Fidelity Emerging Markets — Repositioned for emerging opportunities

As financial markets turned south at the start of the year, Price and Tennant continued to focus on finding attractive companies to invest in. The managers believe that inflation will persist for some years to come, resulting in higher commodity prices. They expect prices to remain high for many reasons, including deglobalisation, underinvestment, the move to renewables, an escalating ‘climate crisis’, energy and food security issues and the potential for stock piling. The managers differentiate between inflation in developed markets (DM) and EM economies. They note that in EMs inflation is generally lower than in most DMs. They expect that while DM governments will increase rates to respond to inflationary pressures, overall rates cannot remain high given that many economies have unsustainably high debt/GDP ratios. What sets EM apart is that inflation has been tackled early and proactively, giving central banks scope to manoeuvre.

While FEML’s country and sector positioning are the result of a bottom-up stock-picking approach, a number of themes have emerged. In the managers’ view, China will remain volatile but the direction of the Chinese market is looking more positive, supported by lower valuations and less focus on platform regulations, while stimulus is likely to come given the rising unemployment rate. FEML’s overweight positions in the materials and semiconductor sectors are driven by the green agenda and multi-year underinvestment in the former. For the latter, strong fundamentals and long-term structural demand underpin the manager’s conviction, given that technological advancement continually requires greater processing power and memory.

At 30 June 2022, the portfolio’s 164 holdings included 93 long and 71 short positions (including short positions in the MSCI EM Index (7.2%) and the MSCI India Index (2.7%)). As described in our initiation report, Fidelity’s team can build a higher gross long exposure as part of its long/short strategy, while its net exposure is targeted to be a neutral c 100–110%.

We present FEML’s geographical split in Exhibit 1. Fidelity’s high conviction approach results in significant concentration in the top three countries: China, India and Taiwan (c 56% and c 62% if we include Hong Kong). While Hong Kong is overweight, India and Taiwan are underweight the MSCI EM Index.

Exhibit 2 illustrates FEML’s portfolio by sectors. Combined, the cyclical information technology (24.8%), financials (22.1%), materials (14.0%) and industrials (12.3%) sectors represent 73.2% of the portfolio, giving it a cyclical tilt, albeit the focus on owning quality stocks is prevalent across all sectors. Since taking over the management of the portfolio in October 2021, the team has materially reduced the fund’s exposure to the consumer discretionary sector (12.6% and underweight the benchmark 2.2pp) due to concerns about the cost of living. Communication services is the largest sector underweight position relative to the benchmark of 7.3pp (at 30 June 2022) as the team is finding better investment opportunities elsewhere.

Expecting a stronger inflationary backdrop, the managers used this freed up cash to increase the exposure to commodities. The managers believe commodity prices will remain high, particularly energy commodity prices, which will lead to higher prices in general. In addition, issues such as deglobalisation, food and energy needs, will facilitate and accelerate the move to renewable energy sources.

Exhibit 3 lists FEML’s top 10 overweight positions versus the benchmark (at 30 June 2022). As the table illustrates, the active weight of the top 10 overweight stocks versus the benchmark is 39.3%.

The section below presents examples of the team’s active sector exposures and stock picks.

FEML’s commodities positioning reflects the ‘all cap, go-anywhere’ approach and with holdings in a wide range of commodities, including copper miners (First Quantum, Grupo Mexico) it remains an area of high conviction, given the increase in renewable energy and scarcity of commodities’ supply. Nevertheless, the overall exposure to commodities is benchmark neutral.

After the outbreak of the war in Ukraine the materials sector was used to balance the portfolio in the absence of energy ideas. However, gold has subsequently been reduced given the market’s expectations that interest rates will continue to rise.

In energy, the managers added positions, such as Africa Oil (Canadian listed with assets in Kenya and Ethiopia), alongside two European multinational integrated oil, gas and petrochemical companies. Under-researched opportunities such as tin (Alphamin) and mineral sands (Kenmare) are reflected in the portfolio.

The strategy has higher exposure to Chinese real estate (long China Overseas Land). The portfolio managers believe that the demise of Evergrande and the consolidation of the sector will see a healthier industry structure going forward; conservatively run, well capitalised developers will benefit. The managers believe that the company can, if it chooses to, short highly leveraged sub-scale developers that will not be able to refinance their debt.

The managers believe that India remains attractive on a highly selective basis; however, the additional investment powers, such as the use of shorts and derivatives, allow for an index hedge to actively manage the country weighting.

Alibaba is another example of a company, where the managers have growing conviction. The stock price has been on a downward trajectory. The team says that prolonged lockdowns will result in lower revenues, but it is attractively valued with no value ascribed to its cloud business segment. The team also believes that the stock is currently at the peak of uncertainty and it expects the downward share price trend to reverse.

Higher market volatility offers the opportunity to generate income by writing options. Examples include Alibaba, HDFC Bank and KE Holdings.

Genesis’s emerging markets team had been running the company since its launch in July 1989 until Fidelity took over, effective 4 October 2021. Therefore, FEML’s historical performance until the start of October 2021 is attributable to Genesis (GSS). We have included the performance track record of FAST, launched by the current fund manager, Nick Price, in 2011. As we show in Exhibit 4, FAST outperformed the MSCI EM Index and Genesis’s strategy, which was applied to FEML historically on a net asset value (NAV) total return basis over one, three, five and 10 years.

More recently, FEML’s NAV has outperformed FAST over one, three and six months, benefiting from its closed-end structure, though it underperformed versus the MSCI EM Index during these three periods.

The bulk of underperformance year-to-date and shorter periods (c 84%) is attributable directly to its Russia exposure and there is also some secondary impact from this exposure. There was a 10% country hedge on Russia but it did not mitigate all the losses as the position was c 18% in absolute terms.

The other notable detractor from the fund's short-term performance was the technology sector for a number of reasons, the first being market rotation. Technology was regarded as more expensive and as the market has rotated more into value, growth technology stocks have sold off sharply. Technology hardware within consumer electronics businesses were hit by inflation fears and weakening consumer confidence. Korean and Taiwanese technology portfolio stocks, including Samsung, MediaTek, SK Hynix and TSMC – all had a negative effect on the performance. With regards to TSMC, for example, the team notes that the business has been hit by fears of a reduction in consumer spending, supply chain disruption and the collapse of crypto currency, yet the balance sheet remains robust. TSMC has continued to deliver operationally, but the stock price is down c 14% year to date (in sterling to end-July).

FEML's Q222 performance was also negative due to the underperformance of the long book although this was mitigated to an extent by the short book and some yield enhancement. For example, the short book benefited from its position in an ecommerce platform in the Europe, Middle East and Asia region, which underperformed after it posted weaker Q1 results. Brazilian shorts also contributed as investors withdrew from Brazilian equities against a backdrop of risk aversion. Locally, new social measures to alleviate inflation led to increasing concerns of fiscal risk. The sell-off was exacerbated by domestic outflows from equities to bonds given high interest rates.

The areas that did well during the first two quarters of 2022, thus mitigating some of the underperformance until recently, include the fund’s exposure to copper, Brazil and the Middle East, such as UAE fertiliser company Fertiglobe, which benefited from increased demand as international fertiliser buyers switched from Russian suppliers.

Exhibit 5 shows what we believe are the five most relevant peers to FEML from the AIC Emerging Markets sector. Note the company’s performance to end-October 2021 was principally due to Genesis, as Fidelity took over the company at the start of October 2021. We also show FAST’s superior performance over FEML (Genesis run) and the sector average over one, three, five and since Fidelity took over FEML on 4 October 2021.

While the performance since Fidelity took over FEML has been disappointing, this is attributable principally to the two factors discussed in detail above: the exposure to Russia up to February 2022 and the exposure to the technology sector. The portfolio managers have adjusted both exposures.

FEML is currently trading at a 12.4% discount to its cum-income NAV. As shown in Exhibit 6, the discount narrowed during Q421, following Fidelity’s takeover of the company, when the market digested and began viewing Fidelity’s appointment as positive.

The discount widened sharply at the start of the war in Ukraine and while it has since narrowed and stabilised, the company’s NAV is still trading on a wider discount than at the end of calendar 2021. The current discount is also wider that the one- and three-year averages of 10.9% and 10.7% respectively. The current discount differential may present investors with an entry opportunity, as the fund’s performance stabilises under Fidelity’s tenure.

On 1 July 2021 FEML’s board announced the appointment of Fidelity as the company’s manager. The previous manager was Genesis Investment Management (Genesis), which launched the company in July 1989.

FEML aims to achieve long-term capital growth from an actively managed portfolio made up primarily of securities and financial instruments providing exposure to EM companies, both listed and unlisted. The lead portfolio manager, Nick Price, supported by the co-portfolio manager, Chris Tennant, employs an actively managed global growth equity strategy with additional investment tools, enhancing the long-only approach. These include a series of complementary strategies, relaxing the typical constraints of traditional long-only strategies to generate enhanced risk-adjusted returns. At least 80% of the company’s total assets (measured at the time of investment) are exposed to EM companies. The managers aim to maintain a diversified portfolio of a minimum of 75 holdings (comprising a mixture of long and short exposures) in companies listed in or operating across at least 15 countries. Gearing is permitted either through borrowing of up to 10% of NAV and/or by entering into derivative positions (both long and short), which have the effect of gearing, to enhance performance.

The appointment of Fidelity took effect on 4 October 2021, following shareholder approval at the extraordinary general meeting (EGM) on 1 October.

The board undertook a review of investment management arrangements, looking to:

We summarise the benefits for the company’s shareholders listed in the board’s announcement on 1 July 2021:

Given extremely high commonality, FAST is used to illustrate FEML’s investment strategy.

The following differentiate FEML from FAST:

The company is managed by Nick Price and Chris Tennant, with the support of Fidelity’s wider EM portfolio management team and 45 (as at 31 October 2021) equity research analysts responsible for the coverage of emerging market stocks. Both managers also tap into the expertise of the EM debt team at Fidelity.

Price designed the approach applied to FEML. Having launched FAST, he has developed, managed and grown the strategy for more than a decade. He has 24 years’ investment experience and has been with Fidelity since 1998. The co-portfolio manager, Chris Tennant, is an emerging market specialist with 10 years’ investment experience, all with Fidelity. Chris started his career as an analyst across various sectors before progressing to a portfolio management role in 2019.

The strategy has outperformed the MSCI EM Index since launch in October 2011 (Exhibit 7). Exhibit 8 illustrates that FEML’s strategy’s higher gross exposure increases active money; Fidelity believes that the increased exposure provides the strategy a greater opportunity to outperform going forward.