Genesis Emerging Markets Fund — Depressed sentiment belies bright outlook

The 11-year equity bull market has been brought to an abrupt end by the spread of the COVID-19 pandemic. As shown in Exhibit 2 (RHS), since its outbreak at the beginning of 2020, most major markets have experienced sharp falls, with few safe havens. Valuations of equity markets have retreated, in many cases to levels not seen since the global financial crisis in 2008. Over the short term, the direction of markets is likely to continue to be driven by developments related to the disease, and by government measures. However, stock markets have a history of survival and full recovery from major systemic shocks, and the long-term outlook for emerging markets continues to be positive. As shown in Exhibit 2 (LHS), emerging markets equities, as a perceived riskier asset class, have sold off sharply, and currently trade on a forward P/E multiple of c 10x, representing a discount to global equities of c 24%. Yet, as shown in the chart on the front page, over an extended period of time, emerging markets and developing economies have grown at a significantly faster pace than advanced economies. This is underpinned by multi-decade secular growth trends, including rising incomes, urbanisation and growing working-age populations.

Launched in July 1989, GSS is one of the first UK-listed funds focused on emerging market equities. It aims to generate long-term capital growth through following a long-established, disciplined and bottom-up approach to investing in high-quality companies at attractive valuations. The manager is not constrained by its benchmark, the MSCI Emerging Markets Index, and is able to invest in companies that have substantial exposure to emerging markets and developing economies but are listed elsewhere, such as in frontier markets and developed markets. As a result, the fund is typically very different from the index, and divergences in performance can be expected.

GSS is managed by Genesis Investment Management, LLP (Genesis), a specialist emerging markets boutique with over $20bn in assets under management. This is the firm’s only asset class, and all its resources are deployed towards managing emerging markets equities, which is a differentiating feature of GSS. The firm has a partnership structure whereby the key members are also shareholders; this has contributed towards attracting and retaining a stable team of investment professionals. Genesis’s client base mainly consists of sophisticated blue-chip, long-term institutional investors. GSS is its only vehicle available to the retail investor.

Equity markets have been very volatile during Q120; however, the manager steadfastly focuses on long-term fundaments and is confident of a positive outlook. The team explains that significant parts of the portfolio, including some smaller-cap and frontier market countries, have compelling return prospects that are yet to be appreciated by the market. The team sees considerable value on offer in emerging markets equities, and its proprietary list of companies has a median forecast five-year annualised internal rate of return (IRR) of around 11% in US dollar terms. The manager also believes the environment may become more conducive to Genesis’s investment style, following an unusually extended period between 2014 and 2019 of large-cap stock outperformance against the MSCI Emerging Markets Index. The manager notes that GSS’s diversified portfolio typically performs well when small- and mid-cap stocks are in favour, and says that, in a historical context, this period of small-cap underperformance is exceptional.

Genesis’s investment process involves a detailed, bottom-up approach to get to know companies, often over a long period of time, prior to purchase. The investment team consists of 10 portfolio managers (PMs) with between six and 30 years of experience, and two analysts. They are well-resourced to support extensive research, which involves the PMs visiting over 1,000 companies pa, as well as use of third-party sources, including commissioning proprietary studies from industry and academic experts. Each PM has a well-defined country and sector responsibility, and typically has primary responsibility for 10–15 stocks in the portfolio. This allows them to know their companies, industries and managements very well, which enables constructive challenge within the team. Genesis looks for firms that have an enduring competitive advantage, enabling them to sustain excess returns on capital. Environmental, social and governance (ESG) assessments are an important part of the investment process, as is valuation discipline; the team looks for companies that are intrinsically undervalued based on its assessment of a five-year US dollar IRR. Each company under the team’s coverage is assigned a quality rating, which influences whether the stock can enter the portfolio, and at what position size. The expected return, level of conviction and correlation with other holdings are also considered as part of the portfolio construction process. The portfolio construction team (PCT) has oversight of the integrity of the investment process, shape and risk of the overall portfolio, and can challenge PMs on the appropriateness of an investment. The PCT consists of three PMs and a risk officer, who is not a member of the investment team.

Exhibit 3 shows the portfolio’s sector exposure as at end-February 2020, which reflects the team’s bottom-up stock selection. The largest weight is to the consumer sector at 36.2%, which represents a significant 15.1pp overweight compared to the MSCI Emerging Markets Index. This reflects one of the manager’s key investment themes of middle-class income convergence towards that of developed markets, which it believes to represent a multi-decade investment opportunity. Although the portfolio appears to be roughly neutral in the financials sector, GSS’s holdings are very different from those of the index. Genesis favours banks in early-stage economies, which are typically simple businesses that are attractive because of their long-run market penetration opportunities. The portfolio has no holdings in Chinese state-owned banks, which are dominant in the index. Furthermore, GSS is significantly underweight state-owned enterprises, which typically perform poorly against Genesis’s quality and governance criteria.

Over the past 12 months, the portfolio has reduced its weighting to the consumer sector (-3.6pp, largely reflecting profit-taking from Chinese internet companies, which have been strong contributors to GSS’s performance). These included 58.com, New Oriental Education and Tencent. Stock selection has also been positive in the information technology sector, where the manager trimmed profitable positions in Korean companies Samsung Electronics and Naver. The latter’s share price surged following its announcement to spin-off its payments business, and did so again when it announced the merger between its Japanese messaging service, Line, and Yahoo Japan. The manager also trimmed Brazilian software company Totvs, following strong performance. Hong Kong-listed insurer AIA was reduced, reflecting the manager’s concerns for the company’s earnings outlook on light of the city’s ongoing political unrest.

Proceeds have been used to add to positions that have been unjustifiably weak, such as Indian IT companies TCS and Infosys, and banks in Latin America, Credicorp (Peru) and Bancolombia (Colombia). A number of new positions have also been introduced to the portfolio. These include Chinese sportswear manufacturer and retailer Anta Sports. This company has been on Genesis’s radar for some time, and a sharp fall in its share price brought the stock within the manager’s valuation range. Genesis believes that sportswear remains an underpenetrated market in China, with the potential for 15–20% revenue growth over the next few years. It finds the company to be well-managed and favours its vertically integrated model, which in the team’s view, brings greater control and business resilience compared with companies that rely on third-party manufacturers and distributors. Also in China, the manager purchased pharmaceutical company CSPC Pharmaceutical, and property company Greentown Services (Greentown). Genesis is positive about CSPC’s cash-generative portfolio of patent-protected drugs, and believes it has a strong pipeline of innovative drugs. It has a positive view that this pipeline of potentially higher-margin drugs can help increase the company’s long-term profitability, becoming a greater proportion of the company’s revenues relative to its generic and bulk products. Greentown provides property management services for residential and commercial real estate nationwide. The manager believes the company has a strong brand and high service quality, which differentiates it from many competitors. In its view, there is growing demand for property management services in China’s real estate sector, and industry trends are favouring larger, more reputable companies, such as Greentown, which is well positioned to gain market share over time.

As shown in Exhibits 5 and 6, GSS has a solid performance track record; its NAV total return has meaningfully outperformed its benchmark over one, three, five and 10 years. It has lagged over shorter time periods when equity markets globally have been extremely volatile. Genesis is focused on the long-term investment horizon, and is not influenced by shorter-term fluctuations in performance.

As at 1 April 2020, GSS is trading at a 12.3% discount to cum-income NAV, which is wider than the three-year average of 11.9%. As shown in Exhibit 8, this has narrowed considerably from the recent extreme discount levels in response to the COVID-19 pandemic. We observe that discounts among peers remain generally wider since the disease’s outbreak. The board is proactive in its discount management, and since 2017 has introduced a number of measures to broaden the appeal of the fund under more normal market conditions, including the introduction of a dividend, a reduction in fees, and more active promotion of GSS. A tender offer for 10% of the fund’s shares was completed in August 2018, and a potential further tender offer of 25% of shares will take place in 2021 if the NAV performance over the five years to June 2021 is behind the index. There is considerable scope for the discount to narrow towards the three-year average should GSS continue to deliver solid performance, and investor confidence improve.

GSS is a Guernsey-based, authorised, closed-end investment scheme. There are two classes of share: founder shares and participating preference shares, the principal share class. The latter have priority over founder shares in a wind up and they are classed as equity, with the right to receive any surplus assets available for distribution. There are 121.5m participating preference shares in issue. There are 1,000 founder shares in issue, which are not redeemable and confer no rights upon the holders, except the entitlement to one vote at general meetings.

Genesis Investment Management is paid an annual management fee of 0.90%, reduced from 0.95% with effect from 1 July 2019. This is paid from both the capital and revenue accounts, split 80:20 to reflect the board’s expected long-term balance of capital and revenue returns. At end-December 2019, the ongoing charges ratio was 1.07%, slightly reduced from 1.11% for the year ended June 2019, reflecting the fee reduction. There is no performance fee.

The fund’s primary objective is to deliver long-term capital growth. However, the board recognises shareholders’ desire for income, and in 2017 introduced an annual dividend. Dividends are declared in US dollars and paid in sterling using the exchange rate prevailing on the payment date. In FY19, GSS paid participating preference shareholders a dividend of 19 cents per share (14.8p), unchanged from FY18 in US dollar terms.

Exhibit 9 shows the AIC Global Emerging Markets sector peer group for funds with market capitalisations over £100m. The funds within the sector are diverse, including funds specialising in frontier markets, income and infrastructure; therefore, direct comparisons should be treated with caution. GSS is the third largest fund in this group. Its NAV total return performance ranks fourth over one, three and five years, and third over 10 years. GSS does not have an income focus, and ranks fourth for dividend yield. The trust’s ongoing charge ranks fourth, and it does not charge a performance fee. It has one of the widest discounts to cum-fair NAV; however, since the outbreak of COVID-19, discounts have generally widened across the peer group.

The board consists of six independent non-executive directors and is chaired by Hélène Ploix (appointed in November 2012 and assumed her current role in October 2015). Russell Edey is the senior independent director (appointed in January 2015). The other directors and dates of appointment are Saffet Karpat (October 2011), Sujit Banerji (October 2013), Katherine Tsang (July 2017) and Simon Colson (July 2019).