Walter Scott Emerging Markets (MAQ0651AU) Report & Performance

• The Fund returned -0.11%, net of fees, in July 2023, compared with a return for the Benchmark of 4.93%, with ongoing concerns around the health of the Chinese economy remaining a source of negative market sentiment towards some of the portfolio’s Chinese and China-related businesses, impacting relative performance.

• All emerging market sectors advanced in July, with Consumer Discretionary, Financials and Materials making the largest contributions to index returns. For the Fund, holdings in Industrials, including AirTAC International and Zhejiang Sanhua, in Materials, namely Hansol Chemical, and in Consumer Discretionary, which lagged the rise of the broader sector, were the largest relative detractors. During the month, Walter Scott completed the initial purchase of Sinbon Electronics, a Taiwanese manufacturer of cables and connectors for specialist applications, with around 35% exposure to green industries, such as renewable energy, smart grids, ebikes, and electric vehicles. Global trends towards decarbonisation and electrification will be material drivers of future growth.

• A broadly pessimistic view of China’s prospects appears to have become embedded in the collective psyche of investors of late. A barrage of negative headlines around insipid consumer spending, youth unemployment and the travails of the once-mighty real estate sector have further cemented the bearish narrative. Undoubtedly the economy has some serious challenges that need to be addressed, but fixating solely on these challenges risks overlooking the country’s very real strengths, as well as the robust long-term fundamentals of many excellent Chinese and China-related companies. Silergy, for example, has been in the midst of a particularly painful downturn in the inventory cycle of its core analogue semiconductor market, but there are signs that this cyclical headwind is now starting to dissipate, which should bring its compelling long-term opportunities back into focus. The business is particularly excited about the opportunity in automotives, as electric vehicle adoption increases demand for analogue semiconductors. Taiwanese pneumatic component manufacturer AirTAC International, meanwhile, is seeing demand improve month-on-month, despite some weaker manufacturing data in its core Chinese market. On a call in June, AirTAC’s CFO explained that the market was too optimistic about China’s post-Covid recovery, but that today’s slow-but-steady recovery is in line with the company’s expectations.

• While the portfolio’s underperformance in July has been disappointing, Walter Scott sees little correlation between this and the fundamentals of the investee companies. Walter Scott will, as always, monitor closely each company for evidence of a deterioration in their long-term investment case, and in time fully expect these fundamentals to reassert themselves and for investors to again recognise the merits of market-leadership, consistent cash generation, pricing power, cost discipline and excellent management.

• The Fund returned 1.13%, net of fees, in June 2023, compared with a return for the Benchmark of 0.91%.

• Emerging market equities lagged their developed market peers in June, with the Consumer Discretionary and Energy sectors driving the subdued advance. For the Fund, holdings in Consumer Staples, such as Dino Polska and Clicks Group, and in IT, including LEENO Industrial and Koh Young Technology, were the largest relative contributors. Relative detractors included holdings in Consumer Discretionary, namely Allegro.EU, and in Communication Services, including Naver and Telekomunikasi Indonesia. During the month, Walter Scott completed the final sales of Jardine Matheson, to raise funds for other portfolio companies with more compelling fundamental characteristics, and Sunny Friend, which is facing greater profitability headwinds from evolving environmental regulation, unexpected maintenance shutdowns, and increased competition.

• Two members of the Walter Scott Research team travelled to Taiwan and China in June, providing a welcome chance to meet faceto-face with the management teams of several portfolio companies on their home patch after a long period of travel restrictions. One company that is capitalising on the post-Covid landscape is AIA Group, as explained by AIA China CEO Fisher Zhang during a meeting at the company’s Shanghai offices. One of the lasting impacts of Covid has been growing recognition of the value of insurance. People are now more cautious about health and risk, and understand the need to plan accordingly. And as interest increases, so too does the sophistication of the average consumer. This transformation of demand is forcing the supply side of the industry to adapt in turn. Three years ago, the life insurance market in China had ten million sales agents. Most were part-time operators from domestic Chinese companies who lacked the requisite knowledge to meet changing consumer demands. Today, the number of agents has more than halved to three-to-four million. Over the same period, the number of AIA China agents has held steady, leaving the company ideally placed to grow market share as it continues to expand its presence across China.

• Geopolitical and macroeconomic concerns are likely to dominate the headlines in the near term, but as long-term fundamental investors Walter Scott continues to look beyond the headlines and stay focused instead on the progress of the portfolio companies. Here, the Research team remain confident in their ability to leverage their inherent strengths to capitalise on what remain, despite some near-term headwinds, highly compelling long-term growth opportunities.

The Fund returned 0.20%, net of fees, in May 2023, compared with a return for the Benchmark of 0.40%. Emerging markets remained on a cautious footing across the month as investors continued to monitor closely China’s post-Covid rebound but found only cause for concern, as industrial production and consumer spending proved weaker than many had expected.

The IT sector was the sole positive index contributor of note during the month, with Consumer Discretionary, Materials and Communication Services among the largest detractors. For the Fund, holdings in Consumer Staples, such as Clicks Group and LG Household & Health Care, and in Financials, including AIA Group and Ping An Insurance, were the largest relative detractors. Relative contributors included holdings in Materials, namely Hansol Chemical, and an underweight to the sector, as well as holdings in Consumer Discretionary, including Allegro.EU and Hyundai Mobis. There were no initial purchases or final sales within the portfolio in May.

After a chastening 2022, a more optimistic narrative is now emerging around Brazilian equities. The economic picture is admittedly far from perfect, with recent data telling a somewhat mixed story, but there are reasons for positivity, most notably perhaps an easing of inflationary pressures. Having raised rates aggressively in a bid to quell runaway post-pandemic inflation, Brazil’s central bank now has some scope to deliver rate cuts in a bid to boost activity. TOTVS, Brazil’s leading ERP (Enterprise Resource Planning) and financial technology company with a focus on small- and medium-sized businesses, and one of the Fund’s top individual contributors in May, reported during the month. The first three months of the year saw the business make encouraging progress on its core strategy of developing the ‘3D Ecosystem’ across its three primary business units – Management, Techfin, and Business Performance – with year-on-year revenues up 17%, 16% and 32% respectively. Through its techfin business, however, TOTVS is seeing some evidence of macroeconomic pressures. Profitability at Supplier, the B2B credit intermediary acquired by TOTVS in 2019, was negatively impacted by increased credit restrictions and a slowdown in some market segments. Supplier’s response was to successfully focus on preserving its historically low credit delinquency levels, which fell sharply to end the quarter 190 basis points below the Brazilian average – a welcome sign that TOTVS can leverage its operational excellence to navigate near-term headwinds.

Performance summary

• The Fund returned -1.32%, net of fees, in April 2023, compared with a return for the Benchmark of 0.20%, as uncertainty continued to pervade emerging market equities and the usual suspects – geopolitical fears, monetary policy concerns, China growth worries – weighed on investor sentiment.

• Financials and Energy moved higher in April, while Consumer Discretionary and IT lagged. For the Fund, holdings in Industrials, such as ASUR and Zhejiang Sanhua, and an underweight to Financials were the largest relative detractors. Relative contributors included holdings in Consumer Discretionary, namely Allegro.eu, and an underweight to the sector, as well as holdings in Consumer Staples, including Dino Polska and Wal-Mart de Mexico. Walter Scott completed the final sale of Meituan during the month, following Tencent’s decision to distribute its holding in the company to Tencent shareholders by way of an in-specie dividend.

• Indonesian communication services companies PT Telekomunikasi Indonesia (Telkom Indonesia) and Sarana Menara Nusantara (SMN) both delivered robust results during the month. At the former, year-on-year revenues and operating profit were up 2.9% and 4.3% respectively. The fixed broadband offering, IndiHome, continued to drive revenue growth, with another 9.2 million subscribers added in fiscal year 2022. Telecom tower operator SNM’s fiscal-year results also showed good sales growth, helped by the acquisition of STP, which added 7,000 to the company’s overall mast count. There was pressure on organic growth from the merger of two of its major telecom customers, Indosat and Hutchison, which resulted in the rationalisation of the merged entity’s tower portfolio. This will likely weigh on growth in the near term but does nothing to compromise the long-term investment rationale for SNM. Mobile data consumption in Indonesia remains far below that of mature markets and future growth will require investment in new towers and tenancies to maintain the quality of the network. More broadly, both SNM and Telkom Indonesia have been beneficiaries of Indonesia’s relative economic outperformance in recent years.

• Optimism amongst emerging market investors has ebbed somewhat in recent weeks, with the ebullience of January now a distant memory. Not that outright pessimism has taken hold, although renewed fears around instability in the banking sector and its knock-on effects on economic activity has the potential to turn investors more bearish. Although further bumps in the road for the global economy may be unavoidable, Walter Scott retains confidence in the ability of the companies in the portfolio to remain resilient whilst continuing to harness the long-term growth opportunities in their markets.

The Fund returned 2.81%, net of fees, in March 2023, compared with a return for the Benchmark of 3.74%, with the eyes of emerging market investors resting on Silicon Valley for much of the month. The collapse of Silicon Valley Bank (SVB), a key player in the tech ecosystem, had observers pondering the implications for not just the tech start-up scene that relied so heavily on SVB funding, but also the health of the wider financial system.

All emerging market sectors, with the exception of Real Estate, advanced in March. For the Fund, the largest relative detractors included holdings in IT, such as Silergy and LEENO Industrial, and in Utilities, namely China Resources Gas Group. Relative contributors included holdings in Industrials, such as OMA and AirTac International. There were no initial purchases or final sales within the portfolio during the month.

Fears of contagion and worries over skeletons in the closets of other financial institutions led to some indiscriminate selling of financials during the month, with Ping An Insurance and AIA Group both weaker as a result. Such jitters are to be expected; investors tend to get very jumpy at even the merest hint of problems in the banking sector and memories of 2008 linger. Central to SVB’s demise, however, was a reliance on a narrow depositor base and a spectacularly ill-advised bet on long-dated US Treasury bonds. Both Ping An and AIA on the other hand are well-diversified insurance businesses with reputations for being conservatively managed. Their long-duration liabilities are matched by long-duration assets (duration matching was conspicuous by its absence at SVB) and both are run by experienced management teams with a long-term perspective and a focus on resilience. Recent market turbulence aside, the long-term prospects for these companies are positive.

Walter Scott often reiterates the importance of certain criteria that the investment team look for in investee companies. Amongst these are balance sheet strength, the ability to finance growth internally, and limited debt levels. Often the merits of such attributes only come truly into focus during more challenging periods for corporates. As the impact of the new interest rate regime starts to make itself felt in the real economy and as credit availability likely tightens in the wake of the banking sector’s recent travails, this should be one such time. An environment of this kind is likely to prove an unforgiving one for those companies who used excessive leverage to finance growth during the long era of cheap money.

• The Fund returned -1.70%, net of fees, in February 2023, compared with a return for the Benchmark of -2.28%, with some of the steam coming out of Chinese and Hong Kong equity markets in February due to a mix of both market technicalities and more fundamental macroeconomic concerns.

• IT and Consumer Staples were the only emerging market sectors to advance in February, with the Consumer Discretionary sector the most significant detractor. For the Fund, the largest relative contributors included holdings in Industrials, such as AirTac International and Voltronic Power, and in Consumer Discretionary, namely Zhejiang Supor, as well as an underweight to the latter. Relative detractors included holdings in Financials, including Ping An Insurance and Grupo BMV, and an underweight to the sector. During the month, Walter Scott completed the initial purchase of Aspeed, the global leader in baseboard management controllers, a form of micro-controller enabling remote server management. Long-term growth for the company will be underpinned by server deployments of cloud-computing hyper-scalers, where the opportunity is significant.

• Taiwanese industrials Voltronic Power and AirTac International both reported good full-year results. In a robust demand environment, Voltronic delivered excellent sales and profitability growth, as customers played catch up on deferred orders for the company’s uninterruptible power supply systems and power inverters. The mix of products sold was beneficial for Voltronic’s gross profit margin, as was the strength of the US dollar. AirTac, which makes pneumatic products for a range of end markets, saw momentum accelerate in the final months of 2022 due to rising demand from its automotive, battery and energy customers. Meanwhile, moderating input cost inflation and strong utilisation rates boosted operating margins. Looking ahead, management sounded a confident note, particularly on its efforts to expand into the linear-guide market. After lacklustre progress last year, the prospects for this market appear brighter in 2023, thanks in part to shorter lead times and a 20-30% pricing discount on AirTac’s linear-guide product offering.

• In the weeks ahead, investors will be watching carefully for signs that China’s reopening is energising its domestic economy, as well as sending out positive ripples more globally. Eyes and ears will also be focused on inflation prints and the prognostications of central bank policymakers. Until a clearer picture emerges, emerging market indices may remain largely directionless. More pertinent to Walter Scott’s research and analysis, however, will be the ongoing performance of the companies in the portfolio as they navigate this still challenging but broadly more optimistic operating landscape.