Templeton Emerging Markets Investment Trust — Step-up in relative performance

Exhibit 2 (LHS) shows that, in sterling terms, over the last five years, emerging market equities have delivered a higher total return than UK shares, but have lagged the performance of the world market. The MSCI World index is dominated by the US (c 60%), a market that has performed particularly strongly in recent years. Since the beginning of 2018, global equities have returned to more normal levels of volatility, following a particularly benign period in 2017. Recent volatility reflects tension between the continued supportive monetary environment and concerns about slowing global growth, which has been exacerbated by the escalation in tariffs by the US and its trading partners.

Relative growth prospects continue to favour emerging over developed markets. In its April 2019 World Economic Outlook, the International Monetary Fund forecast growth for emerging markets and developing economies of 4.4% and 4.8% for 2019 and 2020 respectively, markedly higher than 1.8% and 1.7% for advanced economies. Factors for the higher growth outlook include an expanding educated middle class with higher levels of disposable income.

Along with better growth prospects, in aggregate, emerging market companies remain attractively valued, which may provide an opportunity for investors seeking to add global emerging market equity exposure. Highlighted in Exhibit 2 (RHS), the MSCI Emerging Markets index is trading on lower P/E and price-to-book multiples than the MSCI World index, while also offering a modestly higher yield.

Launched in June 1989, TEMIT is celebrating its 30th anniversary. The trust is quoted on both the London and New Zealand stock exchanges and is managed by Franklin Templeton Emerging Markets Equity (FTEME), which has c $35bn of assets under management. TEMIT’s lead manager since 1 February 2018, Chetan Sehgal (based in Singapore, and a Franklin Templeton employee since 1995) aims to generate long-term capital growth from a diversified portfolio of emerging market equities, selected on a bottom-up basis. In September 2018, Sehgal was joined by co-manager Andrew Ness, who has 25 years of investment experience and is based in Edinburgh. TEMIT’s performance is benchmarked against the MSCI Emerging Markets index. A maximum 10% of the trust’s assets at the time of investment may be held in the securities of any one issuer. Gearing of up to 10% of NAV is permitted (net gearing of 1.8% at end-May 2019). Data from TEMIT show that over the almost 30 years from its launch to the end of FY19 (31 March), TEMIT’s NAV total return of 12.6% pa is considerably ahead of the benchmark’s 10.0% pa total return.

FTEME prides itself on the breadth and depth of its in-house resources, which allow TEMIT to hold a portfolio that is differentiated from its peers’, and around one-third of the fund is in names that are not included in the MSCI Emerging Markets index. The deep resources allow FTEME significant access to company managements and there is a high degree of collaboration between all members of the investment team. Along with distinct portfolio managers and company/sector analysts, there are now also portfolio analysts (there are two working on TEMIT) that support portfolio managers, working to uncover tactical opportunities. Sehgal and Ness suggest that this is an important enhancement to the investment process.

Despite being based in different locations, Sehgal and Ness work very closely together, sharing a belief that company earnings are the primary driver of equity returns over the long term. They say the market can misprice equities in the short term, and these opportunities can be identified via fundamental analysis. The managers highlight that over the last 18 years, the MSCI Emerging Markets index has delivered total returns of c 10% pa primarily driven by earnings growth, with an additional c 3% pa contribution from dividends broadly offset by lower valuations (c -1% pa) and currency (c -1% pa).

Sehgal and Ness focus on companies that are trading at a discount to their intrinsic worth, not just on companies that are trading on low valuation multiples; they stress the difference between focusing on value as a philosophy and value as a style (value stocks have lagged growth stocks in recent years). The managers say there is a misperception that TEMIT’s strong three-year absolute and relative returns have resulted from a change in approach to invest in high-growth companies. They point out that the performance has come from a wide range of companies across different sectors and geographies.

Commenting on the current investment backdrop in emerging markets, Sehgal and Ness say that in 2018, the US market was very strong on the back of c 25% earnings growth (helped by tax reform), while corporate earnings growth in emerging markets was in the low teens. However, they believe that investors underappreciate the secular changes that have occurred in emerging markets in recent years, adding ‘they are not your granny’s emerging markets’. In their view, this misperception accounts for relatively low allocations to the region by global investors.

The managers comment that an improved policy environment has transformed the emerging markets equity asset class, and has been a structural response to the region lurching from crisis to crisis 15 to 20 years ago. Sehgal and Ness note there has been a lack of crises in emerging markets in recent years, crediting this to improved fiscal behaviour at the country level, and banks being more resilient to economic weakness, with higher levels of regulatory capital. The managers say that emerging market economies have moved away from being susceptible to capital account crises, fixed exchange rates, overvalued currencies and excessive overseas borrowing. Interestingly, they note that in 2018, there were huge financial stresses in Argentina and Turkey, but there was no contagion in other emerging markets.

Sehgal and Ness say that in the late 1980s to early 1990s, the emerging market investible universe was dominated by resource companies and low-tech manufacturing companies that offered little value-added benefit. In 1988, Malaysia, Brazil and Chile made up around two-thirds of the emerging market universe and there were boom-bust scenarios; however, things have changed significantly, with the two consumer sectors, along with technology, now comprising around a third of the MSCI Emerging Markets index, while the cyclical energy, industrials and materials sectors make up just a combined c 20%. The managers suggest that the past does not necessarily predict the future, and emerging markets do not have to echo advances in developed markets. They say that some of the key emerging market technology companies are spearheading global disruption, with world-leading innovation, such as in the areas of e-commerce and big data.

While Ness acknowledges that there are uncertainties surrounding the pace of China’s economic growth, and comments that he has become more cautious following a recent trip to the region; he still sees strong secular growth opportunities in the country. TEMIT’s Chinese investments focus on companies with a strong competitive advantage, such as Brilliance China Automotive (auto parts manufacturer) and multinational conglomerates Alibaba and Tencent.

Sehgal, Ness and the FTEME investment team employ a bottom-up stock selection process based on thorough company research, aiming to identify companies with sustainable earnings power that are trading at a discount to their intrinsic value, and can be held for the long term. The managers explain that in emerging markets there is a wide dispersion in returns between individual companies and sectors, which can provide many investment opportunities that are not captured in exchange-traded funds (ETFs); hence the benefit of bottom-up investment. They believe that companies generating sustainable returns will outperform over time, even more so for firms that are trading at a discount to their intrinsic value. There are three stages to the investment process:

Comparing TEMIT with the MSCI Emerging Markets index, its portfolio has higher returns on equity and assets, lower long-term debt to equity, modestly lower estimated earnings growth, a broadly similar forward P/E multiple, and a modestly lower dividend yield. At end-May 2019, TEMIT’s top 10 positions made up 42.5% of the portfolio, which was a modest decrease in concentration versus 44.7% a year earlier; nine companies were common to both periods. The trust’s sector exposure is shown in Exhibit 3; year-on-year changes are misleading due to changes in the Global Industry Classification Standard (GICS) definitions in September 2018 (mainly affecting information technology and communication services), so it is more meaningful to highlight TEMIT’s exposure compared with the benchmark. Notable deviations are overweight positions in consumer discretionary (+6.8pp) and technology (+6.5pp), with below-index exposure to materials (-4.5pp) and real estate (-3.0pp).

TEMIT’s geographic exposure is shown in Exhibit 4. There have been modest changes in the 12 months to the end of May 2019, with increased exposure to India (+2.6pp) and Brazil (+2.4pp), and lower weightings in South Korea (-1.9pp) and China/Hong Kong (-1.6pp). Despite a reduction in South Korean exposure, the trust retains an overweight position. The manager explains that valuations are attractive in the country, and there are improvements in corporate governance practices. He says that South Korea has some world-leading technology companies, including three of the five globally dominant suppliers of batteries for electric vehicles.

The trust’s portfolio turnover is relatively low at around 20% pa. Some of the more recent additions to the portfolio include China Merchants Bank, China Resources Cement, Cognizant Technology Solutions (US IT services company), H&H Group (Hong-Kong nutrition firm) and MultiChoice Group (South African television satellite company). Recent complete disposals include: Daelim Industrial (South Korean engineering & construction and petrochemical firm), Inner Mongolio Yitai Coal, Pegatron (Taiwanese electronics manufacturer) and SABIC (Saudi petrochemical company).

In FY19, TEMIT’s NAV and share price total returns of +1.8% and +6.0% respectively were ahead of the benchmark total return (essentially unchanged at +0.1%). The top stock contributors were ICICI Bank (India, +1.1pp), LUKOIL ADR (Russia) and Bank Danamon Indonesia (both +0.7pp), while the largest detractor was Brilliance China Automotive (-2.7pp), where a change in the company’s joint venture terms with BMW was poorly received by investors. The largest performance attributions by sector and geographies were: financials (+1.7pp), consumer discretionary (-1.1pp), Indonesia and South Korea (both +0.7pp) and China/Hong Kong (-1.4pp).

Exhibits 7 and 8 highlight TEMIT’s relative returns. There has been a notable improvement in the trust’s performance over the last 12 months; its NAV has outperformed the benchmark by 4.5% and its share price has outperformed by 9.0%, which has led to a narrowing in TEMIT’s discount. The trust has also outperformed its benchmark in both NAV and share price total return terms over the last three and 10 years, while performance is broadly in line over five years.

The board actively repurchases TEMIT’s shares, aiming to reduce discount volatility. In FY19, 20.5m shares were bought back (c 7.5% of the share base) at a cost of c £150m, and boosted the NAV by 1.0%. With the discount having been in a narrowing trend since early-June 2018, the trust is currently trading at a 9.5% discount to cum-income NAV, which compares with the 11.1%, 12.2%, 12.0% and 9.9% average discounts over the last one, three, five and 10 years respectively.

TEMIT is a conventional investment trust with one class of share; there are currently 249.0m ordinary shares in issue. Since 31 January 2017, the trust has had a three-year unsecured multi-currency (sterling, US dollars and Chinese renminbi) lending facility with The Bank of Nova Scotia (increased from £150m to £220m in September 2018). The maximum amount of renminbi that can be drawn is equivalent to £44m.

Effective from 1 July 2018, the annual management fee paid to FTEME was reduced to 1.0% of NAV up to £1bn and 0.85% of NAV above this level (previously 1.0% up to £2bn and 0.85% above £2bn, and prior to 1 July 2017, a flat 1.1% fee); no performance fee is payable. In FY19, TEMIT’s ongoing charges were 1.02%, which was 10bp lower than the prior year (due to the reduction in fees) and meaningfully below 1.34% a decade ago.

On 3 May 2019, the board announced a five-year, performance-related conditional tender offer (subject to the continuation vote being passed at the July 2019 AGM). If TEMIT’s NAV performance fails to exceed that of its benchmark in the five years ending 31 March 2024, the board will undertake a tender offer for up to 25% of the trust’s shares in issue at a price equivalent to the prevailing NAV (minus 2% and costs). The tender offer is also subject to TEMIT’s continuation vote being passed at the 2024 AGM.

Historically, TEMIT paid a single distribution in July, but paid its first-ever interim dividend in January 2019. The 16.0p (c 1.1x covered) total dividend for FY19 is 6.7% higher year-on-year, while net revenue increased by 8.6% to 17.3p per share. TEMIT has meaningful revenue reserves (£109.1m as at end of the last financial year), which is equivalent to c 2.7x the FY19 total distribution. Based on its current share price, the trust offers a 2.0% dividend yield.

TEMIT is a member of the AIC Global Emerging Markets sector; in Exhibit 10, we show the eight funds with a market cap above £100m that have been trading for more than a year. The trust’s NAV total return ranks first over three years (15.4pp above average), is above the mean over one and five years, while lagging over the last 10 years. TEMIT has a wider than average discount, a competitive ongoing charge and a level of gearing that is below the mean. Its dividend yield is broadly in line with the selected peer group average.

There are six directors on TEMIT’s board; five of whom are independent. Chairman Paul Manduca joined the board on 1 August 2015 and assumed his current role on 20 November 2015. The other four independent directors and their dates of appointment are: Beatrice Hollond (1 April 2014, senior independent director since 12 July 2018); Simon Jeffreys (15 July 2016); David Graham (1 September 2016); and Charlie Ricketts (12 July 2018). Gregory Johnson is the remaining director; he joined the board on 12 December 2007, and as chairman and CEO of Franklin Resources (FTEME’s parent), he is considered to be non-independent.