Utilico Emerging Markets — Update 7 July 2016

Following the 2008 financial crisis, emerging markets initially followed a strong uptrend, but performance has been relatively flat in sterling terms over the last five years, albeit with periods of significant volatility. Despite more recent weakness, emerging markets have outperformed developed markets, represented by the FTSE All-Share index (Exhibit 2, left-hand side) over the last 10 years. Within this environment, infrastructure stocks have performed better than the wider emerging markets. Stock price volatility in recent years has resulted from, among other things, slowing growth expectations, weak commodity prices and sharp currency moves. However, according to the International Monetary Fund’s April 2016 World Economic Outlook, growth expectations for emerging markets remain ahead of those for developed markets; the reasons for this include rising infrastructure spending, demand for financial services and higher consumption as a result of rising middle classes.

As shown in Exhibit 2 (right-hand side), the valuation of emerging markets versus the World index is lower in terms of both P/E and price-to-book and they also offer a more attractive dividend yield. For investors wishing to have exposure to emerging markets, a fund focusing on the relatively stable, cash generative infrastructure and utilities sectors may hold appeal.

UEM was launched in July 2005. It is a Bermuda-registered investment company listed on the premium segment of the London Stock Exchange. Its objective is to achieve long-term capital return via investment in emerging market infrastructure, utility and related sectors. The fund is run on a bottom-up basis, without regard to index weightings, but the MSCI Emerging Markets index is used as a comparison. There is flexibility to invest in other asset classes as well as equities; up to 5% of the portfolio can be in unquoted securities. Other internal investment parameters are in place: no single investment should exceed 10%; top 10 investments should not exceed 60%; a single country has a maximum exposure of 30%; single sector exposure should not exceed 25%; and investments outside the core infrastructure and utility sectors should not exceed 20%. Gearing of up to 25% is permitted. The benchmark for the performance fee is the FTSE UK Gilt five- to 10-year index post-tax yield, plus RPIX inflation, plus 2%, subject to an 8% minimum hurdle rate and is capped at 1.85% of average net assets. Since launch, UEM has been managed by Charles Jillings, who works for Bermuda-based ICM. From inception to the end of FY16, UEM’s NAV has compounded at an annual rate of 11.4%.

The manager approaches the market as an owner of assets, without reference to the composition of the MSCI Emerging market index. For example, the portfolio has no exposure to Russia or South Africa, which are sizeable weightings within the index. He highlights two countries where portfolio exposure has been increased: Romania and Mexico.

Romania – the country has a population of 20 million, with GDP per capita of $22,000. It has benefited significantly since the IMF bailout in 2009; there is now more monetary and fiscal prudence at the government level and there is a more conservative approach to investment at the corporate level. Romania is one of the fastest growing economies in Europe; the IMF forecasts GDP growth of 4.2% in 2016 and 3.6% in 2017 vs 2.0% and 2.1% respectively for Europe as a whole. There is strong domestic consumer demand and wages are growing; core inflation is positive and rising. UEM’s investments in the country are primarily in electricity, gas and oil transmission; these are natural monopolies with clear regulation. Historically state-run and inefficient, there is potential for significant cost cutting at these companies. Balance sheets are solid and free cash flow generation strong, with a large percentage returned to shareholders as dividends. Although one-third of the increased exposure during FY16 was a result of share price performance, the manager still believes that valuations of Romanian companies remain attractive.

Mexico – the country has a population of 136 million, with GDP per capita of $10,765. The manager considers the economic background stable, with GDP and inflation running around 2.5%. He highlights airports as attractive investments, with passenger numbers rising by more than 8% pa in recent years. Flight penetration is low and demand is increasing, led in part by the rising middle classes. There is a change in mind-set as passengers increasingly switch from buses to airplanes for domestic travel; in 2006 buses had a 93% market share, which declined to 91% in 2015, with air transportation increasing.

The manager highlights the consistency of the investment strategy; he has no shortage of potential investment ideas; targeting 15% total return pa. He says that the biggest challenge over the last 12 months has been exchange rates such as the Brazilian real, which has been very volatile. From mid-June to late-September 2015 the real fell by more than 35% and between late-January to the end of June 2016 it rallied by more than 20%. The portfolio is not hedged due to the expense involved and the manager sees diversification as the best way to address currency volatility, rather than trying to predict forex movements.

UEM is jointly managed by ICM Limited and ICM Investment Management. Portfolio manager Charles Jillings works in a dedicated team that has deep experience of investing in the emerging markets infrastructure and utilities sectors. The focus on these areas means that performance of the portfolio is somewhat protected in periods of economic weakness. The manager adopts a bottom-up stock selection process seeking to identify companies whose current share price does not fully capture the value of the underlying businesses. The team has built up a bespoke database covering c 900 potential investee companies by conducting in-depth fundamental and building in-house financial models. An important part of the investment process is to meet with the management teams of portfolio and potential investee companies.

The manager is a long-term investor who avoids short-term ‘noise’ in stock markets. He emphasises the consistency of the investment process, highlighting that more than 95% of the portfolio is invested in established businesses, with more than 75% invested in companies that pay a dividend. The fact that holdings in the portfolio are backed by real assets reduces investment risk. Risk is further mitigated through diversification by industry and geography. Favoured countries for portfolio investment are growing, politically stable, have an acceptable legal framework and are receptive to foreign investment. When valuing a business, the team focuses on EV/EBITDA, to address the difference in funding structures between companies.

The portfolio typically holds c 60-90 names. At the end of May 2016, the top 10 positions accounted for 44.3%; this was a decrease in concentration from 52.8% at the end of May 2015 (see Exhibit 1). Reflecting the long-term nature of investments, nine companies are common to both periods. The new name in the top 10 list is Transgaz, a Romanian gas transmission company in its third regulatory cycle with a regulated rate of return of 7.7% until September 2017. There is a long tail of investments in the portfolio as initial position sizes are often small, either for liquidity reasons or to allow the manager to build confidence in the management of investee companies.

Formerly the largest position in the portfolio, Malaysian IT services company MyEG is now the sixth largest holding, with the manager selling down as the shares are considered to be fully valued. The position in Malaysia Airport Holdings is now the largest single exposure. The manager expects good passenger growth at both its Malaysia-based airports and its now wholly owned investment in Sabiha Gökçen International Airport in Istanbul, Turkey.

The fund typically invests/disinvests c £100m per annum. In FY16 £96.1m was invested and £130.5m realised as profits were taken on a number of Chinese H-share positions in the April 2015 market rally, although China remains the largest country exposure. Looking at sector exposure, over the last 12 months the largest increases have been in electricity (3.6pp), gas (2.8pp) and airports (2.3pp), while the largest decreases have been in satellites (3.3pp), other infrastructure (2.9pp) and toll roads (2.1pp).

As shown in Exhibit 5, over five years, UEM’s NAV and share price have appreciated by more than 6% pa. Over 10 years, the NAV has risen by 10.8% per year, modestly ahead of the 9.8% share price annualised return.

UEM has delivered strong performance compared with the MSCI Emerging Markets index; its NAV and share price total return have outperformed over one, three and five years and since the fund was launched in July 2005. Its NAV and share price have also outperformed the MSCI EM Infrastructure index over three and five years and since launch. Over 10 years, UEM has outperformed its performance fee benchmark in both NAV and share price terms.

UEM’s current 11.3% share price discount to cum-income NAV is wider than the 10.4% average of the last 12 months (range of 3.9% to 16.3%) and wider than the averages of the last three, five and 10 years (range of 7.9% to 8.3%). In Exhibit 8, the sharp widening of the discount in August 2015 corresponds to the sell-off in the Chinese stock market. The board and manager closely monitor the discount; there is an inclination, but not a commitment, to repurchase shares when the discount exceeds 10%. While no shares have been repurchased so far in FY17, during a period of market turmoil in early 2016, 1.7m shares (0.8% of issued capital) were repurchased at discounts of 12.0-12.5%.

UEM has 211.5m ordinary shares in issue with the authority, renewed annually, to repurchase 14.99% and allot up to 10% of its issued share capital. At the end of FY16, bank debt had declined by 41.4% over the year to £18.7m. UEM has recently renegotiated its bank debt facility of £50m with Scotiabank Europe for another two years, expiring on 30 April 2018.

Following approval of a one-for-five bonus issue at a special general meeting in September 2015, UEM issued 42.6m subscription shares. They are exercisable on the last business day of August 2016, February and August 2017 and February 2018 at an exercise price of 183.0p. If the shares are exercised, UEM’s fixed costs will be spread over a wider base and liquidity in UEM shares is likely to increase.

The management fee paid to ICM is 0.65% of net assets. Subject to an 8% minimum hurdle, a 15% performance fee is payable on returns in excess of the FTSE UK Gilt five- to 10-year index post-tax yield, plus RPIX inflation, plus 2%. Performance fees are capped at 1.85% of average net assets in each financial year. For FY16, ongoing charges were 1.1%, which was in line with the previous year; no performance fee was payable.

UEM pays dividends quarterly in September, December, March and June. Despite the focus on capital growth, the board aims for a flat or growing annual dividend; this has been achieved every year since fund inception in 2005. In FY16, the dividend of 6.4p was a 4.9% increase versus the prior year. Over the last five years, dividends have grown at a compound annual rate of 4.24%.

UEM is able to distribute from both income and capital when necessary, which allows a smooth progression of the dividend even though income levels may fluctuate significantly. For the 12 months to 31 March 2016, total income rose by 45.9% to £21.3m. This was a yield on gross assets of 4.8% versus 3.0% in the previous year. Most of the increase was as a result of the special dividend distributed by Asia Satellite Telecom in H116. Higher income, coupled with lower costs, led to a revenue return of £17.5m in FY16 versus £10.6m in FY15, meaning that dividend payments were more than fully covered.

Exhibit 9 shows a comparison of UEM with AIC Global Emerging Markets sector trusts that have market caps greater than £50m. Given its focus on specific areas of the market, UEM cannot be compared directly with the peer group; however, its emerging market exposure provides some relevance to the comparison. UEM has outperformed the peer group average over one, three, five and 10 years, ranking second over three and five years and first over 10 years. In terms of risk-adjusted returns as measured by the Sharpe ratio, UEM is in line with the peer group average over one year and higher over three years. Its discount is narrower than average and it has one of the lowest ongoing charges, although a performance fee is payable. UEM’s 3.3% dividend yield ranks it third out of the five peers that pay a dividend.

There are currently six non-executive directors at UEM; five are independent of the manager. Chairman Alexander Zagoreos has been on the board since the trust’s inception in 2005; he has announced his intention to stand down at the September 2016 AGM and will be replaced by John Rennocks, the newest director, who was appointed in November 2015. The other board members (with date of appointment) are deputy chairman Garth Milne (November 2014 and previously a director of UEM from 2005 to 2010), Garry Madeiros (June 2007), Anthony Muh (October 2010) and Susan Hansen (September 2013), who is deemed not to be independent as she is a director of RESIMAC, which has the same majority shareholder as the investment manager.