Templeton Emerging Markets Investment Trust — Sticking to process – potential for higher valuation

Over the last five years, emerging markets shares have performed broadly in line with the UK stock market, but have meaningfully lagged the MSCI World Index, particularly since early 2021 (Exhibit 1, left-hand side – all indices shown in sterling terms).The current tough investment backdrop is characterised by rising interest rates in response to supply-chain bottlenecks, which are leading to higher prices, and are being exacerbated by the war in Ukraine and China’s zero-COVID policy. These uncertainties are leading to increased risks to economic growth and corporate earnings, which unsurprisingly has translated into a period of elevated stock market volatility. However, for investors with a longer-term perspective, an allocation to high-quality emerging market stocks may prove beneficial.

These regions offer the potential for above-average GDP growth; in its April 2022 update to its World Economic Outlook, the International Monetary Fund forecast growth of 3.8% for 2022 and 4.4% for 2023 in emerging market and developing economies compared with 3.3% and 2.4% respectively for advanced economies. An important reason for higher emerging market economic activity is a growing middle class in these regions, which is driving increased demand for consumer goods, such as autos and appliances, and services, including education and healthcare. Global climate change is gaining more attention, leading to developments in areas such as renewable energy, battery storage and electric vehicles, and these operations are not restricted to developed economies. In addition, ongoing political tensions, including between the United States and China, are causing multinational businesses to reconsider their supply chains. As an example, Vietnam is a beneficiary of this trend as the country is now home to the majority of Samsung’s smartphone manufacturing.

As well as above-average growth potential in emerging markets, in aggregate, stocks listed in these areas look relatively attractively valued. Shown in Exhibit 1 (right-hand side), the Datastream Emerging Market Index is trading at an 11.4x forward P/E multiple, which is a 17.3% discount to its five-year average. It is also trading at a 15.0% discount to the Datastream World Index, albeit modestly lower than the 15.6% average discount over the last five years.

Ness comments that inflation is a global phenomenon and the magnitude of higher prices varies within emerging markets; for example, Chinese inflation at 2% is below target so interest rates are coming down, while in India interest rates are rising as its 7% inflation rate is above target. He does believe, however, that in a year’s time ‘we will not be thinking so much about inflation, more likely the concern will be about economic growth’ and suggests TEMIT’s portfolio is not biased to any particular market outcome. The manager notes that a strengthening US dollar is adding to higher energy costs and with India having low per-capita income, the pain of rising inflation and interest rates is greater there than in some other emerging market countries. Ness suggests policy choices are difficult in India ahead of the 2024 general election.

Sehgal comments that the macroeconomic environment is ‘tough’. He says he and Ness need to try to understand how sustainable this current backdrop is and what is already priced into stocks. The manager suggests that if the US 10-year government bond yield has peaked, there is a fair case to be made for emerging markets; however, if bond yields continue to rise, he believes everything will come into question and, if so, global equities will come under further pressure. In this scenario, he opines that emerging market stocks could actually do relatively better than those listed elsewhere given the emerging regions are home to the lowest-cost commodity producers and have higher economic growth prospects. Whatever the outcome, the managers are sticking to their strategy of investing in companies with sustainable earnings power that are trading at a discount to their estimated intrinsic worth. However, Sehgal says they ‘also have to factor in the new realities of rising interest rates, China’s zero-COVID policy, the war in Ukraine and climate change’.

The manager comments that the message from company meetings is that most firms’ fundamentals are intact, but managements are acknowledging that a slowdown is coming. He suggests ‘there is still a gap between investors’ perception and companies’ relative optimism’ and this valuation gap needs to close. Sehgal says ‘a good deal of China’s growth potential is within its own destiny’. Chinese authorities have implemented some changes to slow the economy down and reduce leverage; however, the manager considers the zero-COVID policy to be a challenge. He says it is very difficult to see when the Chinese economy will open up, believing ‘2022 is unlikely, so maybe in 2023’. Sehgal suggests an economic slowdown in the West would reduce the demand for Chinese exports, and Russia had been a large export market for Chinese goods, so he thinks it is hard to see how things will normalise and what will ultimately become structural, rather than cyclical issues.

Sehgal cites a quote from the well-regarded investor Sir John Templeton, who said ‘bull markets are born on pessimism, grow on scepticism, mature on optimism and die on euphoria’. The manager suggests that, given the current level of pessimism, ‘now is probably a good time to buy stocks’. He says that along with investors, companies are responding to the macroeconomic backdrop, so there may be some upside to earnings estimates. Sehgal reports that there are both upward and downward estimate revisions; for example, downward revisions for some Chinese companies due to COVID restrictions, but other companies such as Taiwan Semiconductor Manufacturing Company (TSMC) and Guangzhou Tinci Materials Technology have surprised to the upside.

At end-May 2022, TEMIT’s top 10 holdings, which represent a range of countries and sectors, made up 52.6% of the portfolio, which was a lower concentration compared with 58.7% 12 months earlier; nine positions were common to both periods. Stocks are selected on a bottom-up basis and so the trust’s sector and geographic weightings are a by-product of this process.

Exhibit 3 shows that over the 12 months to end-May 2022, the notable sector changes are lower exposures to communication services (-7.2pp) and consumer discretionary (-5.5pp) and a higher IT weighting (+4.6pp). Ness explains this sector remains the largest overweight position (+14.2pp versus the benchmark) due to positive consumption and innovation-led growth trends. However, this positioning has detracted from TEMIT’s performance in recent quarters as technology stocks’ valuations have declined due to Chinese regulatory pressure, which then spread into other sectors in the country such as education, property and banking, and in response to higher interest rates.

The trust is overweight banks within the financials sector due to developments in the consumer space; there are low levels of credit penetration in emerging compared with developed markets. TEMIT’s holdings tend to be in leading incumbent banks that are working hard to digitise their businesses to counter the competitive threats from fintech businesses. Ness highlights that the trust’s weighting to the materials sector has increased due to adding to TEMIT’s exposure to renewable energy and electric vehicles, but ‘not at any price’.

There are more modest changes to TEMIT’s geographic exposure over the 12 months to end-May 2022 (Exhibit 4). Its Russian stocks were written down to zero at the beginning of March 2022 following the invasion of Ukraine. Ness reports that in January 2022, TEMIT’s Russian exposure was c 6.5% of the fund, which was c 3.0% overweight versus the index. He says the managers decided to hold on to TEMIT’s Russian securities rather than selling them at any price, as a sale would likely be to a Russian interested party and would lock in a capital loss. The manager comments that, as an example, LUKOIL is still making money, so holding on to this position could realise some money for clients in the future.

TEMIT’s largest overweight country exposure remains South Korea (+10.7pp) and the trust is underweight India on valuation grounds (-3.9pp). Ness reports that the trust’s underweight to China/Hong Kong has reduced over the last 18 months (it was 9.2pp at the end of December 2020) and the managers have used market weakness to diversify TEMIT’s exposure towards those companies that are aligned with the Communist agenda. Ness comments that Chinese internet stocks have been under regulatory pressure, and the trust’s exposure has been reduced in favour of further diversification. Also, the zero-COVID policy has negatively affected Chinese economic growth, along with rising commodity prices and the costs of dealing with climate change. Ness says these factors highlight the importance of having a well-diversified China/Hong Kong exposure.

The manager also reports that the trust’s underweight Middle East exposure has detracted from TEMIT’s performance as the region has benefited from the flight out of Russian securities and rising energy prices. Sehgal and Ness did not believe Russia would invade Ukraine and are mindful of the political tensions between China and Taiwan; hence, they highlight the need to insulate the portfolio as much as possible from geopolitical risk.

The manager highlights some of the transactions in TEMIT’s portfolio in FY22. There is a new position in Guangzhou Tinci Materials Technology (Tinci), which is the largest worldwide producer of electrolytes used in batteries for electric vehicles. It is the lowest-cost producer with a 25–30% global market share and has also started to recycle batteries in China. Sehgal believes that Tinci has ‘huge growth opportunities’; it has a high return on capital as its business is not capital intensive and the company generates a significant amount of cash.

Genpact was added to the portfolio. It is a US-listed business processing outsourcer with around half of its revenues in India. The manager explains that technology transformations involve the need to add more software and deploy tools, which benefits Genpact. Although the company is experiencing increased labour costs, this is due to high demand for its products, therefore Sehgal believes that top-line growth will outweigh any margin pressure.

Another of TEMIT’s new holdings is Soulbrain, which manufactures chemicals for the semiconductor industry. It is a dominant supplier to SK hynix and Samsung Electronics. The company is benefiting from high demand for and the increased complexity of semiconductors.

Complete disposals from the portfolio include Naspers, which was to reduce the overall Tencent exposure (Naspers owns c 30% of Tencent). ‘Naspers has a potential capital gains tax liability, so the discount to NAV is not as appealing as it appears to be’, says the manager. Flat Glass Group manufactures solar glass and is a play on the renewable energy theme. The stock was sold on valuation grounds and due to rising energy and soda ash costs, as well as industry overcapacity. Moneta Money Bank was a smaller position in the fund and Sehgal participated in the company’s tender offer.

In FY22 (ending 31 March), TEMIT’s NAV and share price total returns of -17.3% and -21.2% respectively trailed the benchmark’s -6.8% total return. However, to put this relative performance in context, from its launch in June 1989 to end-March 2022, TEMIT’s NAV +3,813.9% total return is considerably ahead of the benchmark’s +1,792.0% total return. There were three broad issues that negatively affected TEMIT’s performance in FY22: weakness in technology stocks following a multi-year period of outperformance; regulatory pressure on Chinese companies; and the Russian invasion of Ukraine. While the board is concerned by the trust’s recent performance, it is reassured by the depth of resources at the investment manager and the quality of insights the team produces, so is confident TEMIT’s performance will turn around in due course.

On a stock-specific basis, the best contributors to the trust’s relative performance in FY22 were ICICI Bank (+1.0pp, India; financials); not holding Meituan (+0.7pp, China/Hong Kong; consumer discretionary); Itaú Unibanco (+0.6pp, Brazil; financials); TSMC (+0.6pp, Taiwan; IT); and non-index stock Bajaj Holdings & Investment (+0.5pp, India; financials). The worst contributors were Alibaba
(-1.5pp, China/Hong Kong; consumer discretionary); LUKOIL (-1.5pp, Russia; energy); Yandex
(-1.3pp, Russia; communication services); Sberbank of Russia (-1.1pp, Russia; financials); and Brilliance China Automotive (-1.0pp, China/Hong Kong; consumer discretionary), whose shares are suspended following a fraud investigation. Sehgal considers that unless there are further allegations against the company, there is value to be realised in this position, based on an evaluation of its asset base including significant cash on its balance sheet.

As shown in Exhibits 7 and 8, TEMIT has experienced a difficult period of relative performance over the last 12 months. This has negatively affected its longer-term record and its NAV has lagged the benchmark over the last one, three, five and 10 years, although its share price has been broadly in line over the last five years.

TEMIT is by far the largest fund in the 12-strong AIC Global Emerging Markets sector. Following a difficult period of performance, the trust ranks 10th over the last 12 months, eighth over three years, fifth out of 10 funds over five years and sixth out of nine funds over the last decade. Sehgal considers Fidelity Emerging Markets and JPMorgan Emerging Markets Investment Trust to be TEMIT’s closest peers. Considering just these funds, TEMIT ranks second out of three over all periods shown.

At 23 June 2022, TEMIT’s discount was modestly wider than the sector average, where just one fund was trading at a premium (Gulf Investment Fund has benefited from a rising oil price). The trust has the second-lowest ongoing charge (c 40bp below the mean), a below-average level of gearing and a dividend yield that is modestly above the mean.

TEMIT pays regular dividends twice a year, an interim in January and a final distribution in July. In FY22, the trust’s revenue earnings were 3.44p per share, which was 40% lower than 5.73p per share in FY21. The total dividend of 3.80p per share was 0.9x covered; however, TEMIT has revenue reserves of 10.01p per share, which is equivalent to 2.6x the last annual payment. Based on its current share price, the trust offers a 2.6% dividend yield.

TEMIT’s shares are trading at a 12.9% discount to cum-income NAV, which is at the wider end of the 5.8% to 16.4% range of discounts over the last 12 months. It is also wider than the 10.6%, 10.6%, 11.1% and 11.0% average discounts over the last one, three, five and 10 years, respectively. The board has regularly repurchased shares with the aim of reducing the volatility of the discount. During FY22, 2.3m shares were bought back (0.2% of the share base) at a cost of £3.6m. This was less than in FY21, when the share base was reduced by 2.6%. There was only one buyback in the first 11 months of FY22, but the pace has stepped up following the Russian invasion of Ukraine.

TEMIT is the UK’s largest emerging markets investment trust and was launched in June 1989. Its shares are quoted on both the London and New Zealand stock exchanges. The trust is managed by FTEME, a pioneer in emerging markets investing with c $32bn of assets under management.

Chetan Sehgal has been TEMIT’s lead manager since 1 February 2018; he is based in Singapore and has 30 years’ investment experience. He was joined in September 2018 by Edinburgh-based Andrew Ness, who has 28 years’ investment experience. The managers aim to generate long-term capital growth by investing in companies listed in emerging markets, or those listed in developed markets that earn a significant amount of their revenues in emerging markets. TEMIT’s performance is measured against the MSCI Emerging Markets Index. There are no specific restrictions on the fund’s geographic or sector exposure, but to mitigate risk, at the time of investment, a maximum 12% of assets may be held in a single issuer, and up to 10% of assets may be invested in unlisted securities (a maximum 2% in a single issuer). Gearing of up to 20% of NAV is permitted; at the end of May 2022, the trust had net gearing of 1.2%.

TEMIT is subject to a five-yearly continuation vote, with the next due at the July 2024 AGM (the July 2019 vote was passed with a 99.95% majority). In May 2019, the board announced a five-year, performance-related conditional tender offer, subject to the next continuation vote being passed. If the trust’s NAV performance lags its benchmark in the five years ending 31 March 2024, the board, at its discretion, will undertake a tender offer for up to 25% of TEMIT’s shares in issue, at a price equivalent to the prevailing NAV minus 2% and the costs of the offer.

Sehgal and Ness, who are assisted by portfolio analyst Manish Agarwal, are able to draw on the considerable resources of FTEME’s investment team. In recent years the levels of collaboration and communication within the team have improved; there are regular meetings, both formal and informal, and all analysts and portfolio managers are expected to contribute to investment returns.

The managers employ a long-term approach driven by ‘3S’s’: seeking structural growth opportunities, investing in businesses with sustainable earnings power that are trading at a discount to their estimated intrinsic value, and they believe in responsible stewardship of client capital. TEMIT has a three-step investment process:

At the end of May 2022, TEMIT had a modestly higher dividend yield than the benchmark, a lower trailing P/E and price-to-book multiple, and a slightly higher price-to-cash flow multiple.

Risk management is also a very important part of the process, with scenario analysis undertaken to ensure the managers are not taking unintentional risks. TEMIT has a diversified portfolio of 60–80 positions invested across the market cap spectrum. All holdings are regularly reviewed to ensure analysts’ recommendations are up to date and reflect any changes in a company’s fundamentals. Sehgal and Ness believe that given the wide dispersion of returns between shares in emerging markets, they can generate alpha via stock selection, which is deemed more important than sector and geographic allocation. The trust’s active share typically ranges from 70% to 85% (this is a measure of how a fund differs from its benchmark, with 0% representing full index replication and 100% indicating no commonality); it is currently 81%.

ESG factors are an integral part of TEMIT’s research process. Its managers employ FTEME’s three-pillar framework aiming to be an emerging market leader in sustainable investing:

Where material, climate change/carbon analysis is integrated into the bottom-up research process, focusing on assessing the impact on long-term business values. This is part of the holistic approach of integrating ESG analysis with traditional analysis to gain valuable insights into the quality and risks of investee/potential investee companies. For more information, please see TEMIT’s inaugural stewardship report.

TEMIT has a £100m five-year, 2.089% sterling-denominated, fixed-rate loan with Scotiabank Europe that matures on 31 January 2025. It also has a £120m three-year unsecured multi-currency revolving credit facility (RCF) with the Bank of Nova Scotia, which can be drawn down in sterling, US dollars or Chinese renminbi (CNH) at the prevailing market rates at the time of drawdown. The maximum amount of CNH permitted is 45% of the combined £220m debt facility. In October 2021, TEMIT drew down £50m of the RCF, which has subsequently been rolled over. At end-May 2022, net gearing was 1.2%. The managers note that the beta of TEMIT’s portfolio is at the higher end of the historical range; hence if gearing is increased it is likely to be used to buy lower-beta stocks.

In FY22, FTEME was paid an annual management fee of 1.00% of net assets up to £1bn and 0.80% above this level; no performance fee is payable. However, with effect from 1 July 2022, the annual management fee will be reduced to 1.00% of net assets up to £1bn, 0.75% between £1bn and £2bn and 0.50% above £2bn. In FY22, TEMIT’s ongoing charges were 0.97%, which was in line with FY21.

TEMIT is a conventional investment trust with one class of share; there are c 1.2bn ordinary shares in issue with a further c 103.8m shares held in treasury. Its average daily trading volume over the last 12 months was c 1.5m shares.

On 10 May 2021, the board announced the appointment of Magdalene Miller with immediate effect. She is a former investment director with abrdn’s global emerging market team. Based in London and Edinburgh, Miller spent 32 years managing listed equity portfolios, investing in Japanese, Asian Pacific and UK markets. She is a Hong Kong native, fluent in Cantonese and Mandarin and has travelled extensively in China and Asia over her career. Miller serves as a non-executive director of Baillie Gifford China Growth Trust and as a trustee for an educational endowment fund and participates in volunteering work.

Beatrice Hollond will retire at the July 2022 AGM, at which time Simon Jeffreys will take on the role of senior independent director. The search for a replacement director is in progress and an announcement is expected shortly. Shareholders will vote at the AGM on the proposed increase in the directors’ annual fees in respect of FY23: chairman +£2.0k to £71.0k; chairman of the audit and risk committee +£1.5k to £53.5k; senior independent director +£1.0k to £42.5k; and independent directors +£1.0k to £40k.