Utilico Emerging Markets Trust — Emerging market growth opportunities at a discount

Emerging markets offer above-average growth prospects, especially countries such as India, China and Vietnam. This potential is being unlocked as many governments have a clear vision. As an example, India is investing in infrastructure and education to enable it to compete globally; this is an ongoing process. There is now a special freight corridor, which enables goods to be moved around the country on dedicated service lines resulting in faster and more efficient transportation. Historically freight was transported on the same lines that service passenger trains, which was very slow and was given lower priority than passenger travel. As well as being quicker, freight corridors mean manufacturers can hold less inventory as their supply chains are now more robust. It is not yet ‘just in time’ inventory management but the process is contributing to the whole world becoming more efficient.

UEM’s investments can be classified within one of four megatrends that are driving the growth potential in emerging markets.

Although UEM's performance is measured against the MSCI Emerging Markets Index, the manager and his team are benchmark agnostic. For example, the index has c 22% in financials and UEM has a zero weighting, while UEM has c 23% invested in Brazil versus a c 5% index weighting. The trust’s sector and geographic exposures are an outcome of bottom-up investing.

While Jillings is encouraged by UEM’s strong relative performance versus the reference index, he believes that portfolio company valuations do not fully reflect their positive fundamental attributes. The manager therefore considers that the trust’s prospects look particularly appealing.

UEM offers a defensive exposure to emerging markets. At the end of FY23, the company’s five-year beta versus the MSCI Emerging Market Index (£ adjusted) was 0.83x. In Exhibit 1, we show the trust’s upside/downside capture over the last decade. In months where emerging market stocks rose, on average, UEM captured 77% of the upside, whereas in months where emerging markets fell, the trust captured just 60% of the downside. In recent years, UEM’s upside capture has remained pretty stable, while its downside capture has been more volatile, in line with the higher volatility in the broader stock market.

The trust’s defensive nature is not surprising given the type of investments in the portfolio – quality businesses with predictable revenue streams and strong cash flow generation. Several portfolio companies have inflation adjustments in their contracts, so can pass on higher prices. Jillings notes that over the last year some investee businesses have enjoyed both unit and pricing growth, leading to strong top-line growth, which he finds very exciting.

UEM’s portfolio resilience is achieved via sector and geographic diversification, although if macroeconomic and political risks in a country are too high, investment there is unlikely. Within the investment team, there is competition to get companies into the fund, which is healthy and means the rationale for existing and potential new investments is challenged on an ongoing basis. Jillings comments that there are always many opportunities in UEM’s investible universe.

Brazil currently makes up around a quarter of the fund and has the largest year-on-year increase in exposure (+1.3pp). While the country already has favourable attributes, further state investment is required, and the Brazilian government is ambitious in this regard. The supply of renewable energy is increasing, but much of this additional capacity is being installed in northern Brazil, while most of its population live in the south. Hence, there is increased demand for transmission assets. Portfolio company Alupar Investimento owns a network of transmission lines. It has a highly regarded management team that consistently meets or beats expectations. When power lines are auctioned, Alupar only bids on selected projects, with clear hurdle rates for project returns and is unafraid to lose out in overbid auctions to protect shareholder returns. The company tends to deliver these ahead of time and under budget, thereby exceeding its initial internal rate of return estimates.

China makes up c 14% of the fund. UEM’s top 30 Chinese holdings include Kunlun Energy Company (gas transmission) and China Datang Corporation Renewable Power Company (renewable energy). This country is currently taking up a significant amount of the team’s time as its economy has not bounced back after COVID-19 as quickly as originally anticipated. However, Jillings’ view is that the Chinese government continues to focus on quality rather than quantity growth with investment opportunities still available within the data centres and gas transmission sectors. The manager suggests that for China, one needs to understand the government’s five- and 10-year strategies and invest alongside these.

At end August 2023, UEM’s top 10 positions made up 35.3% of the portfolio, which was a higher concentration than 31.2% 12 months earlier. Following a revaluation in March 2023, unlisted Petalite has become the trust’s largest position. This took UEM’s total unlisted exposure over the 10% limit, which means no more unlisted investments can be made until the percentage is reduced, although this does not require forced sales of the trust’s private holdings. Unlisted investments remain close to the 10% limit and there are a couple of ongoing transactions, which could occur in the coming months to reduce UEM’s unlisted exposure; the manager’s preference is for listed businesses.

Energy transition – Power Grid Corporation of India has a transmission network of more than 170,000km. For India to meet its renewables targets, huge investment is required in its transmission assets ($50bn by 2030 according to the manager). Power Grid wins around 50% of the tenders it enters; it has a c $7.5bn pipeline of new projects, investing c $1.0bn a year. Jillings reports that the company is a successful operator, and its regulatory regime provides for a 15.5% return on equity. Power Grid has increased its payout ratio from 50% to 65% and its dividend has compounded at an annual rate of 18% over the last five years. The company is trading on a P/E multiple of c 11x and offers a c 6% dividend yield. Jillings says this is a ‘great business with a huge amount of growth still to come’.

Digital infra – FPT Corporation offers IT services to global multinational and local clients. It owns one of the largest fibre broadband networks in Vietnam and is a leading data centre provider. FPT also owns the largest private education company in Vietnam with more than 100,000 students. The country has a skilled and educated workforce, which can compete worldwide. Founded in 1988, FPT has an entrepreneurial culture and has delivered on its 20% annual earnings growth rate. Jillings highlights the company as being ‘a very exciting investment’.

Global trade – International Container Terminal Services (ICTS) is a Philippines company with 33 container ports in 20 countries operating long-term concessions. High operating leverage means the company is benefiting from increased volumes; over the last five years, volumes have increased by 25% but EBITDA has increased by 86%. ICTS has a strong management team, which is expanding the company’s margins. Jillings highlights the company’s attractive valuation and suggests the firm has very strong long-term growth prospects.

Social infra – Orizon Valorização de Resíduos is a Brazilian waste company that listed in February 2021 (UEM participated in the IPO) and owns several landfill companies. In Brazil, the waste industry is very fragmented, and many municipalities dump waste in unlicensed sites, which damages the environment. There is now legislation to shut this practise down and municipalities must use regulated sites, which benefits Orizon. Jillings reports that this company has the capital, expertise and knowledge to run its facilities successfully. Orizon’s EBITDA grew by 66% in 2022, helped by acquisitions. However, the company still only has a c 10% market share and, over the next five years, could double the amount of waste that it processes.

As shown in Exhibit 4 (left-hand side), over the last five years, emerging market stocks have considerably lagged the world market, which has been supported by the strong performance of US and technology stocks for most of the period. However, emerging economies have much better growth prospects than developed regions (Exhibit 4, right-hand side). Of note is India, whose population is estimated to have surpassed that of mainland China. In its World Economic Outlook, July 2023 update, the IMF projects Indian GDP growth of 6.1% in 2023 and 6.3% in 2024.

Exhibit 5 (left-hand side) illustrates how attractively valued emerging market equities are in both absolute and relative terms. The Datastream Emerging Market Index is trading on a 10.8x forward P/E multiple, which is a 15.9% discount to its 12.8x five-year average. It is also trading at a 30.1% discount to the Datastream World Index, which is considerably wider than the 20.7% average discount over the last five years. At the end of August 2023, the MSCI Emerging Markets, MSCI Emerging Markets Utilities and MSCI Emerging Markets Infrastructure indices were all trading at lower forward P/E and price-to-book multiples, while offering a higher dividend yield compared with the MSCI World Index (Exhibit 5, right-hand side).

Exhibit 6 shows the constituent members of the AIC Global Emerging Markets sector excluding a small, recently launched fund. UEM is a mid-sized fund and although its unique strategy precludes a direct comparison with its peers, a broad overview does provide some perspective. The trust’s NAV total returns are above average over all periods shown, ranking third and fourth out of 10 funds over one and three years respectively, while ranking fourth out of nine funds over the last five and 10 years. UEM’s returns do not take the dilutive effect of its historical subscription shares before February 2018 into account.

Unfortunately, the sector’s average valuation is distorted by JPMorgan Emerging Europe, Middle East & Africa Securities, which changed its name and mandate from investing in Russian securities. If this fund is excluded, UEM’s discount is wider than the average 10.4% discount. Its ongoing charge is above the mean and is a reflection of the specialist nature of the trust. UEM’s gearing is below average (half of the group is ungeared). The trust has an attractive dividend yield, which is 1.2pp above the sector mean.

Given the unique nature of UEM’s investment proposition, the trust does not have a formal benchmark. However, to provide context the company publishes its performance versus the MSCI Emerging Markets Index. In FY23 (ending 31 March), UEM’s NAV and share price returns of +2.1% and +0.8% respectively were ahead of the index’s -5.0% total return. The trust’s long-term outperformance versus the MSCI Emerging Markets Index is shown in Exhibit 7.

As shown in Exhibits 8 and 9, UEM has had a strong period of relative performance over the last six months, which has enhanced its longer-term record. It is ahead of the MSCI Emerging Markets Index over the last one, three, five and 10 years in both NAV and share price terms.

Perhaps of more relevance is UEM’s performance versus the MSCI Emerging Utilities Index, on the understanding that utilities make up around a third of the trust’s portfolio. Again, it has outperformed over the last one, three, five and 10 years, but by a considerably greater extent than versus the broader MSCI Emerging Markets Index over the last one and 10 years.

Since launch in July 2005, UEM’s annual dividend has been increased or maintained every year. Quarterly payments are made in September, December, March and June. In FY23, the trust’s 9.40p revenue earnings per share was 13.1% higher year-on-year, while the annual dividend of 8.45p per share was a 5.6% increase versus 8.00p in FY22. Over the last five years the annual dividend has compounded at an annual rate of 3.8%. At the end of FY23, UEM had 4.74p per share in revenue reserves, which is equivalent to c 0.6x the last annual dividend. Around 80% of UEM’s investee companies pay dividends.

In an environment of elevated investor risk aversion due to an uncertain macroeconomic backdrop, UEM’s discount remains stubbornly above the board’s sub-10% desired level. The latest 14.8% share price discount to cum-income NAV compares with average discounts of 14.2%, 13.2%, 12.9% and 11.3% over the last one, three, five and 10 years respectively.

The board typically repurchases UEM’s shares when the discount has widened to more than 10% in normal market conditions. In FY23, c 12.5m shares (c 5.8% of the share base) were bought back at a cost of c £27.2m.

Launched in July 2005, UEM was historically a Bermudan investment company, but redomiciled to the UK as an investment trust via a scheme of arrangement on 3 April 2018. It is listed on the Main Market of the London Stock Exchange and is managed by the ICM Group (ICM and ICM Investment Management), a specialist fund manager based in Bermuda and the UK with c $24.0bn of assets under management (c $1.8bn directly and c $22.5bn indirectly). ICM Group has more than 80 employees, who operate from nine offices around the globe.

UEM is managed by qualified chartered accountant Charles Jillings, who has more than 30 years’ experience in global financial markets. He aims to generate an attractive long-term total return from a diversified portfolio of emerging market equities, primarily in the infrastructure, utility and related sectors. Jillings employs a bottom-up stock-selection process and is unconstrained by benchmark allocations, although the MSCI Emerging Markets Index is used as a reference.

To mitigate risk, there is a series of internal investment guidelines in place (as a maximum percentage of gross assets at the time of investment): individual investment 10%; single country 35%; individual sector 25%; unquoted investments 10%; and top 10 holdings 60%. Gearing of up to 25% of gross assets is permitted. The trust’s currency exposure is unhedged. From launch to end August 2023, UEM’s NAV total return has compounded at an annual rate of 9.3%.

Jillings and his team seek to identify and invest in companies, predominantly in the infrastructure and utility sectors, which are trading at a discount to their estimated intrinsic value, and which they believe have the potential to generate total returns of at least 15% pa, at an investee company level, over a five-year horizon. The focus is on emerging market countries with positive attributes such as political stability, economic development, an acceptable legal framework and an encouraging attitude to foreign investment.

UEM’s investment team has a long-term investment horizon and avoids short-term stock market ‘noise’. It can draw on the expertise of professionals in ICM’s regional offices and has direct relationships with companies. There is a lot of travel involved, meeting with company managements and their operating assets. ICM is often the first phone call when an infra/utility IPO is announced and its investment specialists are used as sounding boards ahead of companies listing. UEM’s investment team is supportive of its investee firms in terms of their capital requirements by participating in follow-on equity offerings and the trust is often among their largest international shareholders.

Stocks are selected on a bottom-up basis following thorough fundamental research (including the construction of a detailed financial model and valuation targets) from an investible universe of more than 1,000 companies. There are c 80 holdings in the portfolio (typical range of 60–90). UEM has an active share approaching 100% versus the MSCI Emerging Markets Index; this is a measure of how a fund differs from an index, with 0% representing full replication and 100% no commonality.

Because of the nature of UEM’s investments, in companies providing essential services, the trust has tended to underperform the MSCI Emerging Markets Index during a cyclical upturn led by sectors such as technology and consumer discretionary, while outperforming in a falling market.

While UEM is not an ESG fund, its board believes it is in shareholders’ best interests to consider environmental, social and governance factors when selecting and retaining investments. In conjunction with assessing the financial, macroeconomic and political drivers when making and monitoring an investment, the manager embeds ESG opportunities and risks into the trust’s investment process. Companies are scanned using a rigorous in-depth framework; however, the decision as to whether to make an investment is not made on ESG grounds alone. The manager can consider a potential investment with a low ESG score but this will need to be outweighed by an attractive total return potential. Every investee company’s ESG footprint is analysed, and there is often still room for improvement at some of these businesses. The manager works to understand a company’s ESG journey and seeks an improving score.

Factors are incorporated into the trust’s investment process in three main ways:

ICM is a signatory to the United Nations-supported Principles for Responsible Investment, a code of best practice for incorporating ESG issues.

UEM has a three-year unsecured £50m multicurrency revolving credit facility with The Bank of Nova Scotia (London branch) that expires on 15 March 2024. Looking at the last 10 financial year ends, the trust’s leverage ranged from a 1.4% net cash position to net gearing of 10.6%. At end August 2023, UEM had net gearing of 1.2%.

ICM is paid a management fee of 1.00% of UEM’s NAV up to £500m; 0.90% above £500m up to £750m; 0.85% above £750m up to £1bn; and 0.75% above £1bn. There is no performance fee following its removal in April 2021. UEM’s board believes that the simpler and more transparent cost structure should contribute to a stable and competitive ongoing charge, while helping to attract private wealth managers and retail investors. A tiered fee structure allows shareholders to benefit from the increasing economies of scale that a larger portfolio provides. In FY23, UEM’s ongoing charge ratio was 1.4%, which is unchanged year-on-year.

UEM has 198.3m ordinary shares in issue and its average daily trading volume over the last 12 months was c 325k shares. The trust has a five-yearly continuation vote, with the next due at the September 2026 AGM. The September 2021 vote was passed with 84.2% of shareholders voting in favour of UEM’s continuation.

The directors’ fees are used to acquire UEM shares, ensuring all shareholders’ interests are aligned. Fees for the financial year ending 31 March 2024 were increased by 5% year-on-year.

Susan Hansen is considered non-independent as she is also on the board of Resimac Group, which is associated with ICM. She has indicated her intention to retire from the board following the conclusion of UEM’s next AGM in September 2023. The company intends to maintain the board with the remaining four directors, all of whom are independent.