Launched to much fanfare in 2014, it’s fair to say the performance of emerging markets investment trust Fundsmith Emerging Equities Trust (FEET) hasn’t quite gone according to plan over the past six years.

Since inception the trust has significantly lagged its benchmark, delivering a total return of 35.5% in net asset value (NAV) terms and just 19.1% in share price terms compared to 60% for the MSCI Emerging & Frontier Markets index.

Compare this to the other products in the Fundsmith stable open-ended fund Fundsmith Equity (B4Q5X52), which has returned well over 100% in the past five years, or small and mid-cap investment trust Smithson (SSON) which has returned over 50% in share price terms since IPO in October 2018.

Star manager Terry Smith stepped back from running FEET in 2019, with portfolio manager Michael O’Brien taking over, assisted by equity analyst and assistant portfolio manager Sandip Patodia. Smith still provides advice to the two managers in his role as chief investment officer.

The managers previously admitted that 2019 was ‘not a vintage year for the fund’ with NAV falling 0.5% compared to a 13.9% gain from the index.

However, 2020 has been a better year so far for the trust, up 11.1% in NAV terms and 8.1% in share price terms compared to just a 3.2% rise in the index.

We think the current management team can address the historic issues and that the trust is a good option for someone looking to gain access to emerging markets. The annual management charge of 1% looks reasonable.

INDEX ‘LARGELY IRRELEVANT’

Speaking to Shares, O’Brien and Patodia are quick to make clear that the ‘index to us is largely irrelevant’ and highlight the fund’s 97% active share, but concede ‘mistakes’ were made in the past and admit to having been caught out by some stocks, particularly in frontier markets.

O’Brien explains: ‘We have in the past had investments in countries where there been deteriorating macroeconomic conditions, which has typically fed through to currency weakness and currency devaluations – Nigeria and Egypt are the best two examples of this.

‘And there’s been a few select cases where we’ve overestimated the company’s growth, or more importantly, underestimated regulatory issues to that company.’

On this point, O’Brien says that when the fund was launched, they took the view that macroeconomic factors were largely irrelevant, instead choosing to focus on company fundamentals in the belief that ‘a good company would thrive regardless of the market or country in which it operates’.

But he adds: ‘Looking back at the experience of the last six years, it has taught us that even a great company in frontier markets is affected to some degree by macro factors.’

As a result, O’Brien explains the proportion of the fund in frontier markets could ‘continue to decline’ after reducing exposure to owning only a ‘very limited, select number of high conviction names’ in a handful of frontier countries, having cut holdings in Nigeria from three to one, in Sri Lanka and Bangladesh from two to one, and with no more holdings in Ghana or Pakistan.

CAN FUNDSMITH FORMULA WORK IN EMERGING MARKETS?

There is also the wider point of whether the Fundsmith investment process works with emerging and frontier markets. Finding companies that generate free cash flow is a key part of that process, but on the face of it this may not always seem compatible with companies that are investing for growth, such as those you might find in emerging markets.

O’Brien and Patodia believe the stocks they own are compatible, pointing to their high levels of cash generation and return on capital, another key Fundsmith metric.

O’Brien notes: ‘The free cash flows after capex of emerging market companies may be significantly lower than companies in developed markets, largely because faster growth requires reinvestment at high returns of capital.

‘We think that largely the business models of those businesses we invest in are relatively conducive to having a compatible outcome in terms of looking at businesses which typically have high returns on capital, generating sufficient cash to fund growth. And typically these businesses would have highly attractive working capital cycles and sound balance sheets to support that growth.’

He also points out the vast majority of companies in the portfolio have no net debt, and says there is less of a dividend culture in emerging markets, so the cash that would’ve used as a shareholder payout is instead reinvested to fund growth, ‘we quite like that as investors because if a company can invest their cash flows rather than give it back to us, it solves a problem of what we do with it’.

Portfolio turnover increased markedly last year, reaching 28% as O’Brien and Patodia made their mark on the fund, and is set to remain elevated in 2020 as the fund lowers its exposure to consumer stocks and increases its allocation to technology and healthcare, two sectors which have experienced supercharged growth in 2020 and are expected to be big beneficiaries as a result of the coronavirus pandemic.

This is however something of a departure from the Fundsmith focus on consumer stocks, with the Fundsmith Owner’s Manual describing how a consumer company which ‘sells many small items each day is better able to earn more consistent returns over the years than a company whose business is cyclical, like a steel manufacturer, or “lumpy”, like a property developer.’

SHIFT FROM CONSUMER STAPLES

Patodia says the focus on staples gave the portfolio downside protection, but concedes that it ‘also somewhat limits the upside’ as it ‘makes the portfolio very defensive and as long term investors your returns are best achieved in companies where you have multi-generational growth opportunities’.

He continues: ‘We wanted to shift the focus from being largely defensive to a more defensive growth allocation. That’s why our allocation to technology and healthcare sectors has increased because it helps the portfolio perform better in both down and up cycles.

‘During a down cycle in the economy, staples would do well because people don’t stop consuming essential items, but in an up cycle there is higher discretionary consumption and more focus on growth. If you have a more balanced portfolio in terms of sectors, we believe performance may be better .’

While technology and healthcare have been the stars of 2020 from an investment perspective, another area exciting investors with its growth potential – but somewhere Fundsmith has been curiously absent when comparing its allocation to other fund groups – is China, which makes up just 7.8% of the fund compared to 42.5% for its benchmark index.

REASONS FOR LOWER CHINESE ALLOCATION

O’Brien insists Chinese companies ‘do provide interesting investment opportunities’ and insists ‘we’ve looked at dozens since we launched the fund’, but says they often have issues related to corporate governance and transparency, and also says Chinese firms generally are ‘poor allocators of capital’.

He says: ‘You’ve got to remember China does not have an independent judiciary. The success rate for prosecutions in Chinese courts is 99.9%. So therefore, if you’re a foreign investor, you typically have a legal system which is stacked against you.’

The managers also took a look at Chinese giant Ant Group as it was readying what would’ve been the world’s biggest ever IPO, and O’Brien reveals the more they looked at Ant, the more issues they found.

Ant had to abort IPO plans after the Shanghai regulator raised questions over its ability to meet disclosure and listing conditions.

O’Brien explains: ‘The more we looked at Ant, the more it looked like a bank, felt like a bank, smelled like a bank and therefore probably could be deemed to be a bank, and we felt that was probably where it would run into regulatory issues.

‘There was clearly a risk impact, both in terms of its credit expansion amongst consumers, but also what we felt was probably the biggest risk was through its platform. It has helped a number of secondary and tertiary lending institutions grow their balance sheet very, very quickly, and we felt potentially there would be some form of regulatory backlash against that.’

BIAS TOWARDS INDIA

The fund’s biggest allocation by country is India, making up 43.5% of the fund, a market which underperformed significantly in 2019 and has seemingly underwhelmed compared to other emerging markets in the past five years, with the MSCI India index recording a five-year annualised return of 7.87%.

But Patodia says any notion India has been an underperformer for the fund is simply not true, highlighting that Indian stocks have been the largest contributor to fund performance since inception, while 13 of the 15 Indian companies in the portfolio are up year-to-date despite the pandemic.

He says India is a ‘large repository of high quality businesses among emerging markets’, especially in the fast-moving consumer good (FMCG) sector, and says the country’s stock market also contains a lot of founder-led or family-owned businesses that are ‘very well run’ and with ‘strong market positions’.

Patodia adds that accounting standards in India are comparable to South Africa, which has the best accounting standards among global emerging markets, and highlights that minority shareholder protection rights in the country are also very high.

Two stocks in the trust which appear to have had a mixed year are the Indian subsidiaries of consumer goods giants Nestle and Unilever, which have recorded modest share price gains over the past year but not the kind of spectacular growth associated with large cap EM stocks. However, both have either tripled or close to it in the past five years.

MULTINATIONAL WINNERS AND LOSERS

Patodia puts multinational subsidiaries generally into two camps – those who understand the local market well, and those that don’t. It’s pretty clear which ones thrive and which ones don’t.

He explains, ‘It’s increasingly apparent to us not all multinational subsidiaries are created equal, and not all excel.

‘Some multinational subsidiaries parachute unincentivised management in from overseas with no real understanding of the market they are operating in, and we found they lose market share to local players, which has a subsequent impact on financial performance.’

But unsurprisingly he points out this is not the case for the Unilever and Nestle Indian businesses, and says both ‘have a very high level of quality.’

He adds, ‘We have found that they’ve lived up to expectation or even exceeded it from both an operational performance point of view and ultimately an investment point of view. In these cases management have a deep understanding of local culture, consumer behaviour and market trends.’

Given the trust’s varied performance so far, investors have understandably been questioning what sort of returns they could expect from FEET going forward.

The managers emphasise they can’t predict returns, but what they will do is stick with the Fundsmith principles of investing in good companies, not overpaying and doing nothing.

O’Brien adds: ‘What I can say is that we are confident in the growth prospects of our companies over the long term.

‘The rise of the consumer class in emerging markets is a trend that still has a long way to go, and at the moment we’re probably only scratching the surface.’

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