Utilico Emerging Markets Trust — Simplified corporate structure

As shown in Exhibit 2 (LHS), emerging market investors enjoyed strong total returns in 2016 and 2017. So far in 2018, emerging market equities (along with those in developed economies) have experienced higher levels of volatility compared with the particularly benign environment in 2017. Investor concerns include: a strengthening US dollar; an escalation in trade disputes as a result of US protectionist policies; and an ongoing economic and financial crisis in Turkey.

In terms of valuation, on a P/E basis, emerging market equities continue to trade at a discount to global equities (Exhibit 2, RHS); however, due to higher investor risk aversion, the differential has widened over the course of 2018 to date. In addition, emerging market equities now offer a higher-than-average dividend yield. Given the favourable long-term growth potential of emerging markets, and relatively attractive valuations, the recent stock market pullback may provide an opportunity for investors with a longer-term perspective.

UEM was launched on 20 July 2005. On 3 April 2018, it completed its re-domicile from a Bermuda-based investment company to a UK-based investment trust; achieved via a scheme of arrangement. Shareholders received ordinary shares on a one-for-one basis in Utilico Emerging Markets Trust, which has a premium listing on the Main Market of the London Stock Exchange. UEM is managed by the ICM Group (ICM and ICM Investment Management, a Bermuda-based company with c £20bn of assets under management) and is headed by Charles Jillings. Following the fund’s move to the UK, there has been no change in the investment objective or dividend policy.

The manager aims to generate attractive long-term total returns from a diversified portfolio of primarily emerging market infrastructure, utility and related equities. He is unconstrained by benchmark weightings, but the MSCI Emerging Market index is used as a performance reference. UEM’s portfolio typically contains 60–90 positions (87 at end-FY18). The trust may invest in shares, bonds, convertible bonds and other securities, including unlisted companies (up to a maximum 10% of gross assets at the time of investment – 4.2% at end-FY18). Other investment guidelines include: a maximum 20% of gross assets in a single investment; up to 20% outside of infrastructure, utility and related companies; and up to 50% in a single country. Gearing of up to 25% of gross assets is permitted; however, at end-August 2018, UEM had a net cash position of 0.5%. Since launch, the trust’s NAV total return has compounded at 10.7% per annum.

Jillings explains that global stock markets are operating outside of normal historical parameters. In terms of monetary policy, unconventional tools are still in operation in Europe and Japan, such as negative interest rates and quantitative easing. However, the US economy has reached a more advanced stage, whereby the Federal Reserve Bank is raising interest rates in response to higher inflation (including higher wages). The manager believes that the dislocation between those regions employing quantitative easing and those that are tightening monetary policy is likely to lead to increased stock market volatility. Jillings’ more cautious view is reflected in UEM’s current lack of gearing, which compares to a historical range of 0–7% over the past 10 years.

Despite higher stock market volatility so far in 2018, companies are still operating in a ‘goldilocks’ environment of economic growth, low interest rates and low inflation. The manager believes that this backdrop will lead to continued robust earnings growth, which should be supportive for further equity gains. However, he is mindful of the risk of increased trade disputes and their negative effect on global economic activity.

Over the longer term, the manager’s positive outlook for emerging markets remains intact. There are underlying structural growth drivers including an increase in urbanisation and a rising middle class, which are leading to increased demand for the services provided by UEM’s portfolio holdings. In addition, there are significant economic reforms underway in some of the larger emerging markets such as Brazil, China, India and Argentina, which should have positive implications for future corporate earnings. Jillings notes that he is continuing to find selected, attractive investment opportunities that fulfil UEM’s high-quality investment criteria.

Jillings and the investment team at ICM invest primarily in the emerging markets infrastructure, utility and related sectors, seeking companies that can generate total shareholder returns of 15% pa, where they believe the underlying value is not reflected in current share prices. These companies are often under-researched and investment opportunities may arise due to technological development, or from changes in the regulatory environment or a company’s competitive position. The team has a deep knowledge of the infrastructure, utility and related sectors in which it invests, and conducts thorough fundamental company research, employing a range of techniques to compare companies across different geographical regions and industries. Established investments are valued in terms of multiples such as P/E, EV/EBITDA, dividend yield or discount to NAV; using valuations based on discounted cash flow, earnings, or net assets. The valuation methodology used depends on the nature of the company being assessed. Jillings and his team believe in the importance of maintaining close working relationships with investee companies, conducting regular site visits and supporting their capital raisings when deemed appropriate. UEM is often among its investee companies’ largest international shareholders.

Those emerging countries favoured for investment have positive attributes such as political stability, attractive economic growth, a robust legal framework and also encourage foreign investment. Jillings typically invests in companies with strong management teams and long-duration assets that are profitable and cash-generative and also pay a dividend. Due to the nature of UEM’s investments, the trust tends to outperform the MSCI Emerging Market index during periods of share price weakness, while underperforming during cyclical upturns when sectors such as technology, materials, financials and consumer discretionary lead the charge.

Over the past couple of years, the manager has reduced the concentration in UEM’s top 10 holdings from c 50% to c 30% of the portfolio (32.1% at end-August 2018 compared to 34.0% a year earlier, see Exhibit 1). In terms of geographic exposure, compared with 12 months ago, UEM now has higher exposure to China/Hong Kong (+6.1pp), with lower exposure to Brazil (-4.3pp) and Thailand (-3.1pp). Changes in sector exposure over the period are more modest with higher exposure to renewables (+2.6pp) and less exposure to electricity (-3.4pp). While exposure analysis can provide a useful perspective, Jillings is keen to stress that UEM’s investments are made on a bottom-up basis.

UEM provides regular and detailed updates on each of its top 20 holdings. At end-August 2018, the largest portfolio position was a long-term holding in International Container Terminal Services, which is a Philippines-listed, global container ports and terminals operator. It operates 29 container terminal facilities spanning 18 countries. During H118, 53% of volumes were generated in Asia, 31% in the Americas and 16% in Europe, the Middle East and Africa. The company saw volume growth of 10%, which directly fed through to 10% top-line growth. EBITDA was up 3%, which reflected start-up costs of new terminals; however, as operational leverage kicks in, EBITDA and margins are expected to improve.

During FY18 (ending 31 March), UEM’s NAV total return +6.6% trailed the MSCI Emerging Market index +11.6% total return. Jillings explains that this is primarily due to UEM’s sectoral bias to more defensive areas of the market. The reference index is dominated by more cyclical businesses such as technology, financials and consumer-related sectors, which all performed well over the period. At 31 March 2018, the largest four stocks made up 17.1% of the index and were all technology companies. Longer term, UEM has a record of outperformance versus the index; since inception in 2005 to 31 March 2018, the trust has generated an NAV total return of 305.8% compared with 229.1% total return for the MSCI Emerging Markets index.

UEM’s NAV total return has outperformed the MSCI Emerging Markets index over 10 years, while lagging over the shorter periods shown in Exhibit 5. It has outperformed its absolute return-based performance fee benchmark over three and 10 years in NAV terms. Looking at the trust’s five-year performance compared with the MSCI Emerging Market index (Exhibit 6), while it has underperformed since early 2016, this follows a period of meaningful outperformance in 2015.

UEM’s shares are trading at an 11.7% discount to cum-income NAV, which compares with the range of discounts over the past year of 8.6% to 16.0%. The current discount compares with the average discounts of the past one, three, five and 10 years of 12.6%, 11.3%, 9.6% and 9.1%, respectively. There is scope for UEM’s discount to narrow now that the trust has a simplified structure, if investor sentiment towards emerging market improves or the trust’s performance improves relative to the wider emerging markets index.

Renewed annually, UEM may repurchase up to a maximum of 14.99% pa of its outstanding shares. Traditionally, the board has bought back shares when UEM’s discount has widened beyond 10%. During FY18, 9.8m shares were repurchased, which represented 4.7% of the fund’s opening share capital. Following the trust’s re-domicile in April 2018, UEM was unable to repurchase shares due to a capital reduction to create distributable reserves. This may have contributed to a wider discount between then and mid-August 2018, when share repurchases resumed. There is also the potential for periodic tender offers (at the board’s discretion), although to date none have been undertaken.

The final exercise of UEM’s 28.87m subscription shares at £1.83 per share was on 28 February 2018. Shareholders exercised 20.46m shares, while an appointed trustee exercised the remaining 8.41m. Of these, 3.65m shares were placed in the market at a price of £2.235p per share, with the remaining 4.76m acquired by UEM for cancellation. In aggregate, these transactions increased the trust’s share count by c 11.5% and raised gross proceeds of £42.2m. UEM is now a conventional investment trust with one class of share in issue; taking into account recent share repurchases, there are 234.0m ordinary shares outstanding. The proceeds of the subscription share issuance were used to pay down the majority of UEM’s bank debt. While the trust has a three-year unsecured £50m revolving credit facility with Scotiabank Europe, which expires on 3 April 2021. As at 31 August 2018, only £5m was drawn, and at that date, UEM had a net cash position of 0.5%. As part of the re-domicile of UEM, a £500m special reserve was created, which will be available to pay dividends and fund share repurchases, along with the trust’s other distributable reserves.

ICM is paid an annual management fee of 0.65% of UEM’s NAV. It is also eligible for a performance fee of 15% of outperformance versus the post-tax yield on the FTSE Actuaries Government Securities UK Gilt five- to 10-year index plus RPIX inflation plus 2%, subject to an 8% minimum level. The maximum performance fee is 1.85% of average NAV over the year, and it is only payable if UEM’s NAV exceeds the high watermark established when a performance fee was last paid (adjusted for capital events and dividends). Any performance fee is paid 50:50 in cash and shares. In FY18, UEM’s ongoing charge was 1.0%, which was 10bp lower than 1.1% in FY17, and no performance fee was payable (the ongoing charge including performance fees in FY17 was 2.9%).

UEM has a progressive distribution policy; annual dividends have been maintained or increased each year since the fund was launched in 2005. Distributions can be made from capital or income, and quarterly dividends are paid in September, December, March and June. For FY18, UEM’s total dividend per share was 7.00p, which was 5.3% higher than 6.65p paid for FY17; the FY18 dividend was 1.3x covered by revenue. The higher level of income in FY18 was due to dividend increases (including special dividends) by investee companies and because of UEM’s larger exposure to Latin America, which typically is a higher yielding region. Based on its current share price, UEM has a dividend yield of 3.6%.

UEM is a member of the AIC Global Emerging Markets sector; in Exhibit 8, we highlight the sector peers with a market cap above £100m. Given the trust’s focus on infrastructure and utility assets, it has no direct peers, but the analysis provides some perspective. UEM’s NAV total return is above the selected peer group average over five and 10 years, while lagging over one and three years. It has one of the widest discounts in the group, with two of the peers trading at a premium. The trust has the lowest ongoing charge in the peer group, but is one of only two funds eligible for a performance fee. UEM’s dividend is the third-highest in the peer group, 1.5pp above average.

There are five directors on the board of UEM, four of whom are independent of the manager. John Rennocks was appointed to the board in November 2015 and was elected chairman in September 2016. Garry Madeiros was appointed in June 2007, Anthony Muh in October 2010 and Garth Milne was reappointed in November 2014. Susan Hansen became a director of UEM in September 2013; as she is also on the board of another company associated with ICM, she is considered non-independent. Manager Jillings stood down from the UEM board in March 2012 in order to increase its independence and to improve corporate governance. The directors’ fees are paid in UEM shares, which ensures that the interests of all shareholders are aligned.