What Investment - The cash generators of an emerging universe

by What Investment | Apr 01, 2021
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Invest in the rise of consumer classes in the developing world

Fundsmith Emerging Equities Trust’s (FEET) objective is to provide shareholders with an attractive return by investing in a portfolio of shares issued by listed or traded companies that have a majority of their operations in, or revenue derived from, developing economies. These businesses provide direct exposure to the rise of the consumer classes in those countries.

The managers buy into cash-generative businesses with sustainable cashflows and highly resilient business models. These companies reinvest generated cashflows at attractive rates of return. The team strives to buy the best businesses and ideally hold them for decades.

Portfolio manager Michael O’Brien and assistant portfolio manager Sandip Patodia, who took over FEET’s day-to-day management from Fundsmith founder Terry Smith in May 2019, apply the house global equity strategy to the emerging market (EM) investment universe.

During 2019, the managers made amendments to the portfolio and the process. First, the development of capital markets since the fund launch has allowed the team to include more stocks in the investible universe and to include a larger number of sectors, emphasising technology and healthcare.

Second, they reduced exposure to frontier markets, where sharp currency movements had negatively affected total returns. Finally, the team shifted portfolio weightings towards locally focused businesses and away from multinational subsidiaries, which, in their view, lack the agility of their local rivals.

The managers do not track a specific benchmark as the majority of the major index constituents do not match their investment criteria. The fund is still very highly geographically concentrated in India and, to a lesser extent, in China, where the fund is materially underweight relative to the benchmark.

These geographic tilts may balance out across the EM universe as the portfolio and
the investible universe are refreshed by managers.

Performance

The fund’s net asset value (NAV) has outperformed the MSCI EM & Frontier Index in two of the past three years, including 2020. The managers have turned performance around with both NAV and share price outperforming the MSCI EM & Frontier Index over one year on a total return basis.

According to Fundsmith, in 2020 there were modest net inflows into EM by way of active funds, in contrast to ETFs and index funds, where there were net outflows.

In 2019, there were net EM outflows of $17.7bn (£12.7bn), led by net outflows of $31.7bn from active funds and $14bn net inflows into ETFs. ETF inflows are typically invested in the largest index constituents, where FEET is invested to a small extent.

Three large-cap stocks – Alibaba, Meituan and Tencent (with only Tencent present in the portfolio during 2020) – were responsible for nearly 90% of China’s outperformance last year, and China, where FEET is underweight, is responsible for the strongest performance within EM since the late March 2020 low point. Heavily featured in the index, Taiwan and South Korea also performed positively.

Rather than attempting to chase the performance of the EM equity market index, FEET’s managers have chosen to focus on owning a number of high-quality companies found in a limited range of consumer-focused sectors. This is something they will not change, regardless of the level of momentum in the market.

While performance against the MSCI EM & Frontier Index has been challenging due to heavy underweights of the majority of the index stocks that performed strongly, for example, tech stocks in China, the trust’s NAV has outperformed the UK equity market. More recently during 2020, it outperformed the global equity market and its benchmark as well, on a total return basis.

Investment strategy

Discover quality stocks then do nothing

The strategy has three building blocks, the first of which is to buy good companies that display quality, growth, predictability and sustainability. Second is not to overpay. In terms of valuation, the team looks at the cashflow yield of a company and assesses it in the context of sustainability, competitive advantage and longevity of growth prospects. Competitive advantages could be represented by brand, market structure, distribution, logistics, regulation or scale.

The third building block is to do nothing. FEET’s ideal holding period is ‘forever’. The companies invested in have the majority of their operations in, or revenue derived from, developing economies, providing direct exposure to the rise of the consumer classes in those countries.

Prior to the fund’s launch in 2014, the team identified about 120 companies that fitted their investment profile. This has since been refined to a list of around 80 businesses that is regularly refreshed and monitored. The fund only invests in quoted businesses on recognised exchanges. The primary criterion for a company to remain in the universe is whether it continues to fit the remit of being a good company, according to the fund managers’ process.

Since Michael O’Brien and Sandip Patodia took over the running of the fund, they have broadened the portfolio beyond direct consumer staples and discretionary, to incorporate technology and healthcare. The managers avoid the financial sector and heavily cyclical areas such as construction and manufacturing, utilities, resources and transport, instead focusing on consumer-exposed businesses.

There has also been the greater attention to the macroeconomic environment. The team assesses all countries eligible for inclusion to evaluate their macro risks, looking in particular at currency risk. They also pay attention to the economic, political, social and business backdrop. The manager is index agnostic and buys good businesses regardless of index inclusion.

The managers’ view

Road to profitability and growth

FEET’s team buys companies that have the ability to reinvest their cashflows in supporting growth at high incremental returns. These businesses’ repetitive and sustainable everyday transactions are the best warranty for them to generate growth and high shareholder returns over the long term.

Although their P/E ratios may exceed those of the benchmark, their cashflow generation ability and return on capital employed are superior. The focused approach centres around buying good companies, not overpaying for them and holding them for a long time.

The largest emerging market countries, namely China (including Hong Kong) and India, are significantly represented in both FEET’s investible universe and its portfolio. Combined, they comprise around 59% (at 31 December 2020) of the holdings, and are likely to continue to form the biggest part of the portfolio going forward.

The trust’s Indian consumer-focused companies have superior fundamental characteristics in terms of profitability, growth and cash generation relative to other sectors. The managers believe India has some of the best global companies to fit the fund’s remit.

Investors are spoilt for choice, with many multinational subsidiaries listed in India, alongside national and regional businesses. The difficult operating environment gives established Indian businesses the advantage of high barriers to entry. These characteristics mean Indian companies fit well within FEET’s mandate.

To date, the team has found only a handful of Chinese companies to fit their investment criteria, discouraged by factors such as opacity, governance, accounting policies, regulation and capital allocation, applicable to many Chinese listed businesses.

There is also some concern about speculation in Chinese stocks. According to the managers, the Chinese government has encouraged equity bull markets after periods of economic weakness before. The FEET team cites state-sponsored journals in the mainland that call for the ‘fostering of a healthy bull market’, helped by the direction of cash from state funds, corporate-backed wealth management products and private investors.

The team has shied away from Taiwan and South Korea in the past, as they consider these two countries developed markets in terms of GDP and demographics. However, they made their first investment in a Taiwanese company in Q4 2020.

Source: Victoria Chernykh and Sarah Godfrey, Edison