Templeton Emerging Markets Investment Trust — Continuation of strategy under new lead manager

The performance of stocks, in sterling terms, over the last 10 years is shown in Exhibit 2 (LHS). Over the period, emerging market equities have performed broadly in line with the UK market, while both have lagged the world index that is dominated by US companies, which have performed particularly well. Economic growth prospects continue to favour emerging markets. In its April 2018 World Economic Outlook, the International Monetary Fund forecasts for emerging markets GDP growth were 4.9% and 5.1% in 2018 and 2019 respectively, which are meaningfully higher than 2.5% and 2.2% respectively for developed markets. Drivers for emerging market economic growth include the rising affluence of the middle classes and improving commodity prices.

While emerging market equities can be more volatile than those in developed markets, one may argue that this risk is fully reflected in share price valuations. On a forward P/E multiple basis, the MSCI Emerging Markets index is trading at a c 25% discount to the MSCI World index. It is also trading on a lower price-to-book multiple, while offering a modestly higher dividend yield.

TEMIT was one of the first UK-listed funds investing in emerging markets and is the largest, with c £2.3bn assets under management. It was launched in June 1989 and is quoted on the London and New Zealand stock exchanges. On 1 February 2018, it was announced that lead manager Carlos Hardenberg, who succeeded Dr Mark Mobius on 1 October 2015, would be stepping down. He has been replaced by TEMIT’s former deputy manager Chetan Sehgal, who had worked closely with Hardenberg for 10 years and has been an emerging markets manager at Franklin Templeton since 1995. There has been no change to the disciplined bottom-up, long-term, value-based investment process.

Sehgal is based in Singapore and is senior managing director and director of portfolio management for the Franklin Templeton Emerging Markets Equity Group. He is able to draw on a broad team of over 80 investment professionals based in 20 offices across the world. The manager aims to generate long-term capital growth from a diversified, actively managed portfolio of companies listed in emerging markets, or companies listed elsewhere that generate a significant percentage of their revenues in emerging regions. TEMIT is benchmarked against the MSCI Emerging Markets index. At the time of investment, up to 10% of assets may be allocated to a single issuer. The trust traditionally ran a small cash balance, but in January 2017, a new £150m debt facility was announced. Gearing of up to 10% of NAV is permitted; at end May 2018, net gearing was 4.1%.

The manager is optimistic on the growth outlook for emerging markets. Supportive factors include: robust trade, with less reliance on developed markets (for example intra-Asian trade is rising in importance); improving commodity prices, such as oil and copper; reasonably valued emerging market currencies; technology companies enjoying long-term secular growth, helped by increasing innovation; and in aggregate, emerging market firms improving their cash flows and earnings power. Coupled with these favourable growth attributes, Seghal notes the relatively attractive valuations of emerging compared with developed market equities.

There have been important political developments in the emerging market regions, such as in April 2018, when there was a meeting between North Korea’s Kim Jong-un and South Korea’s president Moon Jae-in. It was the first time that a North Korean leader had crossed its southern border in more than 50 years. The leaders have announced plans to end military conflict and denuclearise the Korean peninsula. Economic development in the region could provide opportunities for South Korean companies, particularly those involved in infrastructure development.

While there have been concerns about disruptions to global trade as a result of President Trump’s protectionist rhetoric, the manager does not believe there will be an all-out trade war, given the importance of trade to the global economy. Investors may be concerned about rising interest rates, but so far within the US, interest rate increases have been measured. China has become an increasingly important driver of emerging-market equity performance. Its weight in the MSCI Emerging Markets index has increased from c 7% to more than 30% between end-2000 and end-2017. However, the manager notes that over time, China’s economy has become more broad based, which should lead to greater economic stability. Between 1978 and 2016, agriculture has declined from c 30% to c 10% of GDP, manufacturing has declined from c 50% to c 40%, while services has increased significantly from c 20% to c 50%.

Seghal notes the low level of stock market volatility in 2017, which has increased to more normal levels so far in 2018, which may create more value opportunities. In 2017, the greatest pullback in the MSCI Emerging Markets index was just c 5%, which compares to an average c 20% over the last five years and an average c 25% over the last 20 years.

The manager aims to generate long-term capital growth, seeking to invest in undervalued companies with sustainable earnings growth that can thrive in different stages of the economic cycle; he invests for the long term, avoiding short-term ‘noise’ in the markets. There is a five-step investment process: identification of undervalued companies; in-depth fundamental analysis; team peer review; portfolio construction; and portfolio evaluation and attribution analysis. Fundamental analysis combines both qualitative and quantitative elements, including the construction of detailed company models. The wider emerging market sector and regional developments are also assessed. When considering a potential addition to the portfolio, a review of the company’s economic, social and governance (ESG) record is an increasingly important part of the investment process, in the belief that ESG standards can influence a company’s financial prospects. Factors considered include the quality of the management team and the company’s ownership structure. Sehgal and his team actively engage with company managements and other shareholders to monitor ESG practices and promote positive corporate changes. Under previous lead manager Hardenberg, the number of holdings in TEMIT’s portfolio was roughly doubled from c 50 to c 100.

At end May 2018, TEMIT’s top 10 positions made up 44.7% of the portfolio. This was modestly higher than 42.9% a year earlier; eight holdings were common to both periods. Exhibit 3 shows TEMIT’s sector exposure – there have been only modest changes to the fund’s weightings over the 12 months to end May 2018. While we compare the trust to the benchmark, it should be noted that stock selection is made on a bottom-up basis, without reference to the index.

TEMIT’s geographic exposure is shown in Exhibit 4. The largest weighting continues to be in China/Hong Kong, which is c 25% of the fund. Again, there have only been small changes to the trust’s weightings over the 12 months to end May. Less than 5% of TEMIT’s portfolio is invested in frontier markets.

Two recent additions to the portfolio are: BAIC Motor and China Construction Bank. BAIC Motor is a major Chinese automobile manufacturer, which has joint ventures with Mercedes-Benz and Hyundai. The company is undergoing a major business overhaul, which is expected to lead to higher margins. BAIC is trading on 7.5x earnings and offers a dividend yield of 4%. China Construction Bank is one of China’s largest commercial banks, with a strong deposit franchise and a robust capital position. It is trading below book value and offers a dividend yield of more than 4%.

In FY18 (to end March), TEMIT’s NAV and share price total returns of 12.4% and 13.7% respectively were ahead of the benchmark’s 11.8% total return. Over the period, positive contributors to performance included: Brilliance China Automotive, which is benefiting from demand for luxury cars by China’s rising middle classes, and Ping An Insurance, a Chinese provider of personal financial services, which reported annual earnings above consensus expectations.

Exhibit 6 shows TEMIT’s relative returns. Its NAV total returns are modestly ahead of the index over three and 10 years, while lagging over most of the other periods shown. A significant factor affecting near-term performance was share price weakness earlier in 2018, in former largest holding, Brilliance China Automotive. This was sparked by the announcement that the Chinese automotive industry will be opened up to foreign companies. The manager believes that Brilliance’s share price will recover. He has confidence that its joint venture with BMW, which lasts until 2028, provides a significant competitive advantage, as foreign entrants will not be licensed to manufacture combustion-engine vehicles and the luxury car market in China continues to grow.

TEMIT’s current 13.6% share price discount to cum-income NAV is towards the high end of its 12-month range of 9.2% to 15.2%. It is also wider than the averages of the last one, three, five and 10 years of 12.4%, 12.8%, 11.7% and 9.6% respectively. The board actively seeks to manage the discount by repurchasing shares (Exhibit 1); shares are bought back on the majority of trading days. In FY18, 9.7m shares (3.4% of shares outstanding at end FY17 were repurchased at a cost of c £70m), adding 0.4% to NAV per share.

The trust’s persistently wide discount may reflect the perceived higher risk from investing in emerging rather than developed market equities, as a number of peers shown in Exhibit 9 are trading on similarly wide discounts. However, looking at Exhibit 8, over the last three years there have been periods when TEMIT traded at a c 10% rather than the current c 14% discount.

TEMIT is a conventional investment trust with one class of share in issue; there are 266.1m ordinary shares outstanding, with a further 11.8m held in treasury. The trust has a £150m unsecured, multicurrency revolving loan facility with the Bank of Nova Scotia. This may be drawn in sterling, US dollars and Chinese renminbi (up to a maximum of £30m). If the facility was fully drawn, it would equate to gearing of c 5.5%, which compares to the trust’s net gearing of 4.1% at end May 2018.

Effective 1 July 2017, Templeton is paid an annual management fee of 1.0% of net assets up to £2bn, and 0.85% of net assets above this level. No performance fee is payable. (The previous management fee was a flat 1.1% of net assets.) In TEMIT’s FY18 annual report, the board announced a further reduction in fees. Effective 1 July 2018, the annual management fee will be 1.0% of net assets up to £1bn, and 0.85% of net assets above this level.

Since 1 April 2017, 70% of the annual management fee and interest costs are allocated to the capital rather than the revenue account. This 70:30 ratio reflects the board’s outlook for the long-term split between capital and income returns. In FY18, ongoing charges of 1.12% were 8bp lower than 1.20% in FY17. TEMIT is subject to a continuation vote, next due at the July 2019 AGM.

TEMIT historically paid a dividend once a year in July. However starting in the current financial year (FY19), dividends will be paid twice a year in July and January. The FY18 distribution of 15.0p (1.06x covered) was 82% higher than the payment in the prior three financial years. Revenue income of 15.9p was boosted by the change in the fee allocation highlighted above. Following payment of the FY18 dividend, the trust will have c 2x dividend cover in revenue reserves. Based on its current share price, TEMIT’s has a dividend yield of 2.1%.

TEMIT is a member of the AIC Global Emerging Markets sector. In Exhibit 9, we show the eight trusts in the sector with a market cap greater than £250m; TEMIT is the largest fund by a wide margin. Its NAV total returns are above average over one, three and 10 years, but lower than the peer group average over five years. TEMIT’s discount is wider than the peer group average, although at a similar level to a number of its peers. Its ongoing fee is below average and no performance fee is payable. The trust is one of three peers with gearing, and following the higher FY18 dividend, has an above-average dividend yield.

TEMIT has six directors on its board; five of whom are considered independent. The chairman is Paul Manduca; he was appointed in August 2015 and assumed his current role in November of that year. The other four independent directors and their dates of appointment are: Hamish Buchan (June 2008), Beatrice Hollond (April 2014), Simon Jeffreys (July 2016) and David Graham (September 2016). The non-independent director is Gregory Johnson. He was appointed in December 2007 and is chairman and CEO of Franklin Resources, the parent company of the investment manager. Hamish Buchan has announced his intention to retire following the July 2018 AGM; subject to shareholder approval, Charlie Ricketts will be appointed as a new director. He has more than 30 years’ experience in the investment trust sector, including eight years as head of investment funds at Cenkos Securities.