This is independent research. The analyst who has prepared this research is not aware of Kepler Partners LLP having a relationship with the company covered in this research report and/or a conflict of interest which is likely to impair the objectivity of the research and this report should accordingly be viewed as independent.
Fundsmith Emerging Equities Trust (FEET) employs the same strategy as the highly successful Fundsmith Equity open-ended fund, but applies it within the emerging and frontier markets regions. The three core rules as described by Fundsmith founding partner Terry Smith are to buy good companies, avoid overpaying, and “do nothing”.
This has led to a concentrated portfolio of 39 holdings with a strong bias to the ‘quality’ style: companies with high levels of cash generation, high and sustainable (in the manager’s view) return on capital employed, and management that acts in shareholders’ interests.
The fund is also concentrated in terms of geographical and sector exposures. The portfolio has 43% in Indian stocks, which is a passive breach of its 40% maximum in one country, and 66% in consumer staples companies. This latter bias has been unhelpful since late 2016, as staples have underperformed since then and more cyclical areas of the market have done best (technology, consumer discretionary and financial services).
The trust has underperformed its sector and index since launch, returning 29.3% in NAV total return terms, compared with gains of 54% for the MSCI Emerging Markets index and 55.4% for the average AIC Global Emerging Markets trust. The defensive positioning hasn’t helped in a bull market, while the trust has also not employed any gearing.
Terry has taken a step back from day-to-day management of the trust, handing over the reins to Michael O’Brien and his deputy, Sandip Patodia, in May of this year, but he remains CIO and controlling partner of Fundsmith. Since this decision, the shares have slipped onto an 8.8% discount, having traded on a premium for most of the trust’s life.
The company’s objectives are to maximise capital growth, so dividends are paid only to retain investment trust status. Last year the first dividend was paid of 2p, so the historical yield is just 0.2% and there is no guarantee dividends will be paid in future.
Given its concentration, and the strong conviction of the manager in the current strategy, the portfolio is likely to retain its positioning in India and consumer staples. This is in the hope they will win out over the long run against technology and financial companies, as well as China, which have all led the market in recent years and to which the trust is little exposed. This implies a bet on demographic forces (a growing population in India buying more consumer goods) being more important in determining the stock market winners of the coming cycle rather than technological developments and more sophisticated sectors. This narrow focus, which includes not investing in South Korea and Taiwan, makes us wary of viewing the trust as a core emerging market holding.
The trust’s defensive qualities are, in our view, balanced by the higher valuations of the stocks in the portfolio, which could cause it problems should interest rates and therefore discount rates rise. However, the portfolio has performed well in falling markets in this low interest rate environment, and central bank policy seems to be becoming more accommodative, which would imply a good environment for this style of investing.
|A clear and defensible strategy, consistently employed
||The major bets against technology companies and China could lead to relative losses
|A portfolio with strong cash-generation and defensive characteristics
||The willingness to issue shares at a discount is unwelcome in our view
|A wide discount relative to history that could swiftly close with a recovery in performance
||High concentration increases risk (as well as outperformance potential)
Fundsmith Emerging Equities Trust (FEET) employs the same strategy as the highly successful Fundsmith Equity open-ended fund but applies it within the emerging and frontier markets regions. The three core rules as described by Fundsmith founding partner Terry Smith are to buy good companies, avoid overpaying and “do nothing”.
By good companies, Terry means those that can generate a high return on their capital employed, measured in cash rather than accounting profits. The target companies are able to reinvest those cash flows in their own businesses to generate returns that are consistently higher than their peers due to some competitive advantage that cannot be replicated. This is often achieved by intangible assets such as brands, but may also refer to supply and logistics chains that cannot easily be replicated, or networks of distributors. The team prefers companies that generate their returns from predictable, small-ticket items, which in practice means there is a massive bias to the consumer staples sector. As much as 65.8% of the trust’s portfolio is in that sector, with a further 15.1% in healthcare and 6.7% in consumer discretionary.
Terry and the team (management passed to Michael O’Brien and Sandip Patodia in May this year), also place great importance on the quality of management at their portfolio companies, as this is crucial to capital allocation decisions. They have not been afraid to cut the cord quickly if they feel that management is taking a company in the wrong direction. One such example was when Terry sold out of Shoprite in 2016 when management was pursuing a merger with Steinhoff that he saw as being in the interests of management but not shareholders. In fact, this has been a reasonably frequent occurrence that has led to the turnover being higher than the Fundsmith Equity fund, at 30.4% a year over the past three years, compared to 11.5% for the open-ended fund (all figures from Fundsmith). For example, in 2016, the trust quickly repurchased Tiger Brands after a new CEO pulled out of an acquisition that they regarded as foolhardy and had originally caused them to sell.
The aim is to bring the turnover down, as Terry believes that over-trading is a major sin of many investment managers. Trading incurs costs, which he believes eat away at investors’ returns. The strategy behind this trust is to buy stocks that should continue to outperform their peers for many years to come (ideally forever), so trading out after only a few years is undesirable. This explains the third tenet of the strategy: “Do nothing”.
The management team calculates that there are only around 140 stocks that meet their quality metrics and are worthy of consideration in their universe. This compares to 1,289 stocks in the MSCI Emerging + Frontier Markets Index. The team tracks the valuations of these companies and look to buy them when a valuation is tilted in their favour (hence “do not overpay”). It has at times been hard for the manager to access stocks he wants to due to valuations; for example, Kimberley Clark de Mexico was finally purchased in 2018 on share price weakness.
Fundsmith estimates that a third of the companies in their universe are subsidiaries of developed world listed companies, some of which feature in the portfolio: Hindustan Unilever (a top 10 position), Nestle India, Colgate Palmolive (India), plus Procter & Gamble Hygiene were all held in the portfolio as of the end of 2018. As this would suggest, there is a strong bias to India, which comes through on a portfolio level: as of 31 December 2018, 43.3% was invested in the country.
This is a passive breach of the 40% limit in any one country allowed in the prospectus, so we would expect to see reductions here in the current year. The board did float the idea of increasing the amount it could invest in one country to shareholders in 2017, but this was abandoned due to investor reluctance. India is a fertile market for this strategy; the consumer goods sector has a strong potential for growth given an ongoing demographic boom and its superior corporate governance compared to a lot of other emerging markets.
It is fair to say that the strategy hasn’t worked as expected, given the disappointing performance discussed in the performance section. However, it is interesting to note how the portfolio stands out on Terry’s preferred metrics, even against the more successful Fundsmith Equity fund. As the table below shows, the FEET portfolio has substantial advantages over the index in each of the desired qualities, while also being superior to Fundsmith Equity in terms of ROCE, cash conversion and free cash flow growth.
PORTFOLIO CHARACTERISTICS, as at 31.12.18
|Return on Capital Employed
|Free Cash Flow Growth
|Free Cash Flow Yield
This raises the question why the trust has not shared the success of the Fundsmith open-ended fund. In our view, one key reason for this has been that emerging markets have been sensitive to global economic and political events and forces that have swamped stock specifics at times. This trust’s concentrated portfolio has been unhelpful in that context, with more cyclical areas outperforming. While Fundsmith Equity has a bias to defensive and consumer names, its portfolio is more diversified. For example, it has more significant holdings in technology, albeit in the more mature parts of that industry that have proven their ability to generate sustainable revenues (Microsoft, Paypal and latterly Facebook, which was excluded earlier due to doubts about its revenue generating capacity).
In emerging markets over the past few years, the big winners have sometimes been those at an earlier stage of development with less of a track record, such as Tencent and Alibaba, and /or companies with question marks over their corporate governance, such as Alibaba and Samsung, which have therefore not been candidates for FEET’s portfolio. These points have hurt other managers with more of a focus on quality of management too. Meanwhile, in the developed world, the slow growth story has supported more defensive consumer names overall, except for a brief period after the election of Donald Trump in November 2016, when the Fundsmith Equity fund underperformed as rate and inflation expectations soared.
According to Bloomberg data, the forward P/E on the portfolio is more than twice that of the benchmark, at 24.3 times to 12.1 times. The Indian stocks are trading on an average 36 times next year’s earnings versus 18 times for the Indian stocks in the index, but India has persistently been more highly rated than the rest of the emerging markets region. This valuation, and the premium over the market, is in line with the level the trust has been at since launch.
The company has not been geared since it launched and has no borrowing facilities in place. However, the articles of association do allow for it to take out short-term borrowing facilities worth up to 15% of NAV.
Performance has been disappointing since launch, with the trust failing to replicate the success of the Fundsmith Equity fund. Over five years, the trust has returned just 29.3% in NAV total return terms, compared with gains of 54% for the MSCI Emerging Markets index and 55.4% for the average AIC Global Emerging Markets trust.
The trust showed the benefit of its bias to more defensive, stable earnings streams and sectors in 2018. In 2015, these factors were helped by the trust not being fully invested until the end of the year and so benefiting from cash positions in a falling market. However, this has not offset the returns it gave up in the bull market of 2016 and 2017, and it has also lagged the index during this year’s sharp rally.
Although the managers select stocks on a bottom-up basis, the trust’s portfolio has developed serious skews to consumer staples and to India, which has affected returns. These positions have also implied underweights to China and to the information technology sector, both of which have led the market in recent years.
The weighting to consumer staples has hurt relative returns since the election of Donald Trump in November 2016. From that point on, there was a rotation in emerging markets, and cyclical sectors outperformed in the stead of defensive sectors. Expectations of more growth-orientated policies from the US were a factor, although the rally in Chinese and internet-related names in 2017 was fuelled by domestic and stock-specific factors too.
In fact, in 2017, 40% of the returns in the emerging markets index were due to four stocks, none of which FEET owned: Tencent (including Naspers, which is a major shareholder of the company), Alibaba, Samsung and TSMC. China was the strongest market, and FEET had only 11% in the country relative to an index weight of 29%. South Korea also did well, and FEET does not buy stocks in that market as Terry considers it to be a developed market (on the grounds of GDP and standard of living).
Relative performance over the past year has been volatile, and at the time of writing is negative. The trust failed to keep up with the cyclical rallies in January and again in June. Consumer staples, as would be expected, underperformed in these periods, having outperformed over the course of the 2018 calendar year.
One-year relative performance
The company’s objectives are to maximise capital growth, and dividends are paid only to retain investment trust status (which requires that at least 85% of income be paid out to shareholders). In fact, 2018 was the first year that a dividend was paid, which was, at 2p, de minimis. The trust charges costs to the income account and it was only in 2018 that the cumulative income received exceeded the losses in the early years, requiring the payout.
From its launch in June 2014 to May 2019, the trust was managed by Terry Smith, the founder of Fundsmith. In May, Terry stepped back as manager to take an advisory role on this portfolio. However, he remains the chief investment officer of Fundsmith and the two managers, Michael O’Brien and his deputy, Sandip Patodia, report to him, and he remains the majority partner in Fundsmith LLP. Terry founded Fundsmith in 2010 and launched the Fundsmith Equity fund, which has had tremendous success in terms of performance and asset-raising. It invests in equities listed mainly in the developed world. In 2014, FEET was launched to employ the same process but in the emerging markets sector, with a closed-ended structure considered to be more appropriate given the lower liquidity in some parts of the market (small caps, frontiers) that Terry wished to exploit. Terry is a former banks analyst, pension fund manager and chief executive of brokerage Tullet Prebon.
Michael O’Brien joined Fundsmith from Canaccord Genuity after more than ten years as an analyst. He previously ran UK equity funds at Guinness Flight Global AM. Sandip Patodia joined from Morgan Stanley where he worked in the corporate finance department advising UK-listed companies. He is a qualified chartered accountant. Michael and Sandip benefit from the work of two analysts: Jonathan Imlah and Tom Boles.
The company was a high-profile launch by the famous and popularly well-regarded fund manager Terry Smith. It traded at a premium for most of its life until the announcement in May that Terry would be taking a step back from the manager role to an advisory role supporting Michael O’Brien and deputy manager Sandip Patodia. Since then, the trust has sunk to an 8.8% discount. Given that performance has struggled versus its peers and index since launch, we see no obvious catalyst for a re-rating; performance will likely have to improve for the trust’s discount to narrow. Although it is marginally below the sector average at the time of writing, this is unlikely to be by enough to interest value investors hoping for a rebound.
The company has regularly issued shares at a premium to NAV in order to throttle the premium and to increase the size of the trust. In the 2018 calendar year, the trust issued 1.725m new shares at a premium of at least 1.5%, raising £21.5m. In 2019, the trust has issued 250,000 shares, raising approximately £3m. The current market cap is £314m.
Last year, the board proposed giving itself the right to issue up to 25% of the share capital, but following a significant number of shareholders voting against, this motion was withdrawn. The existing facility allows for the issue of up to 10% of the company’s share capital. The board also sought the ability to issue treasury shares at a discount (so long as the discount was narrower than that at which they were brought), but this was abandoned after 20% of shareholders voted against. This would be poor practice in our view.
The board also has the right to buy back shares, and there will be a continuation vote held should the trust trade on an average discount of 10% or more in the 12 months prior to the end of the calendar year (which is also the trust’s financial year). In our view, this serves to reduce the risk of the discount widening significantly further. Perhaps as evidence of this, Terry bought further shares in the company after it fell into a discount on 22 May and again on 12 June and 12 July, taking his personal stake in the company to 3.18% of the shares in issue.
The OCF is 1.52%, more expensive than the average Global Emerging Markets trust, according to JPMorgan Cazenove, which charges 1.27%. However, this doesn’t account for the 0.25% cut in the annual management charge that was implemented when Terry stood down as manager. After that cut, the management fee is 1% and the trust is in line with the current sector average. There is no performance fee. The KID RIY cost is 1.88%, relative to the average for the sector of 1.81%, although it is worth noting that calculation methodologies do vary.
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