Utilico Emerging Markets Trust

Summary

Utilico Emerging Markets Trust (UEM) is managed by Charles Jillings at specialist investment firm ICM Group. He strongly believes the trust’s portfolio is undervalued and is encouraged by the recent earnings reports from the majority of UEM’s investee companies. The trust has generated robust absolute and relative performance compared with the MSCI Emerging Markets Index over the last 12 months. Jillings continues to invest for the medium to long term in companies with attractive business models and avoids short-term ‘noise’ in global stock markets. UEM’s dividend is more than fully covered by portfolio income and the manager says his confidence in the trust’s prospects is reinforced by the board’s regular repurchases of UEM’s shares.

The analyst’s view

The positive relative growth prospects and attractive valuations of emerging compared with developed markets remains intact. UEM offers investors unique exposure to the relatively stable business models of infrastructure and utility companies in emerging regions. They generally have high operating leverage, with long-term assets operating under established regulatory frameworks, which should continue to deliver predictable and sustainable income streams. UEM has a covered dividend, and the annual distribution has grown or held steady every year since the fund was launched in July 2005, while Jillings remains very confident that the trust’s portfolio is undervalued. ESG considerations are becoming an increasingly important element to UEM’s investment process. However, if a potential investment has a high total return potential but a low ESG score, it will not automatically be disregarded as an addition to the trust’s portfolio, as ESG is part of the investment process, not the driver.

Outperformance may warrant a higher valuation

UEM’s discount remains higher than the board’s desired sub-10%. One may argue that the trust’s solid absolute and relative performance over the last 12 months could warrant a higher valuation. UEM’s shares are currently trading at a 14.5% discount to cum-income NAV, which compares with the 12.1% to 12.4% range of average discounts over the last one, three and five years.

Market outlook: Reiteration of favourable growth in EM

While there is undoubtably uncertainty in global markets due to the ongoing pandemic effects and more recently the war in Ukraine, emerging markets continue to have higher growth potential compared with developed markets. Factors driving this higher growth rate include urbanisation, a rising middle class and digitisation. In its January 2022 World Economic Outlook update, the International Monetary Fund forecast GDP growth of 4.8% in 2022 and 4.7% in 2023 for emerging markets and developing economies compared with 3.9% and 2.6% respectively for advanced economies. Highlighted in Exhibit 1 (right-hand side), emerging market and emerging market infrastructure equities remain more attractively valued compared with the world market on a forward P/E and price-to-book multiple basis and offer a higher dividend yield. With better growth potential and relatively attractive valuations, investors may benefit from considering an allocation to emerging markets, taking into account that infrastructure and utility businesses may have more stable returns compared with those in other areas.

The fund manager: Charles Jillings

The manager’s view: A challenging macro backdrop

Jillings says the world’s attention is now focused on Ukraine following the Russian invasion. He considers it shocking that Russian President Vladimir Putin is going down the route of victory at all costs and has escalated the level of aggression. Western nations are trying to put as much pressure as possible on Russia via sanctions and these are expected to increase, with the refusal to accept Russian oil imports by the US an important development. The manager says that unfortunately, the next major step is likely to be weeks or months away. He believes that energy sanctions will bring a whole different ball game, as it will have a material effect on global markets given that the West is short of energy. He suggests that even if a resolution is found or there is a change in direction, taking a medium-term view, Russia will be a pariah state as the West will not back down now and has recognised the leadership’s real motives. Jillings expects commodity prices to remain elevated; he sees the beneficiaries as emerging markets, including Latin America. He opines that there will be a scramble for soft commodities, with farmers likely to offload their excess stocks.

The manager believes that the loss of economic activity in Russia and Ukraine will be more than made up for by strength elsewhere in the medium term. He is optimistic about the prospects for emerging market equities over this time frame; however, over the short term he thinks that it is unclear how the Ukrainian-Russian situation will be resolved and how much of an impact it will have on global stock markets.

While everyone is understandably talking about Ukraine rather than the global pandemic, Jillings says that a real challenge is how China will deal with its zero-COVID-19 policy and move towards a strategy of living with the disease, which has been adopted in other parts of the world. Now that antiviral therapies have been developed and the Omicron variant has been less severe that prior strains, hospitalisation and death rates have declined. However, as evidenced in the UK, with people developing COVID-19 symptoms and isolating, there can be significant disruptions within the work force. The manager suggests that China will have to change its zero-tolerance approach to the disease, but this could lead to disruption in global supply chains and affect China’s short-term GDP growth.

Turning his attention to inflation and interest rates, Jillings believes that while higher interest rates are a headwind to global stock markets, they will not restrict economic activity and business performance; instead, he views them a sensible normalisation following an extended period of very loose monetary policy. The manager says that before the war in Ukraine, European inflation was declining, compared to an acceleration in the United States due to higher wage pressure. He suggests that the war has dented central banks’ confidence in raising interest rates, although an energy price shock remains an issue. Jillings opines that it will be very difficult to deal with a global energy shortage, which he considers is very different to straightforward higher fuel prices.

UEM had less than 0.5% of the portfolio invested in Russian securities before the local stock market closed, as the manager had already sold two-thirds of the trust’s single Russian exposure as tensions built. The residual holding has been written down to zero (for more detail please see the Current portfolio positioning section below). Jillings suggests that the world will recognise that there are a lot of checks and balances that need to be put in place, and the fact that NATO, the United States, Europe and the UK are standing shoulder-to-shoulder against Russia is important as it means that China should think twice before undertaking any aggressive policies. As a result, the manager believes that geopolitical risks should actually decline in the future rather than escalate, although he thinks that China–US trade frictions are likely to continue, and in the short term, tensions remain high.

In general, UEM’s portfolio companies’ earnings continue to surprise to the upside. Its largest holding International Container Terminal Services (ICTS) is a global port management company headquartered in the Philippines. Jillings refers to the firm as a ‘poster child’ that rightly deserves to be UEM’s number one position. ICTS’s recent earnings release was very strong, with Q421 revenues rising by 24.4% and EBITDA by 32.5% with a 61.9% EBITDA margin. Volumes increased by 4.7% and yields rose due to higher port tariffs and the addition of ancillary services. The company’s management is confident that current yields can be sustained, which provides a firm footing for its business in 2022, while it is cautiously optimistic that volumes this year can rise in the mid- to high-single-digit range. ICTS’s exposure to Russia/Ukraine is only via two ports, one in Georgia where 20% of volumes are from Russia and Ukraine, but this represents c 1% of the company’s total throughput, while the other port is in Poland, which has low exposure to Russian businesses. The manager believes that although there may be a disconnect from the conflict in Ukraine, global trade remains strong and ICTS is well positioned given higher tariffs and strong cost controls, which the company implemented during the COVID-19 pandemic-driven economic slowdown.

Jillings notes that portfolio companies provided conservative revenue and earnings guidance during the pandemic, but now some firms are increasing their dividends, including ICTS, which increased its annual distribution and also paid out a special dividend. Generally, capex was reduced during the pandemic but now cash flows are coming through strongly and companies are more willing to return cash to shareholders.

Current portfolio positioning

At end-February 2022, UEM’s top 10 holdings made up 29.8% of the portfolio, which was lower than 31.9% a year before; seven positions were common to both periods. Jillings is encouraged by the fact that dividends are coming through strongly from a number of portfolio companies; for example, within the top 30 holdings, Sonatel increased its dividend by 15%, Telecom Egypt by 33%, KT Corp by 42% and Citic Telecom by 7%.

UEM’s portfolio is widely diversified by industry and geography, as shown in Exhibit 3. The trust holds only one London-listed company operating extensively in Russia: rail freight operator Globaltrans Investment, which was worth £4.3m (0.8% of the portfolio) as at 31 January 2022. During February, the manager sold around two-thirds of this position, realising £1.5m in proceeds. Globaltrans has not been sanctioned; ICM has a strong compliance and risk framework and will continue to ensure that UEM complies with any new sanctions as they emerge. Globaltrans’s shares have now been suspended and the residual holding has been written down to zero. The trust has no direct investments in Ukraine, and its European exposure, primarily investments in Romania, Poland and Bulgaria, was 11.7% of the portfolio at 28 February 2022.

Alupar Investimento is a Brazilian electricity generation and transmission company that has a growing number of projects including four new transmission lines. Its recent earnings results showed strong EBITDA growth helped by inflation-adjusted pricing. The manager reports that this holding has been a significant and successful investment for UEM which has been in the fund for nine years. Some portfolio companies are finding business conditions more challenging, such as Gujarat State Petronet, which is an Indian gas transmission and distribution company that is experiencing higher liquified natural gas (LNG) input costs. The company has put through three rapid tariff hikes, but these have not kept pace with the rate of higher LNG prices, which is squeezing its margins. However, the manager considers that this situation is temporary, and margins will improve.

UEM’s relative performance is shown in Exhibit 6. It has performed particularly well versus the MSCI Emerging Markets Index over the past 12 months and is also ahead over the last decade. The trust’s NAV has outperformed the MSCI Emerging Markets Utilities Index over the last five and 10 years, while its share price has also modestly outperformed over the last three years. Jillings explains that during the pandemic, companies involved in digital technology and working from home performed very well. However, since COVID-19 vaccines were approved in November 2020, there has been a steady rotation back into value and cyclical stocks, while technology stocks have come under pressure. Hence, the manager is unsurprised that UEM has performed so well versus the MSCI Emerging Markets Index over the last year. Meanwhile, he suggests that the valuation metrics of UEM’s portfolio are more attractive now than they have been over the last 15 years.

There are 13 funds in the AIC Global Emerging Markets sector, of which UEM is the fourth largest. The trust has a unique strategy so cannot be directly compared with its peers, although the table above does provide some context. UEM’s NAV total return is above average over the last 12 months, ranking fifth, although it is below the mean over the other periods shown. This is unsurprising given the lower-beta nature of its investments and a strong bull market over the last decade. These returns do not take the dilutive effect of the trust’s historical subscription shares before February 2018 into account. UEM’s valuation is currently the ninth highest in the peer group, where no funds are trading at a premium. It has a below-average ongoing charge and a level of gearing that is in line with the mean. The trust’s dividend yield is the sixth highest in the peer group, 1.1pp above the average, and Jillings reports that UEM is one of the very few funds in the group that had a covered dividend during the pandemic.

Dividends: Progressive policy

UEM’s annual distribution has been increased or maintained every year since the fund was launched in July 2005. Quarterly dividends are paid in September, December, March and June from income or capital when required. So far in FY22, (ending 31 March 2022), three quarterly dividends of 2.0p per share have been declared, and the board expects to pay out the same amount for the fourth quarter; they have been fully covered by income. An 8.0p per share total dividend for FY22 would equate to a 2.9% increase year-on-year, and based on its current share price, UEM offers an attractive 4.0% dividend yield.

Valuation: Board still aspires for a sub-10% discount

UEM’s discount is narrowing gradually, but Jillings comments that it remains stubbornly above 10%. The trust’s current 14.5% share price discount to cum-income NAV compares with a 9.0% to 14.5% range over the last 12 months and average discounts of 12.1%, 12.4%, 12.3% and 10.2% over the past 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. So far in FY22, c 5.3m shares (c 2.4% of the share base) have been bought back at a cost of c £11.3m.

Fund profile: An emerging market equity specialist

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), which is a specialist fund manager based in Bermuda and the UK with c $26.9bn of assets under management (c $2.8bn directly and c $24.1bn indirectly).

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 are a series of 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; at end-February 2022, UEM had net gearing of 2.6%. From launch to the end-February 2022, UEM’s NAV total return has compounded at 9.3% pa.

Investment process: Diligent bottom-up stock selection

Jillings seeks to identify and invest in companies predominantly in the infrastructure and utility sectors that are trading at a discount to his estimated intrinsic value, and which he believes have the potential to generate total returns of at least 15% pa, at an investee company level, over a five-year horizon. The manager focuses on emerging market countries with positive attributes such as political stability, economic development, an acceptable legal framework and an encouraging attitude to foreign investment. Jillings has a long-term investment horizon and avoids short-term stock market ‘noise’.

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 90 holdings in the portfolio, which is at the high end of the typical 60–90 range. 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. Jillings is supportive of UEM’s 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.

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.

UEM’s approach to ESG

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 an attractive total return potential. Every investee company is questioned about its ESG footprint, 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:

• Understanding – in-depth analysis of the key issues that face potential and current holdings, as well as a deep understanding of the industry in which they operate.

• Integration – incorporation of the output of the ‘understanding’ into the full financial analysis to ensure a clear and complete picture of the investment opportunity is obtained.

• Engagement – communication with investee companies on the key issues on a regular basis, both virtually and on location, where possible, to discuss and identify any gaps in their ESG policy to further develop and improve their disclosure and implementation.

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

Gearing

UEM has a three-year unsecured £50m revolving credit facility with The Bank of Nova Scotia (London branch) that expires on 15 March 2024. The trust’s debt is reduced as investments reach fair value; however, Jillings continues to invest in the portfolio, so he expects the level of gearing to gently increase. At end-February 2022, UEM’s net gearing was 2.6%.

Fees and charges

From the start of FY22 (1 April 2021) ICM is paid 1.00% of NAV up to £500m; 0.90% above £500m up to £750m; 0.85% above £750m up to £1bn; and 0.75% above £1bn (previously a flat fee of 0.65% of NAV); and the performance fee has been removed. 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 H122, UEM’s annualised ongoing charge ratio was 1.3%, which was 20bp higher year-on-year.

Capital structure

UEM has 215.9m ordinary shares in issue and its average daily trading volume over the last 12 months is c 245k shares. The trust has a five-yearly continuation vote, 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 board

The directors’ fees are paid in UEM shares, ensuring all shareholders’ interests are aligned. Susan Hansen is considered non-independent as she is also on the board of Resimac Group, which is associated with ICM. Anthony Muh has indicated that he will retire following the conclusion of UEM’s September 2022 AGM.

As part of a board refresh, the trust has two new directors. On 26 November 2021, the board announced the appointment of Isabel Liu as an independent non-executive director with immediate effect, following an external search. She has more than 25 years of global experience investing equity in infrastructure, including the $1bn AIG Asian Infrastructure Fund, the €1bn ABN AMRO Global Infrastructure Fund and was managing director of the Asia-Pacific investment business of John Laing. More recently, Liu served as a non-executive director of Pensions Infrastructure Platform, which is backed by UK pension schemes to invest in UK infrastructure. She has been a board member of Transport Focus, the consumer watchdog for public transport and England's highways, and Heathrow Airport's Consumer Challenge Board. Liu is currently a non-executive director of Schroder Oriental Income Fund. She holds a BA in economics from the Ohio State University, a master’s in public policy from Harvard Kennedy School and an MBA from the University of Chicago Booth School of Business. On the date of her appointment, Liu’s husband held 6,802 UEM shares.

Mark Bridgeman joined the board on 22 September 2021 as an independent non-executive director following an external search. He is currently a non-executive director of Law Debenture Corporation, where he is also chair of the audit and risk committee. Bridgeman has a fund management background, having spent 19 years at Schroders as an analyst and then fund manager, rising to become global head of research. Previous roles at Schroders included head of pan-European research, head of global sector research and an emerging markets fund manager. He left Schroders in 2009 to manage a rural estate and farming business in Northumberland. Bridgeman was also previously a non-executive director of JPMorgan Brazil Investment Trust and Blackrock Emerging Europe.