Utilico Emerging Markets Trust — Offering long-term value in emerging markets

While emerging market infrastructure shares have lagged the performance of broader emerging markets and UK shares over the last five years (Exhibit 2, LHS), there are reasons for optimism. The prospects for economic growth in emerging versus developed countries are considerably higher, helped by a rapidly expanding middle class and urbanisation. This will fuel demand for infrastructure and utility assets, which lie at the heart of UEM’s investment strategy.

As shown the bar chart below, emerging market equities remain attractively valued compared with the world market in terms of lower P/E and price-to-book multiples, while offering a more attractive yield (particularly infrastructure shares).

UEM was launched in July 2005. It was historically a Bermudan investment company, but re-domiciled 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. UEM is managed by the ICM Group (ICM and ICM Investment Management), a specialist fund manager based in Bermuda and the UK, with c $20bn of assets under influence.

Manager Charles Jillings, a qualified chartered accountant with more than 30 years’ experience in global financial markets, aims to generate attractive long-term total returns from a diversified portfolio of emerging market equities, primarily in the infrastructure, utility and related sectors. The fund has a wide spread of investments across a range of subsectors and geographies. At end-H120, there were 88 holdings in the portfolio, towards the high end of the 60–90 typical range.

Stocks are selected on a bottom-up basis, and the manager is unconstrained by benchmark allocations, although the MSCI Emerging Markets Index is used as a reference. Since launch, UEM’s NAV total return has compounded at 10.9% pa. The performance fee benchmark is the UK Gilt five- to 10-year index post-tax yield, plus RPIX inflation, plus 2%, subject to an 8% minimum hurdle and the fee is capped at 1.85% of average NAV.

To mitigate risk, there are a series of internal investment limits (as a percentage of gross assets at the time of investment): individual investment (10%); single country (35%); individual sector (25%); unquoted investments (5%); and top 10 holdings (60%). Gearing of up to 25% of gross assets is permitted; at end-December 2019, UEM had net gearing of 6.5%.

Jillings contends that the recently agreed US-China trade deal is a big event, as the truce enables both countries to move forward. While he thinks there will be ongoing friction, he believes it will be at a reduced level and China should benefit from this. The Chinese authorities were aiming for GDP growth in excess of 6% in 2020 (prior to the effects of the coronavirus), and the manager says that the trade deal will allow them to focus on delivering this desired outcome, while continuing the shift from a capital investment to a consumption-led, technology-based economy. Jillings thinks that this should benefit UEM’s assets in the country, including ports and toll roads.

Moving on to focus on Brazil, the manager says that President Bolsonaro has delivered on his promises for pension reform, which is a positive for the economy. There are also other important policy changes underway, including privatisation of state assets. Jillings says that airport, port and toll road operators in the country will benefit, either directly or indirectly, as the regulatory framework is strengthened (Brazil is by far UEM’s largest geographic exposure – Exhibit 3). He expects GDP growth in Brazil to come in above consensus expectations, noting that the economy ‘appears to have turned the corner’, and there is now increased business and consumer confidence. Brazilian interest rates are significantly lower than 12 months ago (the benchmark Selic rate has come down from 6.50% to a record low of 4.25%) and could be reduced further as inflation is under control; Jillings says this could lead to a greater investor appetite for Brazilian equities. He also notes that Brazilian companies have historically paid above average dividends compared with other emerging market regions.

In aggregate, the manager believes that if the Chinese and Brazilian economies are robust, it should be positive for emerging market equities as a whole, although the outbreak of the coronavirus puts the near-term growth outlook for China in question. He anticipates that emerging markets will outperform developed markets in 2020, in part helped by the recent signing of the US-China trade deal. On a less positive note, Jillings comments on the heightened level of populism, which is a global phenomenon, in countries as diverse as Chile, France and Hong Kong, driven by growing anger at wealthy ruling structures. There is a focus on rebalancing political priorities and resources, which will likely lead to policy changes in the future. However, a very powerful opposing force is central bank monetary policy, which remains very accommodative. Of particular importance is the US, where the Federal Reserve moved from a tightening to a loosening bias in early 2019, which has proved to be very supportive for global equity prices.

Jillings and other members of the ICM investment team spend a lot of time travelling in the emerging market regions, meeting with portfolio and potential investee companies, along with relevant government officials and market participants. He highlights a recent extended trip to Asia, where he visited China, Hong Kong, Japan, South Korea, Malaysia and Vietnam. The manager observes that within the region there is significant investment in technology infrastructure, which he suggests is ahead of the rest of the world. He also notes very high adoption rates, such as the level of 5G mobile phone use in South Korea, and extensive e-commerce activity in the region, which should be beneficial for the rate of Asia’s economic growth compared with developed markets.

Stocks are selected on a bottom-up basis following thorough fundamental analysis (including the construction of a detailed financial model and valuation targets) from an investible universe of c 900 companies. To be considered for inclusion in the portfolio, they must be trading at a discount to their perceived intrinsic value and have the potential to generate total returns of at least 15% pa over a five-year horizon. In order to minimise risk, UEM primarily invests in companies providing essential services such as utilities, transportation infrastructure or communications, or in firms with a unique market position or product. Most of the names in the portfolio have long-duration assets, generate strong cash flows and offer good dividend yields. Jillings seeks companies with strong management teams that are risk aware and are pursuing attractive growth strategies. Favoured countries for investment are politically stable with a robust legal framework, a resilient economy and a positive attitude towards foreign investment.

Meeting company management teams and undertaking site visits are a very important element of the investment process. The manager and his team are supportive of UEM’s investee firms in terms of their capital requirements and engaging in constructive discussions about their business strategies. The trust is often among their largest international shareholders. ICM also has a keen focus on companies’ environmental, social and governance (ESG) credentials. As an example, UEM’s portfolio has very low exposure to coal-fired power production.

Jillings invests in a diversified range of companies that are generally under-represented in the MSCI Emerging Markets Index. UEM has an active share approaching 100%; this is a measure of how a fund differs from an index, with 0% representing full replication and 100% no commonality. The manager has a long-term investment horizon, and avoids short-term stock market ‘noise’. Due to the nature of UEM’s investments, 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.

At end-December 2019, UEM’s top 10 positions made up 37.1% of the portfolio, a higher concentration versus 34.1% a year before; five positions were common to both periods. As shown in Exhibit 3, in terms of geographic exposure, the largest changes in 2019 were higher weightings to Brazil (+5.5pp) and India (+4.6pp) and the complete disposal of the Argentinian holdings (-5.3pp). The manager says that the risk/reward differential in the country is far too high. He reduced exposure prior to the primary presidential election in August 2019 (which had a surprising negative outcome for markets) and has since exited the country due to the introduction of exchange controls under the new socialist government. Looking at sector weightings, the largest increases were in infrastructure investment funds and renewables (both +3.9pp) and road & rail (+3.0pp), while the largest decreases were in gas (-7.4pp) and airports (-5.1pp).

Jillings highlights an increase in deal activity in 2019. In June, one of UEM’s largest positions, Companhia de Gas de Sao Paulo (Comgas), underwent a tender offer by its majority shareholder Cosan, while in September Huaneng Renewables received a takeover bid from its parent company at a c 46% premium to its pre-bid share price. The manager also notes a series of companies raising capital to invest in their own businesses; he argues that these offerings have often been on favourable terms for existing shareholders. Below, Jillings focuses on some of the newer top 20 holdings in the fund:

Complete disposals in the fund include Enel Americas (geopolitical risk from its wide exposure in Latin America, as well as corporate governance concerns) and Shanghai International Airport (on valuation grounds, as the manager saw better opportunities elsewhere).

During the year to 31 December 2019, UEM’s NAV and share price total returns of +14.8% and +19.6% respectively were ahead of the MSCI Emerging Market Index +14.3% total return. They surpassed the annual returns achieved over the last three, five and 10 years. However, rolling forward the performance numbers to the end of January 2020 tells a different story (Exhibit 5, RHS), UEM’s annual returns over the last decade are higher than those over the last one, three and five years. Markets weakened in January 2020 on growth concerns following the outbreak of the coronavirus, while equities rallied strongly in January 2019 following a period of weakness in Q418.

UEM’s relative returns are shown in Exhibit 6. Its NAV and share price total returns have significantly outpaced the MSCI Emerging Markets Index over the last decade, and have also outperformed over the last one and three years. However, of more relevance is a comparison with the MSCI Emerging Markets Infrastructure Index. UEM has outperformed this measure over the last one, three, five and 10 years in both NAV and share price terms. The manager says that the trust’s performance has been negatively affected by around 1pp over the last six months by its Argentinian exposure, which has now been completely divested.

UEM’s discount has narrowed meaningfully in recent quarters from a 10-year high point of 16.9% on 22 October 2018. Its shares are currently trading at a 12.5% discount to cum-income NAV, which is towards the higher end of the 7.0% to 14.3% range over the last 12 months. The manager attributes UEM’s narrower discount to increased investor confidence about the prospects for emerging market equities, rather than to the trust’s change in domicile. Over the last one, three, five and 10 years, the trust has traded at average discounts of 10.9%, 11.8%, 11.1% and 9.5%, respectively.

The board believes that the best way to manage the discount over the long term is to generate good performance and increase awareness of the trust’s philosophy and process. Historically, shares have been repurchased when the discount has widened to more than 10%. During FY19, 4.7m shares (c 2.0% of the share base) were repurchased and in H120, 1.8m shares (c 0.8%) were bought back. There is also the potential for periodic discretionary tender offers, although so far, none has been undertaken.

Following the final exercise of UEM’s subscription shares in February 2018, the trust has a single class of share; there are currently 228.0m ordinary shares in issue. It has a three-year unsecured £50m revolving credit facility with Scotiabank Europe, which expires on 3 April 2021. At end-December 2019, net gearing was 6.5%; the level of gearing has increased in recent months as the manager has been finding additional attractive investment opportunities. He has preferred to take on debt rather than reduce the trust’s large Brazilian exposure.

ICM is paid an annual management fee of 0.65% of NAV. Subject to an 8% minimum hurdle, a 15% performance fee on returns above the UK Gilt five- to 10-year index post-tax yield plus RPIX inflation plus 2% is payable. The NAV must exceed the high watermark NAV from when the performance fee was last paid, adjusted for capital events and dividends. The performance fee is capped at 1.85% of average net assets and is paid 50% in shares and 50% in cash.

In FY19, ongoing charges were 1.0%, which was in line with the prior financial year; no performance fee was payable. In H120, ongoing charges were modestly higher at 1.1% (1.3% including performance fees).

UEM has a five-yearly continuation vote, next due at the September 2021 AGM.

UEM has a progressive dividend policy – annual dividends have been increased or maintained each year since the fund was launched. There are quarterly payments in September, December, March and June, which can be made from income or capital.

In FY19, UEM’s revenue income declined by 13.6%, reflecting fewer special dividends received and a weaker Brazilian currency in H119. The fully covered annual distribution of 7.20p per share was 2.9% higher year-on-year.

So far in respect of FY20, two dividends have been paid. The first interim dividend of 1.800p per share was flat year-on-year, while the second payment of 1.925p per share was +6.9% year on year. If the third and fourth FY20 interim dividends are maintained at this level, it would equate to a total distribution of 7.575p per share (+5.2% year-on-year). In H120, revenue income increased by 7.1% due to increased payments from portfolio companies, partially offset by stronger sterling.

At end-H120, UEM had revenue reserves of £11.3m, equivalent to c 0.7x the last annual dividend payment. Based on its current share price, UEM offers a 3.2% dividend yield.

Jillings notes that companies in Brazil and Latin America offer higher dividend yields than in Asia, but in general, investee companies are increasing their distributions. UEM is receiving fewer special dividends in FY20 compared with FY19, indicating that its underlying earnings growth is stronger, which is translating into sustainably higher dividends for UEM’s shareholders.

In Exhibit 9, we highlight the largest eight funds in the AIC Global Emerging Markets sector, with market caps greater than £250m. While UEM has a unique strategy within the group, a comparison with its peers provides some perspective. Its NAV total return is below average over one, three and five years. However, over the last decade, it ranks first out of five funds, a significant 40.5pp above the mean. (These numbers do not take the dilutive effect of UEM’s historic subscription shares up until February 2018 into account.) The trust’s discount is wider than average, and its ongoing charge is below the mean, although it is one of two funds eligible for a performance fee. UEM’s level of gearing is above average, and its dividend yield is the third highest in the selected peer group, 1.1pp above the mean.

UEM’s board has five non-executive directors, four of whom are independent of the manager. John Rennocks is the chairman; he joined the board in November 2015 and assumed his current role in September 2016. Anthony Muh was appointed as a director in October 2010; Susan Hansen in September 2013 (she is considered non-independent as she is also on the board of a company associated with ICM); and Garth Milne in November 2014.

The newest independent director is Eric Stobart, who joined the board on 1 October 2019 and is chairman of the audit committee. He is a chartered accountant and has many years’ experience in financial services, primarily in merchant and commercial banking including roles at Lloyds Banking Group. Currently, Stobart chairs a Lloyd’s insurance business and is a chairman or a member of the trustee board of four pension schemes.

Charles Jillings, UEM’s manager, stood down from the board in March 2012 to increase its independence and improve corporate governance. The directors’ fees are paid in UEM shares, which ensures all shareholders’ interests are aligned.