Utilico Emerging Markets

1 Material produced by Kepler Trust Intelligence should be considered a marketing communication, and is not independent research. Please see the important information at the bottom of the page. Utilico Emerging Markets Summary Utilico Emerging Markets Limited (UEM) has a portfolio of predominantly developing world equities that has a clear focus on stocks and sectors that display the characteristics of essential services or monopolies. The portfolio is managed by Charles Jillings and the sizeable team at ICM. Charles and the team are bottom-up investors who run the fund with few peers in the investment trust universe, with a portfolio that is almost entirely focused on the emerging market utilities and infrastructure sectors with a bias towards asset backed, cash generative and often monopolistic companies. In essence, Charles aims to own companies that meet the growing needs of the ever-increasing middle classes in emerging markets countries, which we discuss in this article. UEM has built up a long term track record of outperformance particularly in flat or falling markets. Though it lagged the MSCI Emerging Markets index in 216 when sentiment towards the developing world improved dramatically, its NAV total returns of 48.9% over five years to the end of February 218 puts the trust considerably ahead of the index (4.7%) and its average peer in the Morningstar IT Global Emerging Markets sector (35%). There have been certain notable changes to the portfolio over the past year. Charles and the team have reduced overall concentration, shifted the portfolio away from Asia and more towards Latin America while recently reducing the overall level of gearing. The decision to increase the trust s weighting to Latin America has had a positive impact on the dividend, which yields 3.11% at the time of writing. UEM has tended to be one of the highest yielders in the sector and the board has not cut the dividend since its launch in 25, but due to various factors, had to fund a proportion of the 212, 213, 214 and 215 dividends from capital. However, the higher yielding nature of the Latin American stock market, has meant the trust s revenue return per share has increased dramatically over the past two years resulting in covered dividend payments in 216 and 217. This leaves the trust (as at the 217 financial year end) with revenue reserves of.69x. Discounts across the AIC Global Emerging Markets sector have remained wide for some time now, and UEM is no exception, averaging a -1.69% discount over the past three years (to the end of February 218). The board aims to mitigate the discount getting too wide and buys back shares when the discount pushes too far past double-digits. They have been very active in this regard, having cancelled 9.8m shares so far in 218 already. The trust currently trades on a 14% discount (as of the end of February 218), which is wider than its longer-term average. Portfolio UEM is run via a bottom-up, benchmark-agnostic strategy. Charles and the team have a differentiated investment approach, as they focus on stocks and sectors that display the characteristics of essential services or monopolies. This means the portfolio is heavily skewed towards what they view as highquality utilities, transportation infrastructure, communications or companies with a unique product or market position. As the managers put it, they are aiming to own shares in businesses that meet the needs of the growing and increasingly wealthy emerging market middle classes. Charles takes a long-term perspective when investing, actively seeking cash generative companies, the majority of which are asset backed. The portfolio is constructed with no reference to a benchmark index but via a bottom-up screening process of their investible universe of approximately 9 companies. The companies that pass the selection criteria undergo thorough fundamental research, which includes construction of detailed financial models and valuation targets. Accompanying the fundamental research, the team visits both the assets (a vital activity given its focus on utility and infrastructure names) and the company management. This helps to ensure they are gaining exposure to strong management teams who are good allocators of capital; illustrated by the fact that around three quarters of the trust s holdings pay a dividend. Charles also tries to gain an insight into the overall economic picture through speaking with government ministers and economists, helping to gain a greater understanding of the trends driving emerging market economies and how they will impact corporates. This helps to further understand the corporate governance of the company, which is a major attraction for the team. The sector breakdown is highlighted in the chart below, with stocks within the electricity, gas, ports, airports and water and waste industries all featuring prominently in the portfolio. Over the past year, ten changes have been made to the top 2 holdings and Charles has shown a clear push to make the

2 portfolio more diversified, having reduced the concentration of top 1 holdings (the top 1 positions accounted for 44% of NAV as of the 216 annual report and at the time of writing equate to 32.8%). Interestingly, this is a result of the team s positivity towards emerging markets and (thanks to various structural changes within different developing world economies) they are finding an increasing number of opportunities to invest into. Infrastructure Investment Funds Source: Utilico Water and Waste Road and Rail Utilico Emerging Markets Exposure Telecoms Renewables Satellites Other Other Infrastructure Airports Sector Exposure Electricity Gas Ports An area where the team have found increased opportunities has been Latin America. In Argentina, for example, UEM has increased exposure by 8.3% (over the last year to end-january 218). The election of Mauricio Macri has had a significant impact on this. Under the previous administration capital controls meant the country was almost un-investable, but the new president s team have fast tracked various political reforms including those focused on the energy sector. This has led to the implementation of new tariffs, making companies such as TGS (the country s dominant gas transmission company and one of the trust s newest holdings) far more profitable. Since January 217 (to end-january 218) UEM have also increased their exposure to Brazil (+5.%), an area where the team has witnessed a marked improvement in corporate governance. An example of this change is Rumo, Brazil s largest railroad-based logistics operator in terms of total volume transported. The company has four rail concessions across Brazil to the country s main export centres, but up until recently, hadn t been run in the interest of minority shareholders. However, following a change in management, the company is now far more focused on cost management and less on short-term pricing all of which has culminated in far stronger earnings growth. The team note that Rumo is an example of how they can find opportunities via bottom-up research in an area of the market where more macro-focused investors would avoid all together. The regional breakdown of the portfolio is highlighted below, with 31.6% of the portfolio now in Latin America (nearly 24% of which is in Brazil). This compares to 2.2% weighting to Latin America in March 216. This increased weighting has predominately been funded by a reduced allocation to Asia, which as we note in the performance section, has had a material effect on the trust s income account. Other Latin America Other Europe Malaysia Middle East / Africa Source: Utilico One of the trust s other large country positions is Romania, which accounts for 1.4% of the NAV. There are various reasons why the team are positive on the country. Firstly, economic growth is strong in Romania, while recent policy announcements have forced state-owned enterprises to distribute significantly more cash to investors. UEM s exposure to Romania has been a major contributor to recent returns, but the team remain very positive on their holdings in the country (particularly Conpet, Transelectrica and Transgaz) as valuations are still very low despite the favourable macroeconomic backdrop. It is worth noting that the trust s relatively niche investment universe (the team s bespoke database totals c.9 potential stocks) and the team s bottom-up approach leads to a portfolio that is highly differentiated relative to both the MSCI Emerging Markets index and its average peer. A further differentiator is the trust s 3.5% weighting to private companies, though Charles doesn t expect this segment to play a major part of the portfolio going forward due to the team s focus on companies that offer regular reporting and a better corporate governance framework. Gearing The managers have maintained their bullish approach moving into 218, with the trust currently 7% geared. This less than the past year s average of approximately 11%. Returns Other Asia India Chile The Philippines Utilico Emerging Markets Thailand Argentina Regional Breakdown Brazil China (including Hong Kong) Romania For the past seven years (up until the end of February 218), UEM s NAV return (87.7%) has outperformed both the MSCI Emerging Markets index (51.%) and the Morningstar IT Global Emerging Markets sector average (5.4%). However, throughout 217, UEM has struggled to offer the same returns. Over the year, UEM s NAV return was 19.8%, in comparison to the MSCI Emerging Markets NAV return of 25.4%. The average peer in the

3 Morningstar IT Global Emerging sector also outperformed UEM, with an NAV return of 24.9%. % 1 75 5 25-25 Utilico Emerging Markets: Performance vs Benchmarks 17/3/11-28/2/18 212 213 214 215 216 217 218 Utilico Emerging Markets (NAV) Utilico Emerging Markets (Price) Morningstar IT Global Emerging (NAV) MSCI Emerging Markets (NAV) Given the team s investment style, UEM tends to have less exposure to economically-sensitive stocks than the benchmark and that more defensive tilt has been a primary driver of the trust s medium- and long-term outperformance. On the other hand, this defensive approach has contributed to the underperformance experienced during 216 and 217. Over five years to the end of February, for example, in NAV terms the trust has been less volatile and posted a considerably lower maximum drawdown (-18.9) than the Morningstar Investment Trust Global Emerging peer group (-23.3). It has also posted as Sharpe ratio of.49, which is better than the risk-adjusted returns for the MSCI benchmark (.4) and the Morningstar sector average (.3). All the while, UEM s 5-year (to the end of February 218) down market capture ratio has been 6.1%, in comparison to the peer average of 88.14% (Morningstar IT Global Emerging). The flipside of this more cautious positioning, however, is that the trust has tended to lag in rallying markets. This is reflected in the trust s upside capture ratio relative to the index of 75.% (an upside capture of less than 1% means the trust doesn t partake in as much upside when an index goes up in value). Another way of highlighting the trust s performance profile is via its discrete annual returns, as shown in the chart below. Utilico Emerging Markets: Returns 21-218 In 216, a year when sentiment towards the developing world improved dramatically, the trust struggled to keep pace with the index (which is biased to areas such as mining and financials, sectors the trust has no exposure to). It also lagged the index in 29, the year markets rebounded from the global financial crisis and (despite strong absolute returns of 17%) is struggling to keep pace with the index over 217. However, it protected capital more effectively in 211 (the year China s economic slowdown first started to spook markets) and in 215 (a year when China s stock market collapsed and growth scares caused a global equity market correction). It even managed to deliver double-digit gains in 213 when the index and sector fell 5%. One of the risks that face shareholders in UEM is that of rising US interest rates, which might mean that DCF valuations of the companies that UEM owns might come down. Currently dollar weakness is probably offsetting this, but should the dollar strengthen once again, this could prove a headwind to the strategy. Dividend As previously mentioned, income is a major part of the team s strategy. The managers of UEM focus on management teams who are good allocators of capital and therefore prefer those that have the discipline of paying a dividend. UEM has typically been one of the highest yielders in the AIC Global Emerging Markets sector (current yield is 3.1%) and the board have not cut the dividend since the trust s launch in 25, though it has held the dividend at times over the period. Therefore, there is a clear incentive for the board to not cut these dividends, and to maintain this long track record. UEM s income generation is generally greater during the first half of the year, thus, an announcement has been made to increase the third and final interim dividends from 1.7p to 1.8p, indicating a total dividend of 7.p for FY18, 5.3% higher than in FY17. 1 Ultilico Emerging Markets: Dividend 26-217 4 7.5 2 5-2 2.5-4 21 211 212 213 214 215 216 217 218 Utilico Emerging Markets (NAV) Morningstar IT Global Emerging Markets MSCI Emerging Markets 26 28 21 212 214 216 Dividend Per Share Revenue Per Share

4 As the chart above shows, however, the trust s revenue return per share dropped significantly after 212 meaning the board has to rely on a proportion of capital to fund its dividend to shareholders. Recent portfolio activity has meant the trust s portfolio income has increased dramatically since 215, resulting from the team s bottom-up approach to investing more in Latin America (which has higher yielding stocks). This allowed the board to pay a covered dividend in 216 and 217, meaning it now has revenue reserve cover of.69x of the total 217 dividend and we would expect that to increase over the coming years. Overall, the trust annualised dividend growth over five years has been 3.8%. We understand that Charles is confident in the portfolios own earnings per share growth over the coming few years. Management Charles Jillings, who is a director at ICM Limited, the Bermudabased fund manager with over 16bn under management, has been responsible for the day-to-day running of UEM since its inception in 25. He is a qualified chartered accountant with over 3 years experience in financial markets and is supported by a large team at ICM including 1 sector specialists. Charles sat on the board of UEM until 212, when he stepped down to strengthen its independence. For example, the board aims to buy back shares if discount widens into double-digits, and so far in 218, 9.8m shares have been repurchased. Despite this, the discount still stands at 14% as of the end of February 218. Charges UEM has management fee of.65% of net assets plus a company secretarial fee. It also charges a performance fee equal to 15% of the amount of any outperformance of the higher of (i) the post-tax yield on the FTSE Actuaries Government Securities UK Gilt 5 to 1 years Index, plus inflation (on the RPIX basis), plus 2%; and (ii) 8%. Excluding this performance fee, the ongoing charges figure (OCF) is 1%, having come down from 1.1% a year ago. ICM Group consider themselves as an innovative, long-term global asset manager. Their approach involves maintaining a strong conviction-led, bottom-up investment approach across multiple companies in varying sectors around the globe. Discount UEM s shares have traded on a persistent discount over the medium term (the average being 8.77% over the past seven years). The discount has been relatively volatile over the past two years as sentiment towards emerging markets has ebbed and flowed, though the board has been active in trying to mitigate this risk. Utilico Emerging Markets: Discount 1/3/11-28/2/18-5 % -1-15 -2 212 213 214 215 216 217 218

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