Genesis Emerging Markets Fund — Exciting long-term opportunities

The medium- and long-term outlook for emerging markets remains compelling, driven by secular trends, including a positive demographic profile, urbanisation and rising incomes. The IMF continues to expect emerging market and developing economies to deliver significant growth between 2019 and 2024, as shown in Exhibit 2 (RHS). The annualised GDP growth forecast of 4.8% is still more than double that of advanced economies. Furthermore, emerging markets equities appear attractively valued, trading at around a 20% discount relative to global equities (Exhibit 2 LHS).

The nearer-term outlook for emerging and global equities is more uncertain. Global growth is slowing and leading economic indicators across most major countries are trending downwards. Following a decade of unprecedentedly low interest rates and abundant liquidity, central banks started to unwind quantitative easing in late 2017 and 2018 and a cyclical slowdown was widely anticipated. However, geopolitical events and the ongoing US-China trade dispute, in particular, have amplified the magnitude of the slowdown and raised prospects of a global recession. Governments are responding to the deteriorating economic picture and some central banks, including the US Federal Reserve and the European Central Bank, have reversed their tightening stances and cut interest rates. In addition, as interest rates are already close to historic lows and many countries are fiscally constrained, the impact of policy measures may be limited. China, which accounts for around 32% of the MSCI Emerging Markets Index, has been one of the main engines of global growth over the past three decades. Now the second-largest economy in the world, its rate of growth is naturally moderating. However, the government’s target annual GDP growth of 6.0% to 6.5% looks optimistic in the wake of US-imposed tariffs. Burdened by high levels of domestic debt, the Chinese government is challenged to manage slower growth, and stimulus measures are thus likely to be modest.

Launched in July 1989, GSS is one of the first UK-listed funds focused on emerging markets equities. Its objective is to deliver long-term capital appreciation through following a disciplined, bottom-up approach to investing in high-quality companies at attractive prices listed in, or with substantial exposure to, emerging markets. These may include companies listed in countries that are not in the benchmark MSCI Emerging Markets Index. The manager is unconstrained by index considerations and the portfolio can invest in countries and companies outside of the MSCI Emerging Markets Index. As at end-September 2019, GSS held over 110 stocks, diversified across 33 countries, with holdings in frontier markets and small caps representing 6% and 12% of holdings respectively. Therefore, the fund is typically significantly differentiated from the benchmark and, at end-September 2019, its active share was 76%.

The manager, Genesis Investment Management, LLP (Genesis), is an emerging markets equities boutique, and all its resources are directed towards this asset class. The firm has c US$20bn under management, most of which is accounted for by high-quality institutions with very long-term investment horizons that have been clients of Genesis for some time. GSS is the only Genesis fund available to the retail investor. The partners (nine of 10 portfolio managers, two of whom are also managing partners, and the managing director) own 41% of Genesis and Affiliated Managers Group owns 59%. This ownership structure has contributed towards a stable team of investment professionals, incentivised to deliver returns for shareholders over the long run.

One of the key reasons for the manager’s optimism for emerging markets’ long-term prospects is rising disposable income. As consumers start to shift spending from basic needs to buying discretionary items, they can participate in ‘premiumisation’. Premiumisation is a powerful investment theme for Genesis, and the team believes companies that have strong brands and can capture aspirational demand often have higher margins and can generate predictable and sustainable cash flows. Emerging markets are fertile ground for these companies as the manager observes that they are home to 85% of the world’s millennials (aged c 20–35), who are core to brand growth. China and India together are home to over 400 million millennials, more than the combined working populations of the US and Western Europe. Genesis argues that building brand equity is often a very lengthy process, but once established, can present an enduring competitive ‘moat’ for a company, underpinning sustained supernormal returns. Around 15% of the GSS portfolio is invested in such companies, including Chinese liquor company Wuliangye, global luxury brands conglomerate Richemont and Dutch brewer Heineken. These investments focus on domestic multi-year secular trends. However, the manager finds investing in quality companies at attractive prices one of its constant challenges, however the current weak sentiment towards emerging markets is offering some exciting long-term opportunities.

The GSS investment process is bottom up and benchmark agnostic. The investment team of 10 portfolio managers (PMs) are highly experienced, each with between six to 30 years’ investment experience. The team is well resourced, able to support a process that involves around 1,000 company and stakeholder meetings per year (the PMs are on-the-ground in their markets one out of every four weeks), and in-depth fundamental analysis. Each PM typically has primary responsibility for around 10–15 stocks held in the portfolio, enabling them to know their stocks very well. Companies are assessed for and given a quality rating based on a number of factors. These include the quality of their competitive advantage and ability to sustain excess returns on capital. Environmental, social and governance criteria are included in the analysis of quality and are a core part of the analysts’ ongoing engagement with managements. Valuation is also key and the team looks for businesses that are intrinsically undervalued based on its assessment of a five-year US dollar internal rate of return. Prior to the purchase of a new holding, its investment case and valuation are shared among the team with constructive challenge seen as a part of the Genesis culture.

Portfolio construction is team based and Genesis’s long-standing culture of collaboration with individual accountability is an important part of its success. Stock weights are influenced by three stock-specific factors (the level of conviction, expected returns and the quality of a company) and two portfolio-level factors (correlation of holdings and investibility). Less-liquid stocks can present an investment opportunity and the manager has a patient approach to accumulating positions in smaller stocks. The portfolio coordination team (PCT) provides oversight of the integrity of the investment process and reviews the shape and risk of the overall portfolio. This PCT team is composed of three PMs and an independent investment risk officer.

Exhibit 3 shows the GSS portfolio’s exposure by sector at end-September 2019. The largest sector is consumer at 37.5% of the portfolio (discretionary and staples combined), representing a significant 16.6pp overweight relative to the MSCI Emerging Markets Index. This reflects the manager’s belief that growing consumption is one of the most powerful investment themes for emerging markets, underpinned by income convergence with more developed markets, urbanisation and a growing working-age population. The manager has added to the consumer exposure recently through the purchase of Gruma (Mexico), the world’s leading tortilla and corn flour producer. The company produces and sells its products globally and its brands include Mission Foods, Maseca and Guerrero. Around 60% of its sales are to the US, where it is the market leader, and it is the largest supplier to Taco Bell. Following in-depth research on the company, the manager believes Gruma has an entrenched market position and the ability to expand revenues and margins. The team’s valuation analysis suggests the company is generating an 8% free cash flow yield and has been trading on a reasonable low teens P/E multiple.

GSS has also recently purchased a position in Tencent, one of the leading internet companies in China. The company is the world’s largest online gaming company by revenue and is China’s leading social media platform provider. The manager believes Tencent has enormous potential to further monetise its businesses, noting the firm’s dominance of internet traffic, with nearly 50% of mobile user time in China spent on its platforms. In addition to advertising revenue, in the manager’s view, Tencent also has excellent prospects to generate returns from its other business segments, including mobile payments, and its portfolio of over 700 investments, some of which may realise value through listing. The purchase was funded from the reduction in Naspers (South Africa), Tencent’s largest shareholder with a 31% stake. The manager says Tencent is the main driver of Naspers’ share price; however, Tencent trades at a significant valuation premium, which has resulted in its preference for holding Naspers. Ahead of the switch, Naspers’ share price outperformed Tencent’s by a significant margin, making it more attractive to own Tencent directly. More recently the portfolio has invested in Prosus, which was spun-off by Naspers in September 2019. Prosus consists of Naspers’ internet interests outside of South Africa, including Tencent, mail.ru and Delivery Hero.

GSS also added to its position in Chinese online gaming company NetEase. Although the company’s market position in China is a distant second to Tencent, the manager believes its assets are underappreciated by the market, which persistently ascribes low P/E multiples to internet gaming companies. The Genesis team has a more constructive view of NetEase and believes its games are valuable franchises, generating sustainable cash flows over the long term. For example, Fantasy Westward Journey was launched in 2001 and it remains the firm’s most valuable game franchise today. Furthermore, the manager says the company’s revenues are well diversified across multiple titles and that NetEase’s model to ‘incubate’ game developers should help it retain its strong market position.

The US-China trade dispute is taking a toll on global trade and sentiment is very poor for trade-related stocks. Genesis has used this as an opportunity to purchase Dubai-listed DP World, the fourth largest container port operator in the world. The team believes the company has an attractive portfolio of 78 ports across 40 countries (80% of the ports are in emerging markets) and argues that concerns over global trade prospects have been overdone, citing the long-term trend of containerisation growth of 1.5x to 3x GDP growth. At the time of purchase, DP World’s share price implied the company’s worth at just above its book value, which the manager believed to present an attractive entry point for investment.

The most significant sector reduction over the year to end-September 2019 was in financials. Recent sales included Garanti Bank (Turkey), where the manager views the medium-term outlook to be challenging; Shinhan Bank (Korea) on signs of a negative credit cycle emerging in that country; and BTG Pactual (Brazil), where the share price had more than doubled since the beginning of the year, prompting profit taking.

As shown in Exhibits 5 and 6, GSS’s NAV total return has outperformed the MSCI Emerging Markets Index over one, three, five and 10 years. Over the past 10 years, the fund has delivered an annualised return of 7.8%. Performance over shorter periods has also been generally positive and the fund has outperformed over three and six months.

GSS trades at an 10.5% discount to cum-income NAV, which is lower than its three-year average of 12.2%. The board monitors the discount and actively considers measures, which may help it to narrow, including the tender offer conducted in August 2018 and increased marketing activity to promote the fund to a broader potential investor base. The board has also announced its intention to offer a further tender offer for up to 25% of the fund’s shares in June 2021 if GSS’s NAV total return over five years to that date does not exceed its benchmark NAV total return, which may help the discount to narrow.

GSS is a Guernsey-based authorised closed-ended investment scheme, listed on the London Stock Exchange and a member of the FTSE 250 Index. There are two share classes. Participating preference shares represent the principal share class; there are currently 121.5m shares in issue. There are also 1,000 founder shares in issue, which are not redeemable and confer no rights on the holders, except the entitlement to one vote at general meetings. Participating preference shares 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. In July 2018, the board conducted a tender offer for up to 10% of the participating preference shares. This was fully taken up, resulting in the repurchase and cancellation of 13.5m shares at 746.03p per share. Gearing is permitted up to 10% of NAV; however, this capability has not been employed and, at end-September 2019, GSS had net cash of 1.6%.

Genesis Investment Management is paid an annual management fee of 0.90% of NAV, reduced from 0.95% with effect from 1 July 2019. In July 2017, the board changed the allocation of the management fee (and certain other costs) from 100% to the revenue account to an 80:20 split between the capital and revenue accounts. This proportion reflects the board’s expected long-term balance of capital and revenue returns. The fund’s ongoing charges ratio for FY19 was 1.11%, marginally higher than 1.10% for FY18. 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 revised GSS’s policy, with the intention to pay an annual dividend. Dividends are declared in US dollars and paid in sterling using the exchange rate prevailing on the payment date. For FY19 the board has declared a dividend of 19 cents per share, unchanged from FY18 (which was paid as 14.8p).

Exhibit 9 shows a subset of the funds in the AIC Global Emerging Markets sector, with market capitalisations over £100m. The sector contains a diverse range of funds, including those specialising in frontier markets, income and infrastructure, therefore, direct comparisons may not be relevant. GSS is the third-largest fund in the group. Its NAV total returns rank third over one and 10 years, and fifth over three and five years. Its ongoing charges ranks fourth and dividend yield ranks fifth. The fund’s discount to cum-fair NAV is one of the widest among peers, ranking sixth.

The board consists of six independent non-executive directors and is chaired by Hélène Ploix, who was appointed in November 2012 and assumed her current role in October 2015. Russell Edey serves as the senior independent director and was appointed in January 2015. John Llewellyn recently retired from the board in June 2019 following nearly 10 years of service. With effect from 1 July 2019, Simon Colson was appointed as independent non-executive director. Colson has over 30 years’ experience in financial markets. His previous roles included being managing director at Deutsche Bank London, in charge of closed-ended fund origination and distribution, and non-executive director of The Association of Investment Companies. The other members of the board and their dates of appointment are Saffet Karpat (October 2011), Sujit Banerji (October 2013) and Katherine Tsang (July 2017).