, there have been no ad-hoc buybacks since 2012. Before mid-2013, there was a policy of twice-yearly 5% tender offers. A new discount policy was adopted in August 2013, which the board views as in the better interests of long-term shareholders. From the 2016 continuation vote onwards, a 24.99% tender offer will be launched if BRLA has underperformed the benchmark in terms of US dollar total returns by more than 1% per year over the previous two financial years and the share price discount to cum-income NAV has averaged more than 5% over the same two-year period.

BRLA is a conventional investment trust with one class of share in issue; there are currently 39.4m shares outstanding. The trust is subject to a continuation vote every two years; the next one is due at the AGM in 2018. Gearing of up to 25% of net assets is permitted and BRLA has a $40m overdraft facility with Bank of New York Mellon at an annual rate of Libor plus 1%. At the end of April 2016, net gearing was 1.2%. The annual management fee payable to BlackRock Investment Management is 0.85% of NAV and is charged 75% to capital and 25% to income. A performance fee of 10% of NAV outperformance versus the benchmark is payable, subject to a 1% hurdle. This fee will only be paid if the cumulative NAV performance since 1 July 2007 is ahead of the benchmark. No performance fee has been paid since FY10.

Dividends are paid twice a year in September and April. Between 2011 and 2014, a 30c annual dividend was paid. For 2011 and 2012, the interim dividend was 5c and the final dividend was 25c. In 2013 and 2014, both the interim and final dividends were 15c. In 2015, an interim dividend of 15c was again paid but the declared final dividend was reduced to 6c. The revenue return in 2015 declined to 24.10c versus 31.46c in the prior year; weakness in Latin American currencies and dividend cuts by a number of companies had a negative impact on income. In addition, income from writing options was lower during the year (28% of total income). The board considers it prudent to recognise the changed environment, so rather than maintaining the historic level of dividends out of capital, going forward, dividends paid will be in line with earnings. The total 21c dividend for 2015 equates to a yield of 4.5%. If a 6c interim and final dividend is maintained for 2016, this would equate to a dividend yield of 2.6%.

BRLA is one of only two companies in the AIC Latin America sector, so we have also compared it to two closed-end funds listed in the US. Its NAV total return has outperformed the group over one, three and 10 years and is only modestly below the weighted average over five years; over three and 10 years it is ranked first. In terms of risk-adjusted returns as measured by the Sharpe ratio, BRLA is in line over both one year and three years. It has the narrowest discount in the peer group, the lowest ongoing charge and the second highest dividend yield.

Comparing BRLA to a selection of open-ended funds invested in Latin America, its NAV total return has outperformed the weighted average over three, five and 10 years and it has a higher Sharpe ratio over both one and three years.

There are six non-executive directors on the BRLA board. Chairman Peter Burnell joined in 1990 and was appointed chairman in 1997. The Earl St Aldwyn was appointed in 1996, Laurence Whitehead in 2003, Antonio Monteiro de Castro in 2007 and Mahrukh Doctor in 2009. The newest member of the board is Carolan Dobson, appointed in 2016; she is the former head of UK equities at Abbey Asset Managers and former head of investment trusts at Murray Johnstone.