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Fundsmith Emerging Equities benefits from India exposure but returns remain lacklustre

Fundsmith Emerging Equities benefits from India exposure but returns remain lacklustre – Fundsmith Emerging Equities (FEET) has posted its final results for the 12 months to 31 December 2021. During the period under review, the trust’s NAV per share total return was 3.8% compared to a fall of 1.4% in the Emerging and Frontier Markets Index, measured on a net total return, sterling adjusted basis. However, FEET’s share price total return over the year, fared less well at -3.4%.

As a consequence, FEET’s discount widened to 9.8% by the end of the year (compared to 3.1% at the end of 2020). While recent NAV per share performance has been strong, the compound annual return of 5.8% since inception continues to remain below the company’s aspiration over the longer term.

The portfolio benefitted from its high weighting to India, despite currency weakness, with the top five contributors to performance all coming from the sub-continent. In addition, the underweight exposure to China also helped relative performance as 2021 saw a number of the concerns that the manager has about investing in China, including overseas listings, regulation, slower rates of economic growth and state interference, come to the fore.

Following a change in the investment objective, approved by shareholders at the last AGM, the manager’s focus is on buying good quality companies which have the ability to invest in their businesses at attractive rates of return and as such those businesses in which they invest will typically have no debt or only a conservative level of financial leverage. 

FEET’s constitutional documents require that the directors should consider calling a continuation vote in the event that, after the end of the fourth financial year of the company’s existence (being 31 December 2018), the company’s shares have traded at an average discount in excess of 10% of the NAV per share in a relevant year.

The board has kept this under close review and, as the company’s shares traded at an average discount of 6.6% during the year, it believes that such a vote should not be put before shareholders this year. 

Investment manager outlook:

As we have consistently said, we put the quality and long-term potential of the companies in which the Company invests ahead of short-term factors driving investment markets. Simply put, we can control the former; we cannot second-guess the latter.

At the time of writing, the global pandemic is currently at the Omicron wave, which is clearly weaker than its predecessor variants. We are encouraged as to where, on current scientific evidence, the pandemic appears to be heading.

The one exception to this are those countries that are pursuing a zero-Covid policy, most notably China. China continues to place whole cities under quarantine measures following small outbreaks of the virus, causing significant economic disruption. Hong Kong has followed similar measures across its leisure and education sectors. Aside from the concerns about debt and capital investment at diminishing rates of returns, the zero Covid approach is also likely to place pressure on the PRC’s economy where growth is already slowing.

Aggressive use of central bank balance sheets over the Covid period will, at some point have to be reversed, resulting in rising interest rates (although in China where the state has high levels of leverage over the economy the likelihood is for further cuts). Although this has affected the valuation of some of the growth companies we own in the early weeks of this year, we remain confident of the businesses in which we are invested and were we not, we would not own them. Therefore, in the short term, the market may favour sectors such as banks and resource companies, we are happy to let this pass us by. Just as we have always bought businesses and not business plans in sectors such as healthcare and technology, we continue to believe that the investments in the portfolio are well placed to benefit from the secular trends supporting the multi-generational growth of these markets. 

The businesses we own are well placed to withstand the worst impacts of rising rates and inflationary pressures. They typically have high gross margins, do not have energy or hydrocarbon intensive production processes and by and large have no net debt on their balance sheets. Over the longer term, we expect these qualities, and not the ephemeral fickleness of the market, to be the determinant of share price performance.

Across our investment careers, we have seen multiple examples of regulation in emerging markets that simply defies economic or market logic. Over the last two years, this has been exacerbated by the political imperative of Communist Party of China, which is moving increasingly back to its harder line, Marxist-derived roots.

We are of the opinion with, Xi Jinping most likely to have his term in office extended later this year, this trend is only going to continue, whether it be Beijing’s approach to the governing of Hong Kong, dissent, criticism (both domestically and internationally) and international relations. From an investment point of view, although China’s economy is likely to continue to open up, it will do so very much in the interests of the party. Do not expect favourable treatment as a foreign investor.

In particular, Taiwan is an issue, which could, over coming years, increasingly play on investors’ minds. Beijing’s increasing belligerence to Taiwan should not be seen as just a territorial dispute – instead, there are many, particularly on the harder line side of the Chinese communist party who see the seizure of Taiwan as the ultimate end of the civil war. Taiwan and China, between them, account for around half the emerging market index.

Political risk will continue to be a greater issue for developing markets as against developed ones, and the majority of investments open to investors in emerging markets do not have the geographical diversification of larger developed world countries. The year will see elections in Brazil and the Philippines (amongst others) and it is clear that a number of other countries in which the fund can or does invest have challenges. At the time of writing, the Russia-Ukraine situation remains unresolved. We have no investments that have their primary business operations focused on Russia.

Cognisant of these risks, we continue to seek high-quality companies, which offer patient, long-term investors like ourselves the scope for long-term appreciation by their disciplined approach to allocating capital in the growth opportunities open to them. From this, we will not deviate.

FEET : Fundsmith Emerging Equities benefits from India exposure but returns remain lacklustre

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