Normally you would expect the best performing investment trusts in a particular segment of the market to trade on the tightest discounts or largest premiums, but there are other factors that can distort the situation. A case in point is the Fundsmith Emerging Equities Trust (LON:FEET), which is run by the controversial Terry Smith.
Recent research by the investment trust analysts at Winterflood Securities shows that from the launch in June 2014 to April 26 FEET only achieved a net asset value (NAV) total return of 12%. This was well behind the 32% produced by its MSCI Emerging and Frontier Markets index.
The performance is just as bad when you compare it to the rest of the sector. Over the last 12 months the fund’s NAV was up by 18%, which was the worst in its peer group and was just half of the weighted average increase achieved by the others.
Despite the disappointing returns the Fundsmith Emerging Equities Trust is trading on a 1.5% premium to NAV, whereas all of the other funds in the sector – with the exception of the BlackRock Frontiers Investment Trust (LON:BRFI) – are trading at a discount.
The reason for the anomaly is that Smith has a strong following amongst retail investors due to the excellent performance of his £10.5bn open-ended Fundsmith Equity fund. This has distorted the valuation in much the same way that it has for the Lindsell Train Investment Trust (LON:LTI), which I have written about before.
Smith is a controversial figure who first came to public attention with the publication of his book ‘Accounting for Growth’ in the 1990s which highlighted some of the dubious creative accounting techniques employed at the time. He went on to become CEO of the broker Tullet Prebon before stepping aside to concentrate on his Fundsmith investment management business.
Portfolio and approach
Analysis by Winterflood shows that the FEET portfolio consists of 51 holdings with the ten largest accounting for a third of the £267m fund. It is significantly different to the benchmark with a massive overweight position in India (35% of the portfolio) and a huge underweight in China, which only makes up 5% of the fund. There is also no allocation to South Korea or Taiwan, which together account for a quarter of the index, as the manager considers these to be developed economies despite the MSCI classification.
Smith aims to identify companies with a high rate of return and significant growth potential that are trading on a reasonable or cheap valuation. You can see this at the portfolio level as the fund has an average return on capital employed (ROCE) of 53% compared to just 14% for the benchmark (excluding Financials).
The explicit intention is to target businesses that should benefit from growing emerging market consumption rather than global growth. By doing this the fund should benefit from the fact that consumption in the region is likely grow much faster than in the developed markets.
Smith aims to identify companies with a high rate of return and significant growth potential that are trading on a reasonable or cheap valuation.
In support of his strategy Smith makes the point that many emerging market subsidiaries of large multinational companies are able to generate much higher returns than the parent. A good example is Colgate Palmolive India, which has a ROCE of about 90% versus the 35% achieved by its US-listed owner.
Four-fifths of the fund is invested in the Consumer Staples sector with Smith finding opportunities in areas such as the Brewers and Retailers. He expects the latter to benefit from a shift away from the local ‘mom & pop’ stores as disposable incomes improve.
Winterflood’s view is that the focus on companies with high rates of return on capital is compelling and has the potential to deliver strong performance over the long term, but they think that there is better value elsewhere as the fund’s Global Emerging Markets peer group is trading on a weighted average discount of 10%. It is also worth noting that many of the other managers consider the Consumer Staples sector to be expensive and have a much lower exposure.
A more mainstream option would be the £1.9bn Templeton Emerging Markets Investment Trust (LON:TEM). This has been managed by Carlos Hardenberg since October 2015 after he took over from the long-term incumbent Dr Mark Mobius.
Hardenberg had 14 years of experience with the Templeton Emerging Markets Group before he was appointed its lead manager and is supported by a well-resourced team of more than 50 portfolio managers and analysts based in various locations throughout the region.
The manager is a fundamental stock picker with a long investment horizon and a value-bias. He has put together a portfolio of about 90 shareholdings with the top ten accounting for 43% of the assets.
His main country weightings are almost the complete reverse of FEET with 21.9% invested in Hong Kong and China, 12.4% in South Korea and 10.2% in Taiwan, with India making up just 6.1% of the total. The largest sector exposures are Information Technology 29.1%, Consumer Discretionary 22.7% and Financials 19.9%.
The fund has a large institutional backing, with its major shareholders including the likes of Lazard Asset Management, City of London, Investec Wealth & Investment, Rathbone Brothers and Old Mutual. Collectively these firms hold just over 40% of the shares.
Over the last 12 months the share price is up by an impressive 52.5%, but despite this they are trading on a 13% discount to NAV, which is one of the widest in the sector.
Investing in the emerging markets involves an inherently higher level of risk due to the nature of the underlying assets, so it would be sensible to stick to a fund that is managed by someone who has a lot of experience of operating in the region. It is also important to make sure that the portfolio is sufficiently diversified to keep the volatility down to an acceptable level.
A good example is the £951m JPMorgan Emerging Markets Investment Trust (LON:JMG), which has been run by Austin Forey since 1994. He is a genuinely active manager who invests in high quality growth companies with a long-term investment approach.
The portfolio consists of 66 different holdings with the top ten accounting for a modest 37% of the fund. Forey has significantly outperformed his MSCI Emerging Markets benchmark over his long tenure and in the last 12 months the shares are up 37%. They currently trade on a discount of 12.7%.
Templeton Emerging Markets and JPMorgan Emerging Markets both provide mainstream exposure to the region and offer decent value with their double digit discounts. The Fundsmith Emerging Equities Trust has a much bigger retail investor following, but has lagged behind its peers. Its premium rating looks like an anomaly and makes the shares extremely vulnerable.