Infrastructure and utilities in emerging markets

Although UEM is not managed against a benchmark, Exhibit 2 (left-hand side) shows that from January 2006 until April 2015 emerging markets outperformed developed markets, represented by the FTSE All-Share index. Emerging markets have weakened since Q215 as a result of lower growth assumptions, a collapse in the oil price and concerns about rising levels of debt. In this environment, emerging market infrastructure stocks have continued to perform better than the broader emerging market index.

Looking ahead, there are considerable uncertainties in the macroeconomic outlook and in January, the IMF lowered its growth forecasts for 2016 in emerging market and developing economies by 0.2% to 4.3%. However, this is still well above the 2.1% growth expected in the same period for advanced economies.

As shown in Exhibit 2 (right-hand side), valuations in emerging markets versus the rest of the world remain attractive in terms of P/E and price/book multiples, as well as offering higher dividend yields. For investors wishing to take a longer-term view on the higher growth generated in emerging versus developed markets, a fund such as UEM with its focus on at or above GDP growth companies in the cash-generative infrastructure and utility sectors may be appealing.

UEM was launched in July 2005; it is a Bermuda-registered investment company and listed on the premium segment of the London Stock Exchange. It seeks to provide long-term total returns to investors by investing primarily in infrastructure, utility and related sectors, mainly in emerging markets. UEM uses a modest level of gearing, with the aim of enhancing shareholder returns and may use derivatives to provide a level of protection against market corrections. The fund is run on a bottom-up basis; without regard to index weightings, but the MSCI Emerging Markets index is used for comparison. The benchmark for the performance fee is the FTSE UK Gilt five- to 10-year index post-tax yield, plus RPIX inflation, plus 2%, subject to an 8% minimum. The performance fee is capped at 1.85% of average NAV. UEM’s investment manager is ICM Limited, a Bermuda-based manager with over £1.5bn of direct assets under management. Since inception, UEM has been managed by Charles Jillings and to 30 September 2015, achieved an average annual compound total return of 10.7%.

In the context of recent market volatility and weakness, Charles Jillings comments that emerging markets are still growing; there is a continued move towards urbanisation and expanding middle classes. However, he stresses while this creates a positive long-term backdrop, he is investing in individual businesses rather than in a country’s GDP. Jillings sees valuations in emerging markets being as attractive as 10 years ago and states that he is “not short of investment opportunities”. Over time, the relative attractiveness of individual countries change and for example, the portfolio now has less exposure to Brazil given the challenging environment from both political and economic perspectives. However, over the next six months it is possible that exposure will be increased given how far both the currency and equities have fallen.

The portfolio includes several investments in Romania, where the manager has been investing for the last 10 years. Investor concerns about the country centre on corruption, corporate governance and business structures. Jillings notes that following influence from the IMF and EU accession, the Romanian government is starting to tackle corruption, and is looking at privatisations and better corporate governance. Stocks in the country are seen as fundamentally inexpensive and the manager believes that over time stock markets eventually catch up with the value of the underlying assets.

China is viewed as continuing to offer investment opportunities. UEM meets management teams in the country to investigate what is happening at the operational level. By way of example, Shanghai Airport is seeing strong passenger growth, helped by a growing middle class. It is becoming more of a hub in the region and should benefit when the Shanghai Disney Resort opens in June 2016. There are substantial regional differences in China, so the management team is careful to focus on the drivers for individual assets within the country.

With regards to regulation, the manager believes that every industry has government intervention to varying degrees. If regulation is seen as an impediment, he will walk away from an investment. There needs to be an understanding of why the regulation is in place and what the likely outcome is. For example, China is focusing on cleaning up its environment, which will be beneficial for the gas sector, (where UEM has two investments in its top 10 holdings). Due to the collapse in the oil price, there has been a near-term shift in demand from gas to oil. However, over the next five years the Chinese government will be encouraging the use of gas as it is a cleaner fuel. It is a volume-driven business; over time margins are sustainable, subject to short-term effects from the timing of changes in input and output prices.

The manager pursues a bottom-up stock selection process seeking to identify companies whose underlying value is not reflected in the current share price. He is supported by a team of analysts who monitor a universe of c 900 companies. Models are constructed for potential investments and target prices determined. For each company held, post an earnings release, models and earnings forecasts are revised and a report is written highlighting details of the results, any changes in view, a valuation and a buy or sell recommendation. Holdings in the portfolio are long term and the manager avoids short-term ‘noise’ in the stock markets. Investments are primarily in listed companies and sectors having the characteristics of essential services or monopolies for example, infrastructure and utilities. Most investee businesses are operational rather than greenfield and generate strong cash flows supporting above-average dividend yields. The manager stresses the importance of site visits to gain a real insight into how well assets are positioned and operated. A top-down overlay controls sector and geographic exposures in the portfolio and there are internal investment limits.1 At the end of September 2015, unlisted securities were just 2.8% of the portfolio’s gross assets. Favoured markets for investment are those that are politically stable, generating economic growth and where foreign investment is encouraged.

UEM has an active and constructive shareholder approach and generally considers it appropriate to support investee companies with their capital requirements. The significant distribution of retained earnings by Asia Satellite Telecommunications in 2015 was welcomed by UEM, as it had been discussing this issue with the company for a number of years.

The portfolio currently has c 90 names; the top 10 positions represent 49.5%, which is down from 53.7% a year ago. There are eight names that are common to both periods; this reflects the manager's long-term investment stance. The two new names in the top 10 holdings are Transelectrica (a wholly-regulated Romanian electricity company) and China Resources Gas Group (a gas distributor).

Looking at the sector exposures; the areas that have seen the largest increase over the last 12 months are electricity (+4.2%) and gas (+2.8%), while the largest decreases have been in ports (-4.1%) and toll roads (-3.9%). Among the larger country exposures, the main changes over the last 12 months were reductions for China/Hong Kong and Brazil and an increase for Romania, reflecting decisions made on individual companies, market moves and currency fluctuations.

As shown in Exhibit 6, UEM has outperformed the MSCI Emerging Market index over all time periods shown in terms of both price and NAV total return. It has outperformed the MSCI Emerging Market Infrastructure index in terms of NAV total return over all periods, with the exception of the very short term. UEM has outperformed its absolute benchmark since inception, but marked weakness in emerging markets has meant that it has lagged over shorter periods. Exhibit 7 shows a near-term relative outperformance versus the MSCI Emerging Market index during a period of heightened stock market volatility.

Underlying the positive relative performance year to date, there has been a divergence between different holdings. MyEG Services, for example, has performed well and some profits have been taken on the position. International Container Terminal Services has seen its share price decline by c 20% on concerns about slowing GDP. The manager considers that the shares are oversold and present a buying opportunity, given the longer-term growth opportunities for the company, a disciplined management team and a refinanced balance sheet.

The board and manager closely monitor the share price discount to NAV. There is an inclination, but not a commitment, to repurchase shares when the discount moves above 10%. As shown in Exhibit 8, the discount has widened, as investor sentiment towards emerging markets has become more cautious. The sharp increase in the discount in August 2015 corresponds to the sell-off in the Chinese stock market. The current discount of 11.3% is wider than the averages of the last one, three, five and 10 years (range of 6.3% to 9.5%). Due to the widening discount, UEM has been repurchasing shares; year-to-date 1.4m shares have been repurchased at a cost of £2.3m.

UEM has 211.6m shares in issue. It has the authority to repurchase up to 14.99% and allot up to 10% of its issued share capital. At 30 September 2015, bank debt had decreased by 43% to £18.1m year-on-year. This was due to realisations and a special distribution from Asia Satellite Telecommunications. UEM has a £50m lending facility, which matures on 30 April 2016, and the board will seek to extend this for two years.

In September 2015, UEM announced a one-for-five bonus issue of subscription shares and following approval at a special general meeting, 42.6m subscription shares were issued. They are exercisable on the last business day of February and August in 2016 and 2017, and the final opportunity is 28 February 2018. The exercise price is 183.0p and if the shares are exercised, UEM’s fixed costs will be spread over a wider base and liquidity in UEM shares is likely to increase.

In April 2014, changes were made to the fee structure. The management fee was changed from 0.50% of gross assets to 0.65% of net assets. An 8% minimum hurdle was introduced to the performance fee benchmark and performance fees were capped at 1.85% of average net assets in each financial year. Had this new structure been in place since the fund’s inception, UEM estimates that total fees paid to the manager would have been more than 10% lower. For FY15 the performance fee was £3.1m and ongoing charges were 1.1%.

The board’s objective is to maintain or increase the annual dividend, which has been achieved each year since the fund was launched in 2005. Dividends are paid quarterly and for FY16 the board has forecast a 6.4p total dividend representing an increase of 4.9% (1.525p for the first quarter followed by three payments of 1.625p). UEM is able to distribute from both capital and income returns, which allows a higher dividend to be paid than if paid solely from dividend income.

For the six months to 30 September 2015, revenue income increased by 60.5% year-on-year to £17.9m. This was mainly due to Asia Satellite Telecommunications distributing its retained earnings to shareholders; UEM received £7.7m as a result. Excluding this distribution, for the six month period, revenue income was more than 1.5x dividends paid by UEM. On a seasonal basis, there is more dividend income received in H1 versus H2.

The selected group shown in Exhibit 9 comprises the AIC Global Emerging Markets sector excluding those funds in realisation phase or with a market cap below £50m. UEM cannot be directly compared with the peer group, given its focus on areas such as infrastructure and utilities. However, its exposure to emerging markets means the comparison has some relevance. UEM’s NAV total return is above the peer-group average by a significant margin over one, three, five and ten years. In terms of risk-adjusted returns, its Sharpe ratio is ahead of the peers over one and three years. UEM’s share price discount to NAV is in line with the peer group and its ongoing charge is lower. The yield of 3.7% ranks third in the peer group, where five out of nine trusts pay a dividend.

The board comprises six non-executive directors, five of whom are deemed independent of the manager. Alexander Zagoreos is the chairman and was appointed in June 2005; the deputy chairman, Garth Milne (previously a director of UEM from 2005 to 2010), was appointed in November 2014. Gary Madeiros was appointed in June 2007 and Anthony Muh in October 2010. Susan Hansen (appointed September 2013) is deemed not to be independent due to her directorship of RESIMAC, which has the same majority shareholder as the investment manager. The newest member of the board is John Rennocks, who was appointed in November 2015, having recently retired as deputy chairman and senior independent director of Inmarsat.