abrdn Latin American Income Fund — Valuation providing attractive opportunities

Latin American stocks have performed relatively well so far in 2022, as growth has exceeded consensus expectations, with the MSCI Emerging Market Latin America Index returning a +3.9% return from 31 December 2021 to 31 July 2022, which compared to a 17.6% decline in the MSCI Emerging Markets Index and a 14.4% decline in the MSCI All Countries World Index (all returns in US dollars). However, the region remains out of favour with investors, as shown in the table below (Exhibit 1, right-hand side). The Datastream Latin America Index is trading on a modest forward P/E of 8.6x and a 40.3% discount to the Datastream World Index, which is considerably wider than the 26.4% average discount over the last five years. Brazil is by far the dominant weight within Latin American indices (more than 60%) and has experienced double-digit valuation multiple compression so far this year. While 2022 is a presidential election year in Brazil, the two front-running candidates are known quantities, so perhaps investors are overestimating the political risks in Brazil. Also, Latin America is exposed to segments which should show resilience in an environment of economic slowdown, such as the agribusiness sector, while corporate earnings have held up well so far this year. Hence, global investors may benefit from an allocation to a region that looks somewhat unloved and has the potential to be afforded a higher valuation.

In a recent webinar, Viktor Szabó (a member of abrdn’s emerging market debt team) and Mubashira Bukhari Khwaja (a member of abrdn’s global emerging markets equities team) discussed their outlook for Latin America. Bukhari Khwaja considers it to be a good time to consider Latin America, as she believes the region remains a ‘value play’ with attractive investment opportunities at a reasonable price. Latin America is a beneficiary of the global energy crisis and the negative economic COVID impacts are lessening, which is helping domestic businesses. The manager comments that Latin America has historically offered higher dividend returns compared with other regions and, in aggregate, she expects this to continue, supported by strong free cash flow from higher commodity prices.

Bukhari Khwaja explains that abrdn’s emerging market equity specialists seek long-term winning companies whose shares can be held even in challenging times. She notes that consumer stocks have performed well even as interest rates have risen, and economies have been closed due to COVID. abrdn has had an office in São Paulo since 2009 and the manager stresses the importance of having a local presence to regularly engage with companies. The team is a long-term investor, which helps to maintain a perspective when markets are volatile. Bukhari Khwaja highlights some of the important investment themes in ALAI’s equity portfolio including ‘aspiration’, where consumer companies are benefiting from strong demand from an expanding middle class and healthcare businesses from a low but growing private insurance penetration in Brazil. Embracing the ‘digital future’, the manager prefers better-established software companies with wider economic moats and broader customer/geographic bases than fintech businesses with higher valuations. For ‘going green’, Bukhari Khwaja comments that Latin America is home to some of the best-in-class producers of important commodities such as lithium, required for transition and electrification trends. ‘Financial services expansion’ is ALAI’s largest equity theme, where holdings include banks and stock exchanges. Regarding ‘tech enablers’, the manager says that Latin America offers access to skilled human capital and an innovative culture, which enables the creation of attractive business models in the technology space.

Szabó gives some perspectives on the macroeconomic backdrop in Latin America. He says inflation has surprised to the upside, led by higher food and energy prices, while investors have been cautious about the war in Ukraine. With inflation coming in above expectations, central banks have been tightening their monetary policies; for example, in Brazil, the base rate has risen from 2.00% to 13.75%. However, the Latin America market has performed relatively well compared with other regions as it benefits from higher soft and energy commodity prices despite political noise in the region. The manager says that an important issue is how leaders will address underlying structural issues in Latin America, where there are wide inequalities.

ALAI’s managers embed environmental, social and governance (ESG) considerations into the research of each asset class as part of the investment process. It is about active engagement, with the goal of improving the fund’s performance. The managers aim to make the best possible decisions, by understanding the whole picture, before, during and after an investment is made. This includes focusing on the environmental (including climate change), social and governance risks and opportunities they present, and how these could affect the longer-term performance of investments.

abrdn employs more than 1,000 investment professionals, who take ESG factors into account during their company research, stock selection and portfolio construction activities; they are supported by more than 50 ESG specialists around the world. Through engagement and exercising voting rights, the managers actively work with companies to improve corporate standards, transparency and accountability. In doing so, they aim to deliver improved financial performance over the longer term, as well as actively contributing to a fairer, more sustainable world.

At end-July 2022, ALAI’s equity exposure was 3.5pp lower compared with 12 months before and the total number of holdings had reduced by four.

ALAI’s top 10 positions (five equities and five government bonds) made up 38.5% of the portfolio at the end of July 2022, which was broadly in line with 38.8% a year earlier.

In terms of ALAI’s geographic exposure, in the 12 months to the end of July 2022, the most notable changes are a higher (+2.9pp) weighting to Mexico and a lower weighting to Argentina (-2.1pp).

Bukhari Khwaja highlights some of ALAI’s portfolio transactions so far this year. There is a new holding in Assaí Atacadista, a leading cash-and-carry Brazilian retailer that the manager believes is well-positioned to capture consumers’ changing habits. Telefônica Brasil has also been added to the fund. It is the major Brazilian telecom company that is benefiting from an improving competitive and regulatory environment. Complete disposals from the portfolio include: local services marketplace GetNinjas to reduce ALAI’s exposure to growth names; e-commerce retailer Mobly due to a challenging backdrop; retailer Magazine Luiza to fund better opportunities elsewhere; online education company Arco Platform for more compelling opportunities elsewhere with better operational performance; and also, renewable power business Omega Geracao, again to fund better opportunities elsewhere. Bukhari Khwaja explains that most of the exits are from Brazil, some of which were smaller investments in growth company initial public offerings. Some of these businesses are not scalable and it is difficult for a firm to prove itself when access to capital is tight.

Commenting on ALAI’s relative performance so far in 2022, Szabó says the fixed income portion of the portfolio has outperformed its bond benchmark, helped by its overweight exposure to Uruguay. The fund’s Brazilian long-duration exposure has underperformed, as due to higher inflation the Brazilian central bank has hiked interest rates by more than expected. However, the manager believes that over the longer term, a long-duration strategy in Brazil will be a ‘decent investment’ and its central bank is close to the end of its rate-hiking cycle.

Bukhari Khwaja reports that the fund’s Brazilian equity exposure has underperformed its equity benchmark in recent months due to negative stock selection. ALAI has an underweight exposure to Petrobras, as it is a politically sensitive stock with risks surrounding government interference; however, it has performed well and offers a high dividend yield. Within the energy sector, the manager prefers 3R Petroleum, which has high-quality assets acquired from Petrobras and has a holding in Colombia-listed GeoPark. An underweight position in banks has detracted from ALAI’s relative returns; they are high-beta stocks and can be volatile ahead of presidential elections. Stock selection in Mexico has helped ALAI’s relative returns, including not holding América Móvil (lack of growth opportunities and an unappealing valuation) and Cemex (ESG concerns).

ALAI’s equity underperformance in recent months has had a detrimental effect on the fund’s relative returns and it continues to lag the performance of its composite benchmark over all periods shown in Exhibit 7 in both NAV and share price terms.

The two funds in the AIC Latin America sector follow different mandates, so are not directly comparable; ALAI invests in equities and government bonds, while BlackRock Latin American Investment Trust is an equity fund. ALAI’s NAV total returns rank second over the periods shown. It is currently trading on a wider discount and is more highly geared than its peer. ALAI has a higher ongoing charge, as its fixed costs are spread over a smaller base, and is capped at 2.0% per year. The company offers a more attractive dividend yield.

To enable a broader comparison, in Exhibit 8 we also highlight a range of open-ended equity funds that invest in Latin America. ALAI’s NAV total returns are above their average return over one and 10 years, while lagging over the last three and five years. However, the trust’s dividend yield is higher than all those of the open-ended funds.

Historically, more than 60% of ALAI’s income has been derived from its fixed income portfolio. In FY21, the annual dividend was held steady at 3.50p per share for the sixth consecutive financial year; it was 0.76x covered by revenues.

So far in FY22, three quarterly dividends of 0.875p per share have been paid (flat year-on-year). While the dividend has been maintained, supplemented by revenue reserves, the board has previously stated that the payment of a sustainable and covered dividend may necessitate a lower dividend payment in future years. However, it is heartened that there are signs of a post-COVID recovery in ALAI’s income, although it keeps the company’s distribution policy under review. Based on its current share price ALAI offers an attractive 6.7% yield.

ALAI’s 18.3% share price discount to cum-income NAV is at the wider end of the 4.2% to 19.9% range over the last 12 months. It is also wider than the 11.7%, 12.7%, 13.1% and 10.7% average discounts over the last one, three, five and 10 years, respectively. Perhaps investors are concerned about the risk of a possible reduction in the dividend in future years or the fund’s underperformance versus its benchmark.

Renewed annually, the board has the authority to repurchase up to 14.99% and allot up to 10% of issued shares to manage a discount or premium. There have been no share repurchases since March 2020.

Launched on 16 August 2010, ALAI is a Jersey-incorporated closed-end investment company and is listed on the Main Market of the London Stock Exchange. Following shareholder approval at the December 2021 AGM, and effective from 11 January 2022, the company’s name was changed from Aberdeen Latin American Income Fund to abrdn Latin American Income Fund.

The fund is managed by abrdn’s global emerging markets equities and emerging market debt teams. They aim to generate a total return with an above-average yield from a diversified portfolio of Latin American securities. ALAI’s performance is benchmarked against a composite index: 60% MSCI EM Latin America 10/40 Index and 40% JP Morgan Government Bond Index EM Global Diversified (Latin America carve-out); both are sterling adjusted. The benchmark is used as a measurement rather than a portfolio construction tool.

ALAI’s portfolio contains equity, equity-related and fixed income securities; at the end of July 2022, it was split broadly 62:38 between equities and government bonds. To mitigate risk, at least 25% of gross assets must be held in equity and equity-related investments, and at least 25% in fixed income investments. At the time of investment, a maximum 15% of gross assets may be held in a single company, with up to 25% in non-investment grade government debt (rated BB+/Ba1 or lower). ALAI has no restrictions on its geographic, sector or market cap exposure. Derivatives are permitted for efficient portfolio management and to mitigate risk (up to 50% of gross assets). Gearing of 20% of net assets is permitted at the time of drawdown; at 26 August 2022, ALAI’s net gearing was 15.4%.

ALAI’s managers adhere to abrdn’s focus on quality and value. The two teams communicate regularly to discuss the macro backdrop, findings from recent company meetings and portfolio positioning (including the level of gearing).

Stocks are selected following thorough fundamental analysis; the emerging markets equities team essentially seeks ‘long-term winners’. These are high-quality companies with robust balance sheets that are cash generative and have strong management teams. An assessment of a firm’s ESG credentials is integral to the investment process. Risk management is also an important consideration; abrdn has an independent performance and risk team to ensure funds adhere to their respective guidelines and managers are aware of their risk exposures. ALAI’s portfolio turnover is relatively low, generally around 15% pa, which implies an average seven-year holding period, although many equity investments have been held for considerably longer.

The emerging market debt team seeks high-quality securities that generate a sufficient level of income, so investments are biased to higher-coupon issues, ensuring that the equity team can focus on selecting companies for their total return potential rather than income. Analysis is on a bottom-up basis, with emphasis on the perceived prospects of each individual country. The team looks for relative value opportunities and builds ALAI’s debt exposure accordingly. For liquidity reasons, investments are made in government or quasi-government issuers rather than corporate debt. They are generally in local rather than hard currencies, but the team can hedge or take forward currency positions. Fixed income positions are also held for the long term.

ALAI is not permitted to take out fixed long-term borrowings. The company has a one-year £6m revolving multi-currency loan facility with The Bank of Nova Scotia, London branch, of which £5.5m is drawn down. The board continues to monitor the level of gearing under recommendation from the manager and taking current market conditions into account. At 26 August 2022, ALAI’s net gearing was 15.4%.

ALAI pays abrdn an annual management fee of 1.0% of its NAV, which is divided 40:60 between the revenue and capital accounts respectively. This reflects the prospective split between future revenue and capital growth. The manager has agreed that the fund’s ongoing charge ratio (OCR) will be capped at 2.0%, with any excess fees rebated by the manager. In FY21, the OCR was 2.0% (including a £127k rebate), which was in line with FY20 (including an £83k rebate).

ALAI is a Jersey-registered investment company with one class of share; there are currently 57.1m ordinary shares in issue (with a further 6.1m held in treasury). Its average daily volume over the last 12 months is c 80k shares.

As part of the board’s succession planning, Richard Prosser stood down as chairman at the conclusion of ALAI’s AGM on 20 December 2021; he is succeeded by Howard Myles. Prosser continued to act as a non-executive director until the completion of an external search for, and the appointment of, a Jersey-resident independent non-executive director.

On 18 February 2022, the board announced the appointment of Michael Gray as an independent, non-executive director, effective immediately. He has extensive investment management experience, including as a closed-end fund director. Gray has over 30 years’ management experience in banking, both with ultra-high net worth clients and corporate banking. More recently, he has utilised his corporate experience across a range of industries and is now acting as an adviser to several companies with global interests. Gray is non-executive director of EPE Special Opportunities, Foresight Enterprise VCT, GCP Infrastructure Investments (where he is chairman of the investment committee), JTC and TEAM. He will stand for election as one of ALAI’s directors at the AGM to be held on or around 14 December 2022.