Utilico Emerging Markets Trust — Market not reflecting very strong fundamentals

UEM is the only UK fund that is focused on infrastructure and utility assets, most of which are asset backed and more than 95% are operational. Jillings has a high degree of confidence in the positive prospects of the trust’s portfolio companies. He and his team undertake detailed fundamental research to fully understand UEM’s current and potential holdings, employing a long-term investment approach. Due to the nature of the assets held, UEM is a low-beta fund and more than 80% of the portfolio pays dividends, which supports the trust’s progressive dividend policy.

Here is a reminder of the four megatrends that Jillings and his team have identified as the drivers of emerging market growth, along with an example of a portfolio company in each category.

Social infra (28.5% of the portfolio at end August 2024) – urbanisation and the rise of the middle class are driving demand for better social infrastructure. Manila Water owns one of the largest water concessions in the Philippines as well as smaller operations domestically and in other countries including Indonesia, Saudi Arabia, Thailand and Vietnam. Along with volume growth due to increases in per capita water usage, expanding service coverage and urbanisation trends, the regulatory environment in the Philippines has improved; the government acknowledged the need for increased industry capex allowing Manila Water to generate a higher return on equity. A change in its controlling shareholder has shifted the company’s focus to operational efficiency and enhancing shareholder returns. Manila Water remains inexpensive, trading at 6.6x EV/EBITDA with a 6.5% dividend yield.

Energy transition (27.6%) – decarbonisation and investment in energy is supporting strong economic growth. India Grid Trust is a tax-efficient infrastructure investment trust, distributing 90% of its net cash flows to investors, which include private equity backers such as KKR & Co. The company develops and operates power transmission lines; it also has a newer solar renewables business. India Grid Trust is a well-positioned, efficient operator, running completed projects, under long-term contracts, so generates strong cash flow. The company is valued at 10.7x EV/EBITDA and offers a dividend yield above 10%.

Digital infra (23.6%) – rapid digital adoption is accelerating the demand for digital infrastructure. Sonatel is the largest telecoms company in Senegal and also operates in Mali, Sierra Leone, Guinea Conakry and Guinea Bissau. The company is controlled by Orange and most of its local currency revenues are pegged to the euro. Sonatel is well positioned and growing strongly in mobile data, fibre broadband and mobile money services. The company is listed in a frontier market, which has underperformed emerging markets, leading to a very attractive valuation of 2.9x EV/EBITDA and a 7.9% dividend yield.

Global trade (20.3%) – trade is being fuelled by structural growth drivers, geopolitical dynamics and shifting supply chains. Santos Brasil Participações operates three port container terminals in Brazil and provides integrated logistics for cargo transportation. The company is the third largest Brazilian port operator and is in the favourable position of having spare capacity at its main terminal asset in Santos port, while its two larger direct competitors are capacity constrained. The majority (60%) of Santos’s volumes are from the MSC shipping line and price negotiations with the company occur every two years. In 2023, Santos was able to negotiate a 60%+ price increase with MSC and, while the 2025 price rise is likely to be smaller, it should provide a modest margin uplift. The company is trading on an 8.5x EV/EBITDA multiple, generates sustainable cash flow and has a 95% dividend payout ratio. It has a 6.5% dividend yield and a special dividend from excess capital is expected to be paid by the end of 2024.

Jillings comments that across the globe, inflationary pressures are easing albeit interest rates remain elevated, and the consensus view is that most central banks will continue to lower interest rates. He notes that despite the growth headwind of a higher cost of capital for both governments and corporates, employment has been relatively resilient across all economies.

The manager suggests that despite this backdrop GDP growth has generally been ahead of consensus, which is being driven by a broader economy and underlying structural drivers. During the global pandemic, there was an acceleration in the roll-out of the digital economy, including in the financial system, which has resulted in increased formalisation of people in the workforce (witnessed in India and Mexico) and has therefore helped to drive economic activity. According to Jillings, despite the ongoing noise, global trade remains robust, as geopolitical tensions have led to shifts in the manufacturing base, benefiting countries such as Mexico and Vietnam.

Although US GDP has recently exceeded expectations, the manager believes the Federal Reserve will start to lower interest rates, because if they remain elevated, they will eventually stifle economic growth. Jillings is looking for two 25bp interest rate cuts before the end of the year. Regardless of the size of the cut, it should lead to a weaker US dollar and stronger emerging market currencies.

At the end of August 2024, UEM’s top 10 positions made up 37.2% of the portfolio, which was a higher concentration versus 35.3% a year earlier. All four of the growth megatrends are represented in the trust’s largest holdings.

Exhibit 2 shows UEM’s portfolio breakdowns by geography and sector at the end of August 2024, which are a result of bottom-up stock selection. A detailed year-on-year comparison by geography is not possible due to a change in the way that the data are presented. However, compared with the MSCI Emerging Markets Index, UEM has a notable higher weighting in Brazil (c 26% vs c 5%) and a meaningful lower allocation to China (c 12% vs c 24%). In the 12 months to 31 August 2024, the largest changes in UEM’s sector exposure were a higher weighting in waste & water (+4.8pp) and a lower allocation to renewable assets (-3.8pp).

As shown in Exhibit 3, there are 11 funds in the AIC Global Emerging Markets sector. It is only possible to make a broad comparison of the peers as they follow such diverse mandates. UEM’s NAV total returns are above average over the last three and 10 years, ranking third out of 10 and fifth out of nine funds respectively. The trust’s performance does not take the dilutive effect of UEM’s historical subscription shares before February 2018 into account.

Excluding JPMorgan Emerging Europe, Middle East & Africa Securities, which formerly invested in Russian securities and distorts the averages, UEM’s discount is wider than the average 12.0% discount and its ongoing charge is in line with the mean. The trust is moving from an ungeared position now a new debt facility has been arranged. UEM has an attractive dividend yield, which is 1.4pp above the sector mean.

While UEM has given back some of its relative performance in recent months, Jillings reports that the trust’s underlying investments are continuing to perform strongly. Hence, UEM is well positioned from a valuation perspective. The trust has faced currency headwinds, especially in Brazil, which is the largest country exposure (c 26%), where the Brazilian real has declined by around 15% year to date against sterling. Negative currency moves have offset positive share price moves following strong earnings reports, such as for Santos Brasil Participações, whose Q224 revenues grew 38.6% and adjusted EBITDA was 56.8% higher year-on-year.

UEM’s relative performance is shown in Exhibit 5. Its NAV and share price are meaningfully ahead of the MSCI Emerging Markets reference index over the last three years, while its NAV has outperformed over the last decade.

UEM offers a specialised yet defensive exposure to emerging markets. In Exhibit 8, we show the trust’s upside/downside capture over the last decade. In months where emerging market stocks rose, on average, UEM captured 71% of the upside, whereas in months where emerging markets declined, the trust captured just 59% of the downside. In recent years, UEM’s upside capture rate has remained relatively stable, while its downside capture has been more volatile, which chimes with higher stock market volatility over this period.