Utilico Emerging Markets Trust — Companies’ operational strength not priced in

Over the last five years, emerging market stocks have made little headway and have materially lagged the performance of the world market (Exhibit 1, left-hand side). However, in aggregate, emerging economies have considerably better growth prospects compared with developed regions, as illustrated by the International Monetary Fund (IMF) World Economic Outlook January 2023 update in Exhibit 1 (right-hand side).

As shown in Exhibit 2 (left-hand side), emerging market equities remain very attractively valued on both an absolute and relative basis. The Datastream Emerging Market Index is trading on a 10.8x forward P/E multiple, which is a 15.6% discount to its 12.8x five-year average. It is also trading at a 27.2% discount to the Datastream World Index, which is wider than the 20.3% average discount over the last five years. At 28 February 2023, both the MSCI Emerging Markets Index and the MSCI Emerging Markets Utilities Index were trading at lower forward P/E and price-to-book multiples, while offering a higher dividend yield than the MSCI World Index (Exhibit 2, right-hand side).

Commenting on current market volatility, Jillings says that politics are injecting a level of uncertainty and central bank actions are having a real impact, which, along with geopolitical events, have led to extremely high market volatility, with major swings in the day-to-day prices of individual investments. Inflation is rolling over in emerging markets, so the manager anticipates that at some stage this year central banks will be able to lower interest rates, which should be beneficial for equity markets. In developed markets, Jillings believes that UK inflation has not yet peaked, but once it does, the inflation rate should come down sharply, while in the United States, inflation numbers have rolled over and the manager expects further lower datapoints. If these scenarios play out, Jillings suggests that interest rates in developed markets should also be reduced, although the timing is still uncertain.

The manager comments that there have been collateral outcomes from the accelerated pace of interest rate increases. Recently, Silicon Valley Bank failed due to an asset/liability duration mismatch and, while the Federal Reserve acted swiftly to protect customer deposits, Jillings suggests that there may possibly be another event in the banking sector that unsettles markets.

Focusing on war in Europe, the manager believes that there is a stalemate in Ukraine; Jillings’ view is that this conflict will take time to play out, especially as the summer months make it easier to wage war. Regarding the discussions between Russia and China about resolving the war in Ukraine, he believes there is common ground, as both countries have challenges with the West. However, the manager believes that the talks are unlikely to lead to anything, as China is wary about how a relationship with Russia would affect its standing with the rest of the world.

In China, Jillings is surprised about the speed of the policy U-turn away from zero-COVID. The economy has reopened and the government is taking action to support growth, although it will take time to see if these moves will deliver the targeted GDP growth numbers. The manager explains that although there is a global nearshoring trend of companies moving their manufacturing operations closer to home, China remains one of the main consumer markets, so corporates will want to maintain their Chinese manufacturing capacity to satisfy domestic demand. He expects economic growth driven by property and infrastructure investment to continue.

Following a recent trip to Latin America, Jillings reports that there were clear signs of nearshoring. However, as noted, this is not supplanting Chinese operations, and building capacity in Mexico is a marginal decision. He and his colleagues visited Mexico, Chile and Brazil, meeting with around 30% of UEM’s top 30 holdings. A clear message is that they have increased confidence in invested management teams’ ability to take advantage of available opportunities. The managers visited two logistic real estate companies in Mexico that are not held in the portfolio; they are operating at 100% capacity due to strong demand from US corporates. In addition, there is a series of Chinese companies looking to relocate to Mexico to benefit from the North American Free Trade Agreement.

At end-February 2023, UEM’s top 10 positions made up 31.6% of the portfolio, which was a higher concentration versus 29.8% 12 months earlier. As highlighted, one of the trust’s largest holdings, Petalite, is unlisted. At end-H123, unlisted investments made up 9.4% of the fund, which is close to the maximum permitted 10.0%. If increased valuations take unlisted investments above 10%, this does not require forced sales, but no new unlisted investments can be made.

UEM’s portfolio is broadly diversified by sector and geography as shown in Exhibit 4. Although the MSCI Emerging Markets Index is used as a reference, the fund is constructed on a bottom-up basis, without a consideration of the index’s breakdown. Jillings invests across the market cap spectrum; the trust’s investments in small and mid-cap companies may be overlooked by other market participants. The changes in UEM’s geographic exposure in the 12 months to end-February 2023 are generally modest, with the largest being higher weightings in Brazil (+2.5pp) and other Europe (+2.4pp), and lower allocations to China including Hong Kong and Colombia and Malaysia (all are -1.7pp). Vietnam was not stated separately at end-February 2022 as it was classified within other Asia.

The trust’s sector changes are more notable, with increased exposures to renewables (+4.7pp) and electricity (+4.2pp), and lower allocations to infrastructure investment funds (-2.8pp), telecoms and other (both -2.6pp).

Portfolio company Grupo Aeroportuario del Centro Norte (OMA) will benefit from nearshoring in Mexico. It is one of three listed Mexican airport companies and operates 13 airports. Around 50% of its revenues are generated from its Monterrey airport, which is in Mexico’s industrial heartland in the north, and business is beginning to take off, benefiting from nearshoring; so much so that unless there is investment into energy infrastructure, there is a possibility that supply cannot meet demand. Nearshoring in the region, which includes the upcoming construction of a new Tesla facility, will boost demand for business travel. Passenger numbers are already significantly ahead of pre-pandemic levels and are growing month-on-month: +33% in February 2023. While growth is unlikely to continue at this level, Jillings believes that passenger numbers should grow in excess of Mexican GDP, given the lack of transport infrastructure in the country; people would rather fly than take a bus. OMA is viewed as a well-managed company and has EBITDA margins above 70%. It has strong growth in its non-regulated business and an attractive dividend yield.

Top 10 holding Petalite is an unlisted early-stage business based in the UK; UEM owns 28.6% of the company. On 24 March 2023, the board announced that Petalite’s valuation was increased to the level of the last fund-raise in June 2022, which increased the trust’s 23 March 2023 243.57p per share NAV by 4.90p per share. Over the last eight years, Petalite has developed an innovative electric vehicle sinusoidal direct current charging technology, which offers greater reliability, efficiency and security than is currently available, and has won several research grants. ICM participated in the June 2022 fund-raise along with AM Impact Partners; one of its two co-founders has subsequently been appointed as Petalite’s non-executive chairman, so the company has received both capital and management experience.

Another portfolio company, Brazilian waste management firm Orizon Valorização de Resíduos, owns several landfills. New regulation has been introduced, effective in 2024, meaning municipalities cannot dump waste in unlicensed sites and are required to use designated landfill sites. Orizon is a market leader with a greater than 10% share of a fragmented market. According to the manager, it has very efficient landfill operations, and also has newer businesses: collecting biogas, which is used for electricity generation; and sorting lines, removing recyclable metals, plastics and cardboard, which are monetised. The biogas business is covered by United Nations regulation and the carbon credits generated are sold. Jillings considers that Orizon’s nascent biogas and recycling businesses will be important future growth drivers for the company.

Jillings is encouraged by UEM’s strong relative performance over the last 12 months. However, he is convinced that portfolio company valuations are yet to catch up with their underlying business performance; hence, he believes that the trust’s future prospects are very attractive.

Over the last year, positive contributors to UEM’s performance include its Latin American and Eastern European holdings, while its Chinese and other Asian, and Colombian exposures have been less successful. On a more granular basis, Mexican airports have contributed positively to UEM’s performance, while several of its technology holdings detracted; this is unsurprising given the higher interest rate environment.

As shown in Exhibit 6, UEM has outperformed the MSCI Emerging Markets Index over all periods in both NAV and share price terms. Its outperformance versus the MSCI Emerging Markets Utilities Index is even more pronounced, as shown in Exhibits 6 and 7.

UEM is the fourth largest of the 10 funds in the AIC Global Emerging Markets sector. It should be remembered that the trust’s unique strategy means it is not directly comparable with any of its peers. UEM’s NAV total returns are above the sector averages over all periods shown, ranking third and fourth out of 10 funds over the last one and three years respectively. It ranks fourth and fifth out of nine funds over the last five and 10 years respectively. UEM’s returns do not take the dilutive effect of its historical subscription shares before February 2018 into account.

The sector’s average valuation is distorted by JPMorgan Emerging Europe, Middle East & Africa Securities. If this fund is excluded, UEM’s discount is wider than the average 9.9% discount. Its ongoing charge is above the mean. The trust’s gearing is above average as most of its peers are currently ungeared. UEM has an attractive dividend yield, which is 1.1pp above the sector average. Jillings is proud that the trust was one of the few funds in the group that had a covered dividend during the pandemic.

Since launch in July 2005, UEM’s annual dividend has been increased or maintained every year. Quarterly payments are paid in September, December, March and June. In H123, the trust’s 6.83p revenue earnings per share was 13.1% higher than 6.04p per share in H122. More than 75% of UEM’s investee companies pay dividends.

So far in FY23, the board has declared three interim dividends, a first of 2.0p per share followed by a second and third of 2.15p per share. Barring unforeseen circumstances, the board anticipates a fourth interim payment of 2.15p per share. This would equate to an FY23 annual dividend of 8.45p per share, which is a 5.6% increase versus 8.00p per share in FY22, and once again should be fully covered. At the end of H123, UEM had £13.2m in revenue reserves, which is equivalent to c 0.8x the forecast FY23 dividend payment.

UEM’s discount remains stubbornly above the board’s sub-10% desired level. The latest 14.4% share price discount to cum-income NAV is broadly in the middle of the 10.8% to 17.2% range over the last 12 months. The trust’s average discounts are 13.8%, 13.3%, 12.8% and 10.9% over the past one, three, five and 10 years respectively.

The board typically repurchases UEM’s shares when the discount has widened to more than 10% in normal market conditions. In FY22, c 6.5m shares (c 3.0% of the share base) were bought back at a cost of c £13.9m. So far in FY23, a further c 12.5m shares (c 5.8% of the share base) have been repurchased at a cost of c £27.0m.

Launched in July 2005, UEM was historically a Bermudan investment company, but redomiciled 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 and is managed by the ICM Group (ICM and ICM Investment Management), which is a specialist fund manager based in Bermuda and the UK with c $24.0bn of assets under management (c $1.8bn directly and c $22.2bn indirectly). ICM Group has more than 80 employees, who operate from more than 10 offices around the globe.

UEM is managed by qualified chartered accountant Charles Jillings, who has more than 30 years’ experience in global financial markets. He aims to generate an attractive long-term total return from a diversified portfolio of emerging market equities, primarily in the infrastructure, utility and related sectors. Jillings employs a bottom-up stock-selection process and is unconstrained by benchmark allocations, although the MSCI Emerging Markets Index is used as a reference.

To mitigate risk, there are a series of investment guidelines in place (as a maximum percentage of gross assets at the time of investment): individual investment 10%; single country 35%; individual sector 25%; unquoted investments 10%; and top 10 holdings 60%. Gearing of up to 25% of gross assets is permitted. The trust’s currency exposure is unhedged. From launch to end-February 2023, UEM’s NAV total return has compounded at an annual rate of 9.0%.

Jillings seeks to identify and invest in companies predominantly in the infrastructure and utility sectors that are trading at a discount to his estimated intrinsic value, and which he believes have the potential to generate total returns of at least 15% pa, at an investee company level, over a five-year horizon. The manager focuses on emerging market countries with positive attributes such as political stability, economic development, an acceptable legal framework and an encouraging attitude to foreign investment. Jillings has a long-term investment horizon and avoids short-term stock market ‘noise’.

Stocks are selected on a bottom-up basis following thorough fundamental research (including the construction of a detailed financial model and valuation targets) from an investible universe of more than 1,000 companies. There are c 80 holdings in the portfolio (typical range of 60–90). UEM has an active share approaching 100% versus the MSCI Emerging Markets Index; this is a measure of how a fund differs from an index, with 0% representing full replication and 100% no commonality. Jillings is supportive of UEM’s investee firms in terms of their capital requirements by participating in follow-on equity offerings and the trust is often among their largest international shareholders. Because of the nature of UEM’s investments, in companies providing essential services, 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.

While UEM is not an ESG fund, its board believes it is in shareholders’ best interests to consider environmental, social and governance factors when selecting and retaining investments. In conjunction with assessing the financial, macroeconomic and political drivers when making and monitoring an investment, the manager embeds ESG opportunities and risks into the trust’s investment process. Companies are scanned using a rigorous in-depth framework; however, the decision as to whether to make an investment is not made on ESG grounds alone. The manager can consider a potential investment with a low ESG score but this will need to be outweighed by an attractive total return potential. Every investee company’s ESG footprint is analysed, and there is often still room for improvement at some of these businesses. The manager works to understand a company’s ESG journey and seeks an improving score.

Factors are incorporated into the trust’s investment process in three main ways:

ICM is a signatory to the United Nations-supported Principles for Responsible Investment, a code of best practice for incorporating ESG issues.

UEM has a three-year unsecured £50m multicurrency revolving credit facility with The Bank of Nova Scotia (London branch) that expires on 15 March 2024. At end-February 2023, UEM’s net gearing was 3.3%.

Since 1 April 2021 ICM is paid 1.00% of UEM’s NAV up to £500m; 0.90% above £500m up to £750m; 0.85% above £750m up to £1bn; and 0.75% above £1bn (previously a flat fee of 0.65% of NAV was charged); and the performance fee has been removed. UEM’s board believes that the simpler and more transparent cost structure should contribute to a stable and competitive ongoing charge, while helping to attract private wealth managers and retail investors. A tiered fee structure allows shareholders to benefit from the increasing economies of scale that a larger portfolio provides. In H123, UEM’s annualised ongoing charge ratio was 1.4%, which was 10bp higher year-on-year, but in line with FY22.

UEM has 202.2m ordinary shares in issue and its average daily trading volume over the last 12 months is c 365k shares. The trust has a five-yearly continuation vote, next due at the September 2026 AGM. The September 2021 vote was passed with 84.2% of shareholders voting in favour of UEM’s continuation.

The directors’ fees are used to acquire UEM shares, ensuring all shareholders’ interests are aligned. Susan Hansen is considered non-independent as she is also on the board of Resimac Group, which is associated with ICM. She has indicated her intention to retire from the board following the conclusion of UEM’s next AGM in September 2023.