BlackRock Latin American Investment Trust — New dividend and discount management policies

As shown in Exhibit 2 (LHS), Latin American equities have had a tough start to 2018. Within the key Brazilian market, economic growth has been softer than expected; factors include a weaker currency versus the US dollar and a truckers’ strike. As always, politics has been a key driver of Latin American stock markets – there has recently been a presidential election in Mexico and one is due in Brazil in October 2018. However, despite the weakness so far this year, investors willing to take a longer-term view on Latin American equities may be rewarded. While slower than expected in the near term, the Brazilian economy is growing, the key Selic interest rate is down to 6.5%, which is the lowest on record, and President Temer’s programme of reforms is having a positive impact. In Mexico, the recent overwhelming presidential election win by Andres Manuel Lopez Obrador is considered positive for equity markets, as he is anti-corruption and has gained more support from moderate voters. In terms of valuation, the year-to date market setback has made Latin American equities look even more relatively attractive versus the rest of the world. The Datastream Latin America index forward P/E multiple is 12.8x, which is a 14.0% discount to world equities. This is considerably wider than the 4.7% average discount over the last decade.

BRLA was launched in July 1990 and is listed on the Main Market of the London Stock Exchange. Since March 2006, the trust has been managed by BlackRock. Manager Will Landers, who has 27 years’ investment experience, aims to generate long-term capital growth and an attractive total return, primarily from a portfolio of quoted Latin American equities. The closed-end structure of the fund enables him to take a long-term view and, when appropriate, invest in less liquid mid- and small-cap companies. BRLA is benchmarked against the MSCI EM Latin America index. Gearing of up to 25% of net assets is permitted. The board considers that 5% net gearing is a neutral position and the manager should actively manage gearing in a range of plus or minus 10% compared to this level (ie 5% net cash to 15% geared). At end-May 2018, net gearing was 6.8%. Various portfolio construction rules are in place. In terms of geography, Brazilian, Mexican, Chilean, Argentinian, Peruvian, Colombian and Venezuelan exposure is limited to 20pp above or below the index. For other Latin American countries, exposure is limited to 10pp above or below the index weighting. The manager is permitted to invest in companies whose primary operations are in Latin America, but which are listed on exchanges outside of the region. A maximum 15% of the portfolio may be in a single company and up to 10% may be held in unquoted securities. The use of derivatives is permitted for efficient portfolio management. Writing call options is used to generate income, with portfolio coverage of up to 20% permitted. BRLA’s currency exposure is not hedged.

Landers says that sentiment has been driving the relative performance of emerging markets equities. He says that investors are not yet ready to rotate into Latin America; the focus has been on the Asia Pacific region, especially internet and consumer names, despite higher earnings from cyclical sectors, which have not enjoyed a positive rerating. The general perception is that Latin America is export-heavy and geared towards Chinese growth, which has led to investor caution towards the region. However, the manager highlights that Latin America is no longer a leveraged play on the Chinese economy – he says that only 12% of Brazil’s GDP is exports, with China accounting for just a quarter of this. Landers explains that the make-up of the economy has changed in recent years and there is now a much greater contribution from domestic demand. In general, within the region, he expects domestic consumption to rise, while inflation and interest rates continue to decline. For these reasons, he remains constructive on the outlook for Latin American equities.

Within the portfolio, Brazil is a key overweight (c 67%, which is 10pp above the index weighting). The country has undergone an aggressive easing cycle over the last 18 months, with the key Selic interest rate declining from more than 14% to 6.5%, which is likely to be a floor given the pressure that lower interest rates bring on the Brazilian currency. With inflation still below target, the manager expects a pick-up in domestic demand. However, he is mindful that the path for Latin American equities is also affected by the magnitude and pace of change in US monetary policy. Given Brazil’s large weighting in the index, Landers acknowledges that the country’s economy has to advance for the Latin American stock market as a whole to appreciate. He says that the Brazilian presidential election outcome is still up in the air, but that whoever is elected in the autumn, he believes that the country’s reform programme will continue. The manager notes that changes in the labour market are already having a positive effect on the economic and pension reform is a necessary next step. While reform is painful, it can lead to faster economic growth eg Landers highlights the positive effects of demonetisation and the implementation of the goods and services tax in India.

The manager aims to identify undervalued companies with strong management teams and good corporate governance records, strong balance sheets, and robust earnings and cash flow growth. Landers and his team conduct thorough fundamental research on potential investee companies and on-the-ground research is an important part of the investment process, including meetings with company competitors and suppliers, as well government officials, central bankers and industry regulators. The BlackRock Latin American portfolio management team has been in place for more than a decade. There is primary and secondary coverage on a sector basis, to enable team members to research the universe of c 200 investible companies in detail. The primary analyst role includes in-depth financial modelling, while the role of the secondary analyst is to act as ‘devil’s advocate’ and to uncover extra nuggets of information pertinent to the investment case. Investment decisions are made on the basis of company-specific research, along with a consideration of the macro environment. The resulting portfolio typically has 50-75 holdings, with turnover of 40-60% pa.

At end-May 2018, BRLA’s top 10 positions made up 52.1% of the portfolio. This was an increase compared with 47.8% a year earlier; eight positions were common to both periods. In terms of geographic exposure (Exhibit 3), the largest increases to end-May were Brazil (+4.0pp) and Chile (+3.1pp), while the largest decrease was Mexico (-3.7pp). More recently, the manager has increased exposure to Mexico, moving to a modest overweight as he believed that the political uncertainty was already priced into the Mexican stock market – this was achieved by adding to existing positions rather than adding new names to the portfolio.

There have been more significant changes in BRLA’s sector exposure (Exhibit 4), with the largest increases in materials (+6.3pp) and consumer discretionary (+5.8pp), both cyclical sectors, and a 9.4pp lower weighting in consumer staples, which is a more defensive sector.

We highlight some of the newer positions in BRLA’s portfolio:

During FY17, BRLA outperformed the benchmark. Its NAV total returns of +29.0% and +17.7% in dollar and sterling terms respectively were ahead of the benchmark returns of +24.2% ($) and +13.4% (£). The trust’s share price total returns were even better at +31.3% ($) and +19.9% (£), which led to a narrowing of the discount over the period. The greatest positive contributor to returns was Brazilian stock selection, where equities were supported by further interest rate cuts. BRLA’s exposure to Argentina (which is currently not represented in the index) was also a positive contributor, while the trust’s below-index weighting in Chile had a negative effect on performance.

Looking at BRLA’s and the index’s total returns over the last 10 years (Exhibit 5, RHS), Latin America has experienced something of a ‘lost decade’. While there are periods when equities in the region have performed strongly, such as during 2017, stock market volatility suggests that investors in Latin American equities need to be very nimble or very patient. BRLA’s long-term record of outperformance versus the index has been negatively affected by a tough period of relative performance over the last three months. This was primarily due to being levered in a falling stock market and having overweight exposures in Brazil and Argentina.

While long-term economic growth expectations are strong, most Latin American economies are more cyclical than the broader global economy, meaning the discounts of Latin American investment trusts can remain wide. BRLA’s current 13.4% share price discount to cum-income NAV compares with the averages over the last one, three, five and 10 years (range of 8.3% to 13.4%).

BRLA has recently announced a change in its discount control mechanism. Previously a tender offer for 24.99% of shares was triggered if the trust underperformed the benchmark by more than 1% pa over a two-year period (ending 31 December) and the average share price discount to cum-income NAV exceeded 5% over this time. For the two years ending 31 December 2017, while the average discount was 13.4%, BRLA’s NAV increased by 61.7% and the benchmark increased by 63.2%. As a result, no tender offer was implemented in 2018. The board believes that it is in the interests of shareholders if investment performance is assessed over a longer period. Under the revised discount control mechanism, a 14.99% tender offer will be triggered (subject to passing the biennial continuation votes in 2020 and 2022) if the trust underperforms the benchmark by more than 1% pa over a four-year period (ending 31 December) and the average share price discount to cum-income NAV exceeds 12% over this time.

BRLA is a conventional investment trust with one class of share in issue. Following the resumption of share repurchases (Exhibit 1), there are currently 39.3m ordinary shares outstanding. The trust has an overdraft facility with Bank of New York Mellon for up to $40m, at a rate of Libor +1%. Gearing of up to 25% of net assets is permitted; at end-May 2018, net gearing was 6.8%. BRLA is subject to a biennial continuation vote, next due at the May 2020 AGM. BlackRock is paid a 0.80% annual management fee, split 75:25 between the capital and income accounts. Prior to 1 January 2017, the fee was 0.85% and a performance fee was payable, which has now been removed. In FY17, BRLA’s ongoing charge was 1.1% (down from 1.2% in FY16).

Under BRLA’s new dividend policy, rather than semi-annual dividends based on the level of income, the board will pay quarterly dividends of 1.25% of quarter-end US dollar NAV. These will be paid in February, May, August and November. Dividends may be funded out of revenue and capital reserves as well as income. FY18 will be a transitional year, with three dividends being paid based on end-June, September and December NAVs. The board believes that the higher distribution policy will lead to a narrowing of the trust’s discount over time. While portfolio income may be boosted by option writing, during FY17, no call options were written, as the manager had a bullish view on Latin American equities. As a result, the revenue return of 13.03c was meaningfully lower than 17.89c in FY16. Dividend growth in BRLA’s underlying portfolio was c 17%. The FY17 annual dividend of 13c compared with 15c in FY16. Based on the FY17 dividend, BRLA is yielding 2.4%. However, considering the end-June NAV of $605.5, assuming no increase in NAV or share price during the year, the trust has a prospective yield of c 4.0%, based on three quarterly payments, rising to c 5.5% in FY19.

BRLA is one of two trusts in the AIC Latin America sector. Its NAV total return is first over one and five years and second over three years. To enable a broader view, we compare the trust with a selection of open-ended funds. Its NAV total returns are above the average for these funds over all periods shown. BRLA’s fees and dividend yield are also competitive versus the open-ended funds.

BRLA’s board is made up of five directors, all of whom are non-executive and independent of the manager. The chairman is Carolan Dobson, who was appointed as a director on 1 January 2016 and assumed her current role on 2 March 2017. Antonio Monteiro de Castro is the senior independent director and chairman of the audit committee; he was appointed as a director on 12 November 2007. The three other directors and their dates of appointment are: Laurence Whitehead (3 December 2003), Mahrukh Doctor (17 November 2009) and Nigel Webber (1 April 2007). Monteiro de Castro and Whitehead have announced their intention to step down. The board is undertaking a search and selection process and new directors will be announced in due course.