Templeton Emerging Markets Investment Trust — New manager oversees improved performance

In its October 2017 World Economic Outlook, the International Monetary Fund reiterated its above-average growth estimates for emerging markets and developing economies of 4.6% and 4.9% for 2017 and 2018, respectively, versus 2.2% and 2.0% for advanced economies. Factors behind the higher growth include robust demand as a result of rising consumer incomes, relatively low levels of debt and more stable commodity prices. Against this backdrop, emerging markets remain attractively valued versus world equities (Exhibit 2, RHS). Investors seeking exposure to emerging markets may find appeal in an actively managed, diversified fund that has a meaningfully improved recent investment track record.

TEMIT was launched in June 1989 and is quoted on the London and New Zealand stock exchanges. The trust is managed by Templeton, which has more than 30 years’ experience of investing in emerging markets. The Templeton Emerging Markets Group (TEMG) comprises more than 50 portfolio managers and analysts, based in 21 countries around the world. TEMIT aims to generate long-term capital growth from a diversified portfolio of companies listed in emerging markets or companies listed in developed markets that generate a significant percentage of their revenues in emerging markets. The trust primarily invests in equities, but may also invest in equity-related vehicles such as convertibles; it is benchmarked against the MSCI Emerging Markets Index. At the time of investment, a maximum 10% of assets is permitted in a single issuer. Gearing of up to 10% of net assets is also permitted; at end-September 2017, net gearing was 1.0%. (Historically, the trust has run a small cash balance.) Since 1 October 2015, TEMIT’s lead portfolio manager has been Carlos Hardenberg; he is supported by Deputy Portfolio Manager Chetan Sehgal and former lead manager Dr Mark Mobius, who is executive chairman of TEMG.

The manager comments that emerging markets have appreciated somewhat over the past one to two years on the back of a broad-based improvement in corporate earnings across most of the developing economies. He says that margins have expanded, helping to boost earnings from depressed levels. Hardenberg notes that while emerging market currencies have recovered to a certain degree, they remain undervalued versus developed currencies. He suggests that Asian economies are continuing to decouple from the rest of the world as Asian companies become more competitive – he believes that this trend is sustainable, particularly in sectors such as technology. In recent years this industry has gone through a significant period of consolidation, which has led to a more robust pricing environment, and some Asian companies have been able to establish dominant global positions, such as Samsung Electronics and Taiwan Semiconductor Manufacturing.

Hardenberg has been adding exposure to frontier markets, which he says are the next generation of fast-growing countries. As these markets mature, company business models can become more stable, while offering higher growth and exposure to underpenetrated populations. He acknowledges that investing in these countries requires an extra level of due diligence to ensure that potential investments fit within Templeton’s risk profile. Hardenberg highlights TEMIT’s Kenyan exposure: two banks (Equity Group and KCB Group) and a brewer (East African Breweries), which he reports are performing well.

The manager has been researching potential investments in Vietnam. He says that there has been an explosion in foreign direct investment and the economy is very vibrant; the country is now running a trade surplus, having historically run at a deficit. The manager is attracted by rising household income in Vietnam and says that per-capita GDP has increased tenfold in the last 15 years. However, Hardenberg highlights a number of risks, including the immaturity of the banking system, corruption and a real estate bubble, which means that he remains very cautious about making his first investment in the country.

Hardenberg sees the Philippines as an interesting smaller emerging market, which has a negligible index weighting, so its stocks are not widely held. The country has a huge and growing population and while the president has been criticised for his candid approach, reforms are being implemented and GDP growth has accelerated. The manager says that the Philippines has one of the most underdeveloped financial systems in the world, which provides considerable growth opportunities for the banks over the long term. TEMIT currently has positions in BDO Unibank and Security Bank.

The manager seeks undervalued companies with strong fundamentals and growth potential that he can hold for the long term. He follows Templeton’s rigorous five-step investment process: valuation-based stock screening; in-depth fundamental analysis; team peer review; portfolio allocation; and portfolio evaluation and attribution analysis. When researching companies for potential inclusion in the portfolio, the manager puts significant emphasis on an assessment of its corporate governance track record. He tends to favour mid-sized companies, seeking those with strong management teams that can adapt to a rapidly changing business environment. While not an activist investor, TEMIT engages in active dialogue with investee companies. Since taking the role as lead manager, Hardenberg has broadly doubled the number of holdings to more than 90: increasing the trust’s technology, smaller-cap company and frontier markets exposures. However, he is looking to place more of an emphasis on his higher-conviction ideas and envisages that the number of positions is likely to be reduced to 70-75 over time.

At end-October 2017, TEMIT’s top 10 positions comprised 42.2% of the portfolio, which was a modest increase in concentration from 40.1% at end-October 2016; seven positions were common to both periods (Exhibit 1). The trust’s sector and geographic exposures are shown in Exhibits 3 and 4. Over the last 12 months, the largest increases in sector exposure were technology (+5.6pp) and financials (+5.1pp), while the greatest decreases were consumer staples (-2.5pp) and materials (-1.7pp).

Over the last 12 months, TEMIT’s Russian exposure has increased due to share price appreciation. The manager comments that due to investor concerns about sanctions, he was able to take a contrarian view, buying positions in quality companies at attractive prices. This includes Sberbank, which has a similar growth rate to Indian banks, but trades at a significant valuation discount. The manager cites Sberbank’s high-tech operations, quality workforce, low non-performing loans and ambitious multi-year cost-cutting programme, which includes reducing the branch network and outsourcing non-core operations. He says that the impact of sanctions and tighter regulation for financial service companies has benefited Sberbank as consumers have migrated towards high-quality banks.

TEMIT’s higher exposure to China/Hong Kong includes Hardenberg’s first purchase of a Chinese bank. Ping An Bank is a subsidiary of Ping An Insurance (which is also held in the portfolio). While the manager remains cautious about Chinese banks due to increased competition and high levels of corporate and consumer debt, he is confident in the outlook for Ping An Bank. He says that the company has a transparent business model, with relatively low levels of corporate lending, and a high-quality management team that communicates well with investors.

TEMIT participated in the July 2017 initial public offering (IPO) of FIT Hon Teng, which is a subsidiary of Taiwanese electronic component manufacturer Hon Hai Precision Industry (Foxconn). FIT Hon Teng is an electronic connector and cable manufacturer that is benefiting from growth in wireless charging and electric vehicles. Since the IPO to end-October 2017, its share price has nearly doubled.

As shown in Exhibit 5 (RHS), over the last 12 months, TEMIT’s NAV and share price total returns of 24.9% and 27.5%, respectively, are considerably ahead of the benchmark’s 16.7% total return. The greatest positive contributor to TEMIT’s performance was current number two position Brilliance China Automotive, generating a total return in the 12 months to end-October 2017 of c 115%.

TEMIT’s relative performance is shown in Exhibit 6; its NAV total return is meaningfully above the benchmark total return over the last year. It is broadly in line over three years, lags over five years and is ahead over 10 years. Over the last 12 months, TEMIT’s share price total return is higher than its NAV total return, which has led to a narrower discount.

Exhibit 7 clearly illustrates TEMIT’s improved investment performance under the new manager. Hardenberg took on the role of lead manager on 1 October 2015; since then the trust has outperformed the benchmark by c 15pp.

TEMIT’s current 12.4% share price discount to cum-income NAV is modestly narrower than the 13.2% average of the last 12 months (range of 10.2% to 14.7%). It compares to the averages of the last three, five and 10 years of 12.6%, 11.4% and 9.4%, respectively.

As shown in Exhibit 8, TEMIT’s discount has narrowed since mid-July 2017. The board buys back shares at a discount to NAV when it considers it is in the interests of shareholders, and repurchases were made on most trading days in FY17. In aggregate 16.4m shares (5.5% of shares in issue at the end of FY16) were repurchased during the financial year at discounts between 10.9% and 14.7% and prices of 435p to 674p; the repurchases were 0.8% accretive to NAV.

As illustrated in Exhibit 1, TEMIT has continued to buy back shares actively in FY18. Historically, repurchased shares were cancelled. However, at the July 2017 AGM, a resolution was approved allowing the board discretion to allot repurchased shares from treasury. This will allow quick and low-cost reissuance of shares if TEMIT’s shares trade at a premium to NAV.

TEMIT is a conventional investment trust with one class of share; there are currently 276.5m shares in issue. On 31 January 2017, TEMIT announced that it had entered into a three-year, £150m, unsecured, multicurrency, revolving loan facility with The Bank of Nova Scotia, which may be drawn down in sterling, US dollars and Chinese renminbi (with a maximum £30m equivalent). If the debt facility was fully drawn down, it would take gross gearing to c 6% of net assets, which compares with a maximum permitted 10%. At end-September 2017, net gearing was 1.0%.

With effect from 1 July 2017, the annual management fee paid to Templeton is 1.0% of net assets up to £2bn and 0.85% of net assets above that level; the previous fee was 1.1% of net assets. Effective 1 April 2017, 70% of the annual management fee and 70% of borrowing costs will be allocated to the capital rather than revenue account. If this policy had been in place in FY17, revenue earnings would have been 11.72p rather than 6.59p. The 70:30 split between the capital and revenue account reflects the board’s assessment of the likely ratio between long-term capital and revenue returns. In FY17, the ongoing charges ratio was 1.20%, which was a 2bp reduction on FY16, due to the increase in average net assets, and a meaningful reduction from 1.32% 10 years ago. TEMIT is subject to a five-year continuation vote; the next vote is due in July 2019.

In FY17, revenue earnings per share were 6.59p, 6.5% lower than in FY16. However, the annual dividend was again maintained at 8.25p, as TEMIT had substantial revenue reserves. At the end of financial year, after taking the FY17 dividend payment into account, revenue reserves were more than three times the annual dividend. TEMIT’s current dividend yield is 1.1%. There is a higher prospective dividend from FY18 due to the reallocation of expenses noted above.

Exhibit 9 shows trusts in the AIC Global Emerging Markets sector with market caps above £50m and a track record of more than one year. TEMIT is by far the largest fund and has the best performance over one year by some margin; its NAV total return is c 11pp ahead of the second ranked trust and 18pp above the average. Over longer periods, it ranks third out of 11 trusts over three years, fifth out of 10 over five years and fifth out of eight over 10 years. TEMIT’s discount is wider than average, while it has a lower ongoing charge and no performance fee is payable. The trust has lower than average gearing, and befitting its focus on capital growth, a lower than average dividend yield.

There are currently six directors on TEMIT’s board; five of whom are non-executive and independent of the manager. Chairman Paul Manduca was appointed in August 2015 and assumed his current role in November 2015. Hamish Buchan was appointed in June 2008, and Beatrice Hollond in April 2014. The two newest board members are Simon Jeffreys (appointed July 2016) and David Graham (appointed September 2016). Gregory Johnson was appointed in December 2007. He is chairman and CEO of TEMG’s parent Franklin Resources, so is considered to be non-independent. Peter Harrison and Christopher Brady retired at the July 2017 AGM and Hamish Buchan has announced his intention to retire at the July 2018 AGM; the board will commence the search for a new director in Q118.