Adventurous trust outperforms, but discount weighs down share price

Emerging market funds have faced a number of headwinds in the short term, which serves as a reminder to investors of how vital it is to have a stomach for risk and be prepared to think long term when investing in this area of the stock market.

Utilico Emerging Markets (LSE:UEM)investment trust has delivered over the long term, but its share price performance has suffered over its latest financial year (to 31 March 2024) owing to a widening in the discount.

Below, we run through the results and outlook, and share our latest ii View on the trust, which is one of our Super 60 investment ideas.

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The numbers in detail (for financial year to 31 March 2024):

Price Return: +5.8%
Net Asset Value (NAV) Return: +12.8%
Index Return: +5.8%
Dividend: 8.6p (vs 8.45p prior year)
Discount: -19.3% (versus -13.5% prior year)
Gearing: Nil (7.1% prior year)

Performance

The year to March 2024 yielded continued macroeconomic challenges for emerging markets, which were troubled by elevated US bank rates, a continuation of geopolitical tensions and the eruption of war in the Middle East.

Nonetheless, markets were supported somewhat by the expectation of softening interest rates globally, and the MSCI Emerging Market index rose by 5.8%, with Brazil and India performing notably well.

Utilico Emerging Markets Trust gave a strong performance on a NAV basis in the year, returning 12.8%. However, on account of a widening discount to NAV, the price return of 5.8% was in line with the benchmark.

Top contributors to the portfolio at a stock level came from a range of geographies, while the underweight China exposure, as well as a write-down in the notable allocation to the unlisted Petalite, detracted.

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Petalite is a UK start-up that has developed new charging technology for electric vehicles. It is unusual to see a UK unlisted stock in an emerging market portfolio.

Fund manager Charles Jillings has previously explained that the decision to invest in the UK start-up was driven by wanting to have exposure to the electric vehicle (EV) theme, but he said “as a team, we inherently feel uncomfortable going into the unlisted space, into places away from the UK”.

The trust’s track record remains solid, with notable outperformance over three, five, 10 years and further. Over the past 15 years to end of May 2024, the trust has generated an annualised 8.5% return (2.3% above the MSCI EM index).

Outlook

Management’s view is that, despite recent challenges, the same structural growth drivers remain across emerging economies. In addition to the diverse strengths of each country, this broadly includes a rapidly growing middle-class driving consumption, growing and increasingly educated populations, and the expanding role that emerging economies are playing in the development of global infrastructure – a key focus of UEM’s portfolio.

Discount

Despite strong performance in the portfolio, UEM’s discount widened from -13.5% in March 2023 to -19.3% at the period end. This discount exceeds the level desired by the board, and UEM bought back shares to counter this trend, providing marginal support to the total return over the period.

Dividend

A small dividend payout increase of 1.8% to a full-year dividend of 8.6 pence per share was fully covered by earnings. While there was a small dip in earnings per share (EPS), revenue reserves continued to grow healthily and provide some assuredness to future distributions.

Portfolio

Throughout the period, new purchases were subdued due to a priority of capital being employed to buy back shares and pay down debt facilities, which made for a small shrinkage of UEM’s gross assets. Gearing has therefore fallen to nil, although negotiation of a new facility is pending.

The team exited positions in Vamos, a Brazilian truck fleet business (and a recent poor performer), and Grupo Aeroportuario del Pacifico SAB de CV ADR (NYSE:PAC), a Mexican airport operator.

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Brazil remains the highest-conviction allocation, and has grown from 21% to 26% of UEM’s portfolio (just 5% of the benchmark MSCI EM). It’s a country for which management tout a wealth of commodities resources and strong trade position. China is the second-largest exposure (11% of the portfolio). although it has seen some reduction due to 2023’s weakness of valuations.

One notable change to the portfolio is the reduction in unlisted exposure, falling from 10.8% a year ago to 4.5% at period end. While there was some mixed performance in the unlisted portfolio, the largest holding, Petalite, was written down by 70% as the wider EV market weakened.

ii View

Utilico’s results highlight a period of strong NAV outperformance for the listed portfolio versus the wider market, which was negated by a widening of the discount to near -20%.

It’s worth noting that this discount displeased the board. It briefly represented the deepest discount in over three years and was a notable divergence from the three-year average (circa -14%). Even the current discount level of near -17% is confounding given the impressive outperformance across the portfolio and, despite UEM’s appreciable scale and track record, this represents the deepest discount of its peer group. It has been encouraging to see a small, positive contribution from the board putting capital to work in buying back shares throughout the year, and a small narrowing since the period end.

The news of Petalite’s substantial write-down (the largest detractor from the year’s performance) is less pleasant reading for investors, given this was formerly a top holding and UEM own a substantial portion of the business. The decision to revalue the position by the same degree as listed peers (-70%) goes some way in addressing the risk of subjectivity in valuations, and reflects the stresses felt in the wider EV sector and across nascent companies in general. It’s a reminder for investors that private holdings that are being accurately and frequently revalued can also be a source of short-term volatility.

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The trust is a highly active and differentiated product, given its thematic focus on utilities and infrastructure businesses. In addition, it stands out for its private-market allocation, and markedly differentiated country exposures, favouring Latin America and Europe over the index’s China and India. These biases have resulted in a much different return profile for the trust compared with its benchmark over the years.

What has impressed over the long term is the team’s record of excess returns above a conventional benchmark through investment in sectors more typically thought of as defensive – utilities and infrastructure. It is testament to their thesis that these are sectors and companies set to benefit from being the facilitators and foundations of global mega-trends, such as societal transformation, digitisation, and the energy transition.

This reported year was no different. The MSCI Emerging Markets benchmark was driven by technology, especially artificial intelligence (AI) related names such as Taiwan Semiconductor Manufacturing Co (NYSE:TSM), Samsung (LSE:SMSN) and SK Hynix. Utilico, however, managed to derive outperformance on a NAV basis from the structural overweight to industrials and utilities, with contributors spread across regions.

Despite slippage in income within the portfolio, the dividend was grown and the reserve makes up a healthy portion of the current distribution level (circa 3.8% yield).

In conclusion, Utilico continues to provide specialist access to a high conviction and differentiated portfolio of utilities, transport infrastructure and communications companies across predominantly emerging regions.

It is an adventurous approach, much diverged from peers and the index from a geographic and sector perspective, as well as its quite singular exposure to private markets (4.5%).

The small uplift in the yearly ongoing charge (to 1.5%) reflects an increased spend on marketing and admin, as well as the increased cost of financing. It’s a high charge, but UEM offers expert navigation of exposures that are seldom found elsewhere.

Crucially, the trust has still been able to generate good excess returns after fees for investors over time.