Templeton Emerging Markets Inv. Trust — Improving relative performance

Exhibit 2 (left-hand side) shows the performance of emerging market versus world and UK equity indices over the last 10 years. Emerging market equities have lagged world equities due to the strength of the US stock market in recent years; however, in sterling terms, emerging markets outperformed global equities in 2016 by 4.1pp (33.1% versus 29.0% respectively). In its October 2016 World Economic Outlook, the International Monetary Fund maintained its above-average economic growth forecasts for emerging markets and developing economies versus world output (4.6% versus 3.4% respectively). Against a stronger economic background, as shown in Exhibit 2 (right-hand side), emerging market equities continue to be relatively attractively valued – trading at a c 30% discount on a forward P/E basis, on a lower price-to-book multiple and with a modestly higher dividend yield. For investors wanting exposure to emerging markets, a diversified fund with a disciplined, long-term value-orientated approach, may be of interest.

TEMIT was launched in June 1989 and is quoted on the London and New Zealand stock exchanges – it was one of the first UK-listed funds focused on emerging markets. On 1 October 2015, Carlos Hardenberg succeeded Mark Mobius as TEMIT’s lead manager; he continues to draw on Templeton’s broad emerging markets group – a team of more than 50 investment professionals based in 20 offices across the world. Hardenberg aims to generate long-term capital growth, primarily via investment in emerging market equities or in companies listed elsewhere that generate a significant proportion of their revenues in emerging markets. TEMIT is benchmarked against the MSCI Emerging Markets index. Gearing of up to 10% is permitted – historically, the fund has run a small cash balance, but in January 2017, TEMIT announced a new £150m debt facility (see Capital structure and fees section on page 7).

The manager comments that when modelling a company’s five-year earnings estimates, a consideration of the macro environment is the starting point, including a variety of inputs such as the outlooks for inflation, interest rates, exchange rates and potential regulatory changes. He suggests that companies themselves can provide the most reliable guide to local economic outlooks. Comparing the current macro backdrop to historical periods of stress, the manager believes that in aggregate, emerging market economies are stronger and more diverse, with the service sector making a greater contribution. He notes that Asia in particular has seen strong growth in the domestic economy. The biggest structural change has been the rise of value-added goods and services rather than low-end product offerings in industries such as IT components, software and consulting services. As a result, technology now represents a much larger part of the MSCI Emerging Markets index (c 25%). The manager notes that traditional industries such as cement and steel production, which benefitted from a ramp-up in infrastructure, will have to deal with higher costs going forward and as a result, expected to generate lower margins and earnings growth. He opines that the next five to 10 years will be very different from the last five to 10.

Hardenberg considers that Latin America is currently one of the most attractive emerging market areas; he suggests that product penetration is far behind other regions, which offers significant growth potential. The manager considers that emerging market currencies are trading on unusually large discounts versus hard currencies, having depreciated on a relative basis over the last couple of years, and in general emerging market currencies can be supported by their foreign currency reserves and more reasonable current account deficits.

Given the potential for changes in US trade policies, the manager is evaluating earnings sensitivities of potential and current portfolio holdings if tariffs were to be introduced. He notes that some Mexican companies have built their business models around trading with the US, which would suffer with an introduction of tariffs, although Mexican companies with large overseas operations that do not hedge their currency exposures, will benefit from a weak peso.

When discussing themes evident in Q4 earnings reports, Hardenberg comments that within the technology sector, compared to 12 months ago, business visibility is increasing. In general, the managements of technology companies are presenting a confident outlook for the balance of 2017 and into 2018. Many products are entering a replacement cycle and mobile phone manufacturers are adopting new technologies, such as dual and optical zoom cameras, new surface technology and software and increased memory. Industry demand for technology products has been very robust and the manager expects this trend to continue.

TEMIT employs Templeton’s five-stage investment process: identification of attractively valued companies; in-depth fundamental analysis; peer review; portfolio construction; and portfolio evaluation and attribution analysis. Fundamental analysis combines both qualitative and quantitative elements, including the construction of detailed company models and an assessment of the wider environment on a sector and country basis. Hardenberg is able to draw on the broad resources of Templeton’s analyst team, which now includes five people with a dedicated technology focus. Following the change in manager in October 2015, the portfolio has been significantly restructured with the number of holdings broadly doubled from 46 to c 90. The manager comments that more than half of the top 40 positions are new additions since he took over as lead manager. He also notes that TEMIT now has stronger relationships with the managements of investee companies and there is more active engagement on a corporate governance basis, which may involve co-ordination with other key shareholders, to bring about corporate changes.

At end-February 2017, TEMIT’s top 10 positions represented 40.8% of the portfolio, a small increase in concentration from 36.9% a year earlier. Brilliance China Automotive is a joint venture partner of BMW and remains the largest holding. The manager considers Brilliance to be a “rock-solid company”, at the forefront of new battery technology, with a well-positioned product range expected to benefit from rising demand from China’s expanding middle class. TEMIT is very close to Brilliance’s management team, which operates in an open manner. The manager suggests that the company perfectly fits TEMIT’s value and quantitative criteria.

After reorganising the portfolio starting in October 2015, the manager has made no dramatic changes on either a sector or geographic basis over the last 12 months. On a sector basis, the largest increases in exposure are consumer discretionary (+3.9pp) and materials (+2.8pp), with the largest decreases in cash (-4.8pp) and consumer staples (-1.5pp). On an individual country basis, the largest increase in exposure is Russia (+3.2pp) and the largest decrease is Pakistan (-2.2bps).

South Korean company, Samsung is TEMIT’s second largest position, it is a market leader in DRAM and NAND memory solutions and pricing for these products has been strong. Despite the recall and the eventual shelving of the Galaxy S7 Note mobile phone, Samsung’s share price held up relatively well. The manager highlights Samsung as a high-profile example of an emerging-market company that is adopting better corporate governance practices and increasing shareholder distributions in the form of both dividends and share repurchases.

A relatively recent addition to TEMIT’s portfolio is Catcher Technology, a Taiwanese company, which is a market leader in casings for smartphones. This business is highly capital intensive, but Catcher’s capex is backed by customer contracts. The manager has had many discussions with Catcher’s open management team and he is confident that the company can continue to prosper as the industry evolves to using new materials and technology for the manufacture of mobile phone cases. The stock is currently trading on a forward P/E ratio of 10.4x and has accelerating consensus earnings growth estimates (1.4% for 2017 and 9.2% for 2018).

Exhibit 5 (right hand side) highlights the strength of TEMIT’s absolute returns over one year, partly boosted by sterling weakness. TEMIT’s share price and NAV one-year total returns of 48.3% and 49.0% respectively are significantly ahead of the 35.2% total return of the benchmark.

TEMIT’s NAV total return is ahead of the MSCI Emerging Markets index benchmark over one and 10 years, while lagging over three and five years. As a reference to UK shareholders, TEMIT has outperformed the FTSE All-Share index over one, three and 10 years, while its underperformance over five years reflects a relatively weak period for emerging markets in general.

Exhibit 7 shows TEMIT’s performance versus the benchmark over three years; the meaningful improvement since the new manager was appointed on 1 October 2015 is evident. Hardenberg comments that exposure to Brazil and a higher weighting in technology (across the capitalisation spectrum) were positive contributors to performance in 2016. At the stock level, positive contributors include Taiwanese companies Catcher Technology and Largan Precision.

Despite significant returns to sterling-based emerging markets investors and TEMIT’s very strong relative performance over the past 12 months, TEMIT’s discount remains stubbornly wide, perhaps reflecting geopolitical uncertainties and generally higher risks associated with investing in emerging markets. Its current 14.2% share price discount to cum-income NAV is wider than the 13.3% average of the last 12 months (range of 10.4% to 15.3%) and also wider than the averages of the last three, five and 10 years of 12.0%, 10.8% and 9.2%, respectively.

There is scope for the discount to narrow if TEMIT’s investment performance continues to improve or investor appetite for emerging market equities increases. TEMIT’s board actively repurchases shares aiming to manage the discount. As shown in Exhibit 1, buybacks have continued in FY17, so far to 31 March, 16.3m shares (5.5% of shares in issue at the end of FY16) have been repurchased at an average cost of 541.6p.

TEMIT is a conventional investment trust with one class of share; there are currently 281.6m shares in issue. Gearing of up to 10% of net assets is permitted but has not been utilised in recent years. However, on 31 January 2017, TEMIT announced that it has entered into a £150m three-year unsecured multicurrency revolving loan facility (available in sterling, US dollars and renminbi) with the Bank of Nova Scotia, which the manager will use to add to portfolio holdings on weakness, taking advantage of market volatility. The maximum amount of renminbi that can be drawn down is the equivalent of £30m. If the whole facility was drawn down, based on the current net asset value, gross gearing would be c 7.0%.

TEMIT pays a management and administration fee to Templeton Asset Management of 1.10% of net assets – no performance fee is payable. Ongoing charges in H117 (ending 30 September 2016) were 1.21%, a modest reduction versus 1.22% in FY16.

TEMIT pays an annual dividend in July. The FY16 dividend of 8.25p was held steady versus the prior year; it was partially paid out of revenue reserves as it was only 85% covered by income. Prior to FY16, TEMIT’s annual dividend had been increased for five consecutive years, compounding at an annual rate of 17.1%. Based on the current share price TEMIT’s dividend yield is 1.2%.

Exhibit 9 shows the members of the AIC Emerging Markets sector with market caps greater than £50m; TEMIT is the largest of the peers by a wide margin. Its NAV total return over one year is the highest in the group, leading the second ranked fund by 10.7pp. It is in line over three years and has lagged over five years, although TEMIT’s NAV total return ranks second out of six funds over 10 years. Its discount is modestly wider than the weighted average and it has a lower than average ongoing charge. In keeping with its objective of long-term capital growth, TEMIT’s dividend yield is lower than average.

There are currently eight directors on the TEMIT board; seven of whom are independent. Chairman Paul Manduca was appointed in August 2015 and assumed his current role in November of that year. Peter Harrison was appointed in November 2007, Christopher Brady in December 2007, Hamish Buchan in June 2008 and Beatrice Hollond in April 2014. During 2016, two new directors joined the board: Simon Jeffreys on 15 July and David Graham on 1 September. Jeffreys is a director at St James Place, SimCorp and Henderson International Income Investment Trust; he has a background in finance. Graham is a chartered accountant, with an investment management background. The remaining member of the board is Gregory Johnson; he was appointed in December 2007. As chairman and CEO of Franklin Resources, the parent company of the investment manager, he is considered non-independent. There is a succession plan in place, which means there will be further changes to the board over the next few years.