Utilico Emerging Markets — Attractive investment opportunities in abundance

Exhibit 2 (left-hand side) shows the performance of emerging market and UK shares over the last 10 years. The value of overseas equities to UK-based investors has been boosted over the last 12 months by the weakness of sterling. Despite above-average growth, emerging markets continue to trade at a discount to world equities, possibly due to their historical higher share price and economic growth volatility.

In its April 2017 World Economic Outlook, the International Monetary Fund maintained its forecasts for emerging market and developing economies growth of 4.5% and 4.8% in 2017 and 2018, respectively, versus 2.0% growth for advanced economies in both 2017 and 2018. Factors contributing to stronger emerging market growth include higher infrastructure spending, a rapid rise in the middle classes, relatively low levels of household debt and rising standards of education. While emerging market infrastructure stocks are trading at higher valuations on an earnings basis than emerging market stocks overall, they are trading on a similar price-to-book ratio and offer a higher dividend yield. Both asset classes are cheaper on earnings and price-to-book multiples versus world equities (Exhibit 2, right-hand side). For investors wishing to gain exposure to emerging markets equities, a fund offering an attractive yield from a portfolio of relatively stable businesses, which also has a positive long-term performance record, may be of interest.

UEM was launched in July 2005. It is a Bermuda-registered investment company listed on the premium segment of the Official List of the Financial Conduct Authority and its shares are traded on the Main Market of the London Stock Exchange. UEM aims to generate long-term total returns from a diversified portfolio primarily invested in emerging market infrastructure, utility and related sectors.

Since launch, the fund has been managed by Charles Jillings, who is a director at ICM – a Bermuda-based investment company, which has more than £16bn in assets that are managed either directly or indirectly for institutional and retail investors. ICM specialises in the infrastructure and utility, financial services, mining and resources, technology and fixed income sectors. The manager selects stocks on a bottom-up basis; he is unconstrained by index weightings, although MSCI Emerging Market Index allocations are used as a reference. ICM is eligible for a performance fee for outperformance versus the UK gilt five- to 10-year index post-tax yield, plus RPIX inflation, plus 2%, subject to an 8% minimum, which is capped at 1.85% of average NAV.

There are internal risk management guidelines in place, including gross asset limits (at the time of investment) of 60% in the top 10 holdings, 10% in a single stock, 30% in an individual country, 25% in a sector, and 5% in unlisted securities (currently 3.5%). Investments outside of the core infrastructure, utility and related sectors are capped at 20%. The limit on gearing (total borrowings versus gross assets) is 25% at the time of drawdown; at end-May 2017, net gearing was 8.9%.

Since launch to end-May 2017, UEM’s NAV total returns have compounded at 12.0% pa. This is lower than the 15.0% annual total returns that the manager seeks from investee companies as a result of UEM’s running costs, exchange rates and emerging market share price volatility. However, Jillings is optimistic on the outlook for emerging market equities. As a result, he has increased UEM’s gearing meaningfully over the last several months from £11.0m at end-October 2016 to c £50.0m (the full amount of the current debt facility). The manager believes that the next 10 years will provide as many attractive opportunities in emerging market equities as occurred in the last 10 years. He focuses on markets where the political environment is generally stable; economic growth is favourable, helped by growing middle classes that demand better infrastructure, utilities and related services (the sectors in which the majority of UEM’s portfolio is invested); and where there is a positive attitude to foreign direct investment. Jillings stresses the importance of investing in companies with strong management teams that have an appreciation of financial considerations as well their underlying businesses.

The manager says that he avoided investing in Argentina for many years due to capital controls and rampant inflation under the Kirchner administration. The government was interfering in business, such as disallowing tariff increases for energy transmission companies, which in an inflationary environment made them unprofitable. President Mauricio Macri has been in office since 2015; the manager opines that he has rapidly implemented widespread and radical changes. In 2016, a 200% tariff hike was implemented for utility companies, with further substantial increases to be phased in from April 2017 to April 2018. UEM now has a holding in Transportadora de Gas del Sur (TGS), the largest gas distribution company with a c 60% market share. The manager says the company has now had a $2bn utility asset base recognised with an 8.99% allowed rate of return; he expects a dividend to be paid in 2018.

The manager is able to draw on the deep experience of ICM’s investment team to construct a portfolio that is diversified by geography and sector, primarily in the emerging market infrastructure, utility and related sectors. He invests for the long term, avoiding ‘market noise’, aiming to generate both capital growth and income. The focus is on listed companies, the majority of which are currently profitable and paying dividends; the typically strong cash flow generation nature of investee companies provides some insulation during periods of economic weakness or currency fluctuations. UEM’s portfolio consists of c 60 to 90 high-conviction ideas selected from a bespoke investible universe of c 900 companies. Potential investments are subject to in-depth fundamental research, which includes the construction of detailed models and setting valuation targets. Site visits and meetings with company managements and foreign government officials are a key part of the investment process. The manager adopts a strict valuation discipline; buying companies that are trading at a discount to their perceived value, that he believes can generate 15% annual returns for shareholders. Investments in FY17 totalled £161.2m (£96.1m in FY16), partially funded by higher bank debt, and realisations were £142.2m (£130.5m in FY16), which is higher than the historical average due to an intentional diversification away from the largest portfolio holdings.

Over the last 12 months, the allocations to UEM’s largest portfolio holdings have decreased; the manager has expanded the stock list as a result of finding further attractive investment opportunities (during FY17, the number of portfolio holdings increased from 86 to 92). UEM regularly announces its top 20 holdings, which comprised 57.4% of the portfolio at end-May 2017 compared to 63.3% at end-May 2016. The manager also states that in recent years, the percentage of the portfolio in the top 10 holdings has declined from above 50% to the current level of c 35%.

Exhibit 3 shows UEM’s exposure by geography and sector. While stock selection is made on a bottom-up basis, it is interesting to note the major changes over the last 12 months. On a geographic basis, the largest increases in exposure are in Latin America: Brazil (+7.7pp) and Argentina (+5.5pp); while the largest decreases are in Asia: China/Hong Kong (-9.5pp, due to valuation considerations) and Malaysia (-6.0pp). The manager notes that UEM’s FY17 dividend was more than fully covered, partly due to the shift in geographic exposure, as Latin American companies in aggregate pay higher dividends than Asian companies. On a sector basis, over the last 12 months, the largest increase in exposure is electricity (+7.0pp), offset by lower exposure in satellites (-3.9pp) and airports (-3.0pp).

The manager again highlights the attractive investment opportunities available in Romania. A year ago, 2016 Romanian GDP growth was estimated at 4.1% but subsequently was reported as 4.8%. The outlook is for acceleration in annual economic growth, with 5.7% recorded in Q117 and the Romanian finance ministry forecasting 5.2% for 2017. In the December 2016 legislative election, the Social Democratic Party won with a promise to tackle the fiscal deficit. All state-owned enterprises are required to pay out 90% of earnings and surplus distributable reserves. Three of UEM’s top 10 holdings are Romanian: Conpet, Transelectrica and Transgaz. They have yields ranging from c 8% to c 13% and the manager highlights their low single-digit EV/EBITDA valuation multiples, despite significant share price appreciation over the past year. All three companies have significantly increased their dividend payout ratios, but their balance sheets remain strong.

Sterling weakness in H216 boosted the returns for UK-based investors in overseas equities. UEM’s share price and NAV total returns of 18.0% and 16.5% over one year, respectively, lagged the MSCI Emerging Market Index total return of 27.8%, as would be expected given its higher quality, lower volatility focus. However, over the longer term, UEM has outperformed this index. Since inception to end-FY17, UEM’s total return of 280.8% is meaningfully ahead of the 194.8% total return of the MSCI Emerging Markets Index.

UEM’s relative returns are shown in Exhibit 5. It has outperformed the MSCI Emerging Markets Index over five and 10 years, while lagging over shorter periods. However, it has outperformed the MSCI Emerging Market Infrastructure Index over almost all periods shown. UEM’s NAV total return has outperformed its performance fee benchmark over one, three and five years, while lagging over 10 years.

UEM’s current 10.5% share price discount to cum-income NAV is broadly in line with the averages of the last one, three, five and 10 years of 10.5%, 9.6%, 8.3% and 8.6%, respectively. The range of discounts over the last 12 months is 6.9% to 13.4%. There is an inclination, but not a commitment to repurchase shares when the discount exceeds 10%. There have been no share repurchases so far in FY18. In FY17, 4.8m shares (2.3% of issued capital) were repurchased at a cost of £10.0m.

UEM currently has 211.4m ordinary shares in issue. In September 2015, there was a one-for-five bonus issue of subscription shares; the remaining exercise dates are the last business dates in August 2017 and February 2018 at an exercise price of 183.0p. During FY17, 4.8m subscription shares were exercised, raising £8.7m. Exercise of all the remaining 37.8m subscription shares would result in c 3.8% dilution to the current NAV.

The manager increased the level of gearing in H217 (£46.8m versus £19.7m at H117) due to an abundance of attractive investment opportunities. At end-May 2017, bank debt of £49.4m was approaching UEM’s £50.0m available facility; adding back cash, net gearing was 8.9%.

ICM is paid an annual management fee of 0.65% of net assets. In FY17, ongoing charges (excluding performance fees) were 1.1%, which was in line with the prior financial year. Including performance fees, FY17 ongoing charges were 2.9%, which was 1.8pp higher than the prior year. Subject to an 8% minimum hurdle, a 15% performance fee on returns in excess of 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 when the performance fee was last paid). The performance fee is capped at 1.85% of net assets; 50% is paid in shares and 50% in cash.

UEM pays quarterly dividends in September, December, March and June. While its primary objective is capital growth, the board has a progressive dividend policy; annual dividends have been increased or maintained every year since the fund’s inception in 2005. The FY17 annual dividend of 6.65p per share was a 3.9% increase versus the prior year, which was in line with the five-year compound annual growth rate; it was 1.16x covered by revenue earnings.

Revenue income increased meaningfully in FY17 (excluding Asia Satellite Communications’ special dividend in FY16), due to higher dividends from investee companies, larger portfolio exposure to higher-yielding investments, such as in Brazil and Romania, and sterling weakness. At end-FY17, retained revenue reserves were 6.23p per share, which was equivalent to 0.94x the FY17 annual dividend. UEM’s current dividend yield is 3.1%; based on a growing level of dividend income, the manager is hopeful that the trust will be able to grow its annual dividend payout in FY18.

UEM is a member of the AIC Global Emerging Markets sector. Exhibit 8 shows the peers with a market cap in excess of £100m. UEM’s specific focus on infrastructure and utility assets means that the funds cannot be compared directly; however, its diverse emerging market exposure means that there is some relevance to the comparison. Its NAV total returns are ahead of the peer group weighted average over five and 10 years, while lagging over one and three years; UEM’s higher-quality focus may have contributed to weaker relative performance over one year. The fund has a below-average discount and the joint lowest ongoing charge, although a performance fee is payable. Following the recent increase in gearing, UEM has the highest level of gearing and it has the third highest dividend yield of the five peers that pay a dividend.

There are currently five non-executive directors on UEM’s board, four of whom are independent of the manager. Chairman John Rennocks was appointed in November 2015 and assumed his current role in September 2016, following the retirement of Alexander Zagoreos. The deputy chairman is Garth Milne, who was appointed in November 2014. Garry Madeiros was appointed in June 2007 and Anthony Muh in October 2010. Susan Hansen was appointed in September 2013; she is also on the board of Homeloans, which is a company associated with ICM, so is considered to be non-independent. UEM’s manager, Charles Jillings, stood down from the board in March 2012 to improve corporate governance and increase the board’s independence.