Utilico Emerging Markets Trust — Differentiated, undervalued cash-generative assets

As shown in Exhibit 1, left-hand side, over the last five years, emerging market stocks have lagged the global market. However, it is notable how well emerging market utility stocks have performed so far in 2022, despite above-average volatility in other parts of the market.

In aggregate, emerging economies have better growth prospects compared with developed regions (Exhibit 2, right-hand side). In its World Economic Outlook, July 2022 update, the International Monetary Fund (IMF) projects GDP growth of 3.6% and 3.9% in 2022 and 2023 respectively for emerging market and developing economies, which is higher than the 2.5% and 1.4% in 2022 and 2023 respectively for advanced economies. It is worth noting that the negative revisions compared with the April 2022 update are larger for the developed rather than the developing economies.

Emerging market equities look very attractively valued on both an absolute and relative basis (Exhibit 2, left-hand side). The Datastream Emerging Market Index is trading on a 10.6x forward P/E multiple, which is an 19.9% discount to its 13.3x five-year average. It is also trading at a 28.5% discount to the Datastream World Index, which is meaningfully wider than the 18.5% average discount over the last five years.

Drilling down a little deeper, at 31 July 2022, the MSCI Emerging Markets Utilities Index was trading at a lower forward P/E and P/B multiple, while offering a higher dividend yield than the MSCI World Index (Exhibit 2, right-hand side).

Jillings focuses on why he believes that investors should consider emerging markets. The manager points to their higher economic growth prospects and attractive secular dynamics. Growth of the emerging market middle class is driving increased consumption, urbanisation and infrastructure investment, and in aggregate, 60% of global economic growth is generated in these regions. The primary country drivers for this are Brazil, China and India. Jillings highlights that investment in emerging markets bring diversification, as they are heterogenous, providing interesting investment opportunities across economic, political and business cycles. He explains that there can be inefficiencies in the pricing of emerging market assets, as many companies are not well researched or considered by UEM’s peers, while higher stock market volatility in less developed regions can provide attractive entry points for an investor. The manager says that, in aggregate, the valuations of emerging market equities look very attractive on both an absolute and relative basis. Jillings comments that UEM’s investee companies are growing their earnings and improving their financial metrics, but their shares have derated, so he suggests that now looks to be an opportune time to consider an investment in the fund. The manager says he has access to all emerging markets and ensures that there is adequate liquidity in UEM’s holdings to enable him to buy and sell shares when necessary.

At end-July 2022, UEM’s top 10 holdings made up 31.2% of the portfolio, which was modestly lower than 30.7% a year before; five positions were common to both periods. It is interesting to note that there are now two unlisted companies in the trust’s top 10. At end-FY22, unlisted investments made up 8.4% of the fund versus a maximum permitted 10.0%.

As shown in Exhibit 4 below, UEM’s portfolio is diversified by sector and geography. While the MSCI Emerging Markets Index is used as a reference, the fund is constructed on a bottom-up basis, taking into account macroeconomic and political risks, without a consideration of the index’s breakdown. For example, at end-July 2022, 21.5% of the MSCI Emerging Markets Index was made up of financial stocks, while UEM has a zero weighting. The index had a 32.0% exposure to China (including Hong Kong) and a 14.8% exposure to Taiwan, while UEM’s weightings were 15.9% and 0% respectively. The manager also invests in small- and mid-cap companies that are often overlooked by other market participants.

International Container Terminal Services (ICTS) is UEM’s largest holding, making up 4.4% of the fund. It is a global emerging market container port operator with 33 terminals in 20 countries. While the company is listed in the Philippines, just 15–20% of its revenues are generated there. The business has many long-term concession agreements, its import and export volumes are sticky, and there is an increase in the use of containers as it is an easier and more efficient method to handle goods. The manager says that ICTS has an operationally and very cost-focused management team and the company has generated strong revenue and profits growth over the last four years, helped by operational leverage. ICTS has made a series of accretive acquisitions and has recently announced the purchase of a 66.7% stake in an underperforming asset, a multipurpose port in Indonesia, which is South-East Asia’s largest economy. Jillings comments that ICTS is a well-run business trading on an inexpensive valuation that has generated a greater than 110% total shareholder return over the last five years.

UEM’s second-largest holding is Alupar Investimento, a Brazilian transmission operator with smaller renewables and transmission businesses in Brazil, Peru and Colombia. The company maintains 30 transmission lines totalling 6,974km (greater than National Grid’s) and owns an 822MW renewables portfolio. The manager considers that it has a high-quality asset base and management team. Alupar’s transmission projects have a 30-year concession with an annual inflation adjustment and regulated annual revenues. Jillings explains that the risk in transmission projects is at the development stage, and the company’s management is very good at executing these. Over the last five years, Alupar’s network has grown organically by more than 50%, while its management team invests in the company and employs disciplined capital allocation. It has lost bids for new business in recent years because the proposed terms did not offer sufficient returns (there is a 12% real annual return requirement); however, those bids that it won have generated very strong margins. On average, the team spends 20% less capex on comparable projects than its peers and they come on line 12 months earlier, so Alupar gets an additional year of revenue, while via creative financing it takes advantage of low interest rates to maximise returns. As development projects progress, the company cuts its dividend payout ratio until it is in a position to restore it. Jillings believes that a c 10x forward P/E multiple is far too low given Alupar’s high-quality asset base.

Also in UEM’s top 10 list of holdings, and added to the portfolio in 2019, is FPT Corporation, which is a Vietnamese telecoms and IT services company with a global client base. It has a series of subsidiaries grouped into three segments: technology software solutions and IT services (contracts with governments and multinational corporates); telecom (one of Vietnam’s largest fibre broadband and data centre providers); and Vietnam’s largest private-sector education company (only around 10% of revenues, but the fastest growing of the three segments, with c 75k full-time students). FPT is leveraging Vietnam’s skilled workforce, while training the next generation. The manager is impressed with the strength and the ambition of the company’s management team, and it has a high-quality client base including Hitachi, Sony, Honda, Bayer, RWE and Airbus. FPT has a growing US business, and this country is likely to become its largest geography. The company is targeting annual revenue and EBITDA growth of 20% for the next several years. Its H122 revenue grew by 22% and its pre-tax profits by 24%. FPT signed $500m of new contracts, +40% compared with H121, and 77% of which were greater than $1m.

In FY22 (ending 31 March) UEM’s NAV and share price total returns of 14.9% and 17.6% respectively were considerably ahead of the MSCI Emerging Markets Index’s -6.9% total return. The trust’s asset class was largely overlooked by investors early in the pandemic, as they focused on the shift to working from home and the growth of digitisation. Technology stocks were very much in favour then, but since the approval of COVID-19 vaccines, and people returning to work and spending less time at home, their popularity has waned (as illustrated in the front-page chart).

Exhibit 7 shows UEM’s relative performance. It has outpaced the MSCI Emerging Markets Index over the past one, six and 12 months and is also ahead over the last decade.

In Exhibit 8, we show the performance of UEM’s NAV compared with the MSCI Emerging Markets Utilities Index over the last 10 years. While significantly outperforming this index over the last decade, over the shorter periods shown in Exhibit 7, the trust has lagged. As a reminder to our readers, stocks are selected on a bottom-up basis and held for the long term; the manager is confident in the long-term prospects for the companies in UEM’s fund.

Of the 12 funds in the AIC Global Emerging Markets sector, UEM is the fourth largest. Due to the trust’s unique strategy, it cannot be directly compared with its peers, although Exhibit 9 does provide some context. UEM’s NAV total return is above average over the last 12 months, ranking fourth, although it is below the mean over the other periods shown, which is unsurprising given that growth stocks have led the market for most of the last decade. These returns do not take the dilutive effect of the trust’s historical subscription shares before February 2018 into account. UEM’s discount is wider than average in a peer group where no funds are trading at a premium. It has an average ongoing charge and a level of net gearing that is in modestly above the mean; most of its peers are ungeared. The trust’s dividend yield is the fourth highest, 1.3pp above the average, and the manager is proud that UEM was one of the few funds in the group that had a covered dividend during the pandemic.

UEM’s annual dividend has been increased or maintained every year since the fund was launched in July 2005. Quarterly payments are paid in September, December, March and June from income or capital when required. In FY22, the trust’s revenue earnings per share was 0.5% higher year-on-year. This is despite c 15% of the portfolio being invested in the data services and digital infrastructure sector; these businesses tend to be higher growth but pay lower dividends. More than 75% of UEM’s investee companies pay dividends.

The 8.0p FY22 annual dividend was a 2.9% increase compared with the FY21 distribution and remains fully covered by income. At the end of FY22, UEM had £7.3m in revenue reserves, which is equivalent to c 0.4x the last annual dividend payment. Based on its current share price, UEM offers an attractive 3.7% yield.

UEM’s discount remains stubbornly above 10%. The trust’s 14.1% share price discount to cum-income NAV compares with a 9.0% to 15.1% range over the last 12 months and average discounts of 12.4%, 12.6%, 12.6% and 10.5% over the past one, three, five and 10 years respectively.

The board typically repurchases UEM’s shares when the discount has widened to more than 10% in normal market conditions. In FY22, c 6.5m shares (c 3.0% of the share base) were repurchased at a cost of c £13.9m. So far in FY23, a further c 2.9% of the share base has been bought back at a cost of c £13.3m.

Launched in July 2005, UEM was historically a Bermudan investment company, but redomiciled to the UK as an investment trust via a scheme of arrangement on 3 April 2018. It is listed on the Main Market of the London Stock Exchange and is managed by the ICM Group (ICM and ICM Investment Management), which is a specialist fund manager based in Bermuda and the UK with c $24.4bn of assets under management (c $2.1bn directly and c $22.3bn indirectly). ICM Group has more than 70 employees, greater than 20 of whom are sector and country specialists, who operate from 10 offices around the globe.

UEM is managed by qualified chartered accountant Charles Jillings, who has more than 30 years’ experience in global financial markets. He aims to generate an attractive long-term total return from a diversified portfolio of emerging market equities, primarily in the infrastructure, utility and related sectors. Jillings employs a bottom-up stock-selection process and is unconstrained by benchmark allocations, although the MSCI Emerging Markets Index is used as a reference.

To mitigate risk, there are a series of investment guidelines in place (as a maximum percentage of gross assets at the time of investment): individual investment 10%; single country 35%; individual sector 25%; unquoted investments 10%; and top 10 holdings 60%. Gearing of up to 25% of gross assets is permitted; at end-July 2022, UEM had net gearing of 3.2%. The trust’s currency exposure is unhedged. From launch to end-June 2022, UEM’s NAV total return compounded at an annual rate of 9.3% versus 7.9% for the MSCI Emerging Markets Index.

Jillings seeks to identify and invest in companies predominantly in the infrastructure and utility sectors that are trading at a discount to his estimated intrinsic value, and which he believes have the potential to generate total returns of at least 15% pa, at an investee company level, over a five-year horizon. The manager focuses on emerging market countries with positive attributes such as political stability, economic development, an acceptable legal framework and an encouraging attitude to foreign investment. Jillings has a long-term investment horizon and avoids short-term stock market ‘noise’.

Stocks are selected on a bottom-up basis following thorough fundamental research (including the construction of a detailed financial model and valuation targets) from an investible universe of more than 1,000 companies. There are c 80 holdings in the portfolio (typical range of 60–90). UEM has an active share approaching 100% versus the MSCI Emerging Markets Index; this is a measure of how a fund differs from an index, with 0% representing full replication and 100% no commonality. Jillings is supportive of UEM’s investee firms in terms of their capital requirements by participating in follow-on equity offerings and the trust is often among their largest international shareholders.

Because of the nature of UEM’s investments, in companies providing essential services, the trust has tended to underperform the MSCI Emerging Markets Index during a cyclical upturn led by sectors such as technology and consumer discretionary, while outperforming in a falling market.

While UEM is not an ESG fund, its board believes it is in shareholders’ best interests to consider environmental, social and governance factors when selecting and retaining investments. In conjunction with assessing the financial, macroeconomic and political drivers when making and monitoring an investment, the manager embeds ESG opportunities and risks into the trust’s investment process. Companies are scanned using a rigorous in-depth framework; however, the decision as to whether to make an investment is not made on ESG grounds alone. The manager can consider a potential investment with a low ESG score but this will need to be outweighed by an attractive total return potential. Every investee company’s ESG footprint is analysed, and there is often still room for improvement at some of these businesses. The manager works to understand a company’s ESG journey and seeks an improving score.

Factors are incorporated into the trust’s investment process in three main ways:

ICM is a signatory to the United Nations-supported Principles for Responsible Investment, a code of best practice for incorporating ESG issues.

UEM has a three-year unsecured £50m multicurrency revolving credit facility with The Bank of Nova Scotia (London branch) that expires on 15 March 2024. At end-July 2022, UEM’s net gearing was 3.2%.

Since 1 April 2021 ICM is paid 1.00% of UEM’s NAV up to £500m; 0.90% above £500m up to £750m; 0.85% above £750m up to £1bn; and 0.75% above £1bn (previously a flat fee of 0.65% of NAV was charged); and the performance fee has been removed.

UEM’s board believes that the simpler and more transparent cost structure should contribute to a stable and competitive ongoing charge, while helping to attract private wealth managers and retail investors. A tiered fee structure allows shareholders to benefit from the increasing economies of scale that a larger portfolio provides. In FY22, UEM’s ongoing charge ratio was 1.4%, which was 30bp higher than 1.1% in FY21 (no performance fee was payable). During FY21, the ongoing charge including performance fees was 2.1%.

UEM has 208.6m ordinary shares in issue and its average daily trading volume over the last 12 months is c 255k shares. The trust has a five-yearly continuation vote, next due at the September 2026 AGM. The September 2021 vote was passed with 84.2% of shareholders voting in favour of UEM’s continuation.

The directors’ fees are used to acquire UEM shares, ensuring all shareholders’ interests are aligned. Susan Hansen is considered non-independent as she is also on the board of Resimac Group, which is associated with ICM. Anthony Muh has indicated that he will retire following the conclusion of UEM’s September 2022 AGM.