Baring Emerging Europe (BEE) aims to generate strong total returns – latterly with a substantial contribution from dividends – by investing in emerging European equities. In practice this means Russia, Poland and Turkey, which together make up almost 90% of the MSCI Emerging Markets Europe 10/40 benchmark.
Manager Matthias Siller has a strong track record of alpha generation, with the trust being in the top quartile of emerging market trusts for alpha and Sharpe ratio, as we discuss in the Performance section.
Absolute performance has been strong in recent years as the Russian market has generated strong returns thanks to the recovery from the 2014 recession and improving corporate governance. This has supported rising payout ratios which have helped BEE generate a significant yield, now 5.3% on a historical basis.
The board has paid more attention to dividends since 2016, when it committed to paying up to 1% of NAV from capital to support the payout if necessary. This gives the board flexibility to make up for any decline in earnings thanks to the current pandemic, although we note that the dividend was fully covered by earnings last year.
Medically and economically, emerging Europe has coped relatively well with the crisis, although falls in currency have exacerbated modest declines in equities measured in local currencies. Matthias tells us the low levels of government, corporate and household debt give the region good prospects if the current recovery continues.
The trust trades on a discount of 12.6%, with an active buy-back policy and a possible 25% tender vote following the end of the financial year in September (see the Discount section).
Emerging Europe is a relatively little-owned region, but has much to offer investors in emerging markets or in developed Europe. Such high dividend yields are hard to find in developed Europe, and may become harder thanks to the impact of the coronavirus crisis. Meanwhile the region is much cheaper than the North Asian countries which dominate the mainstream emerging-market funds (the benchmark’s P/E is just 7.6 times, compared to 14 times for the MSCI All China Index).
Improving corporate governance and dollar earnings mean that Russian corporates in particular are highly cash-generative, and having been through numerous crises in recent years have strong balance sheets. This should bode well as long as the current recovery continues. Recent market declines have a significant currency component to them, which adds to the value proposition, as does BEE’s discount.
As we discuss in the Dividend section, BEE also has flexibility with regards to its dividend. The ability to pay up to 1% of NAV from capital gives the board the ability to offset at least some of any reduction in earnings which the pandemic causes this year. Despite the strong returns in recent years, the cheap valuations and strong fundamentals in its markets make BEE an interesting recovery play, with manager Matthias Siller’s strong track record of generating alpha a bonus.
|Strong track record of alpha generation versus the benchmark||Small size of trust might exclude some professional investors|
|High yield from a portfolio suffering a relatively limited impact from the coronavirus on earnings||Universe is dominated by Russia, which can be volatile thanks to politics, energy and international relations
|Cheap underlying markets with cheap currencies and low debt levels which could be geared to a global economic recovery||Board and manager have indicated the likelihood of broadening the investment universe to include 15% in other markets, but the timing is unclear|
Baring Emerging Europe (BEE) invests in the developing countries of Eastern Europe, principally Russia, Poland and Turkey. The aim is to maximise total return, but there has been an increased emphasis on dividends in recent years supported by a growing dividend culture in Russia thanks to government support for shareholder-friendly reforms.
The universe is dominated by Russia, which makes up c. 60% of the benchmark MSCI Emerging Markets Europe 10/40 Index. Russia, like the other two main markets, has been fairly resilient in the face of the current pandemic. In fact, although the Moscow stock exchange is down c. 15% in dollar terms year to date (after a bounce), it is down just c. 7% in local currency terms. When we spoke recently to Matthias Siller, BEE’s manager, he told us this reflected many of the strengths of the market which has been rewarded with strong returns in recent years. Balance sheets in Russia and Eastern Europe as a whole are strong, he said, with low levels of debt supported by good cash generation and company management teams who are used to dealing with crises. Dividends are likely to be relatively resilient, supported by dollar earnings for materials and energy stocks and a government drive to see higher payout ratios (influenced by the state’s stake in several important market giants).
As we discussed in our last update, the Russian economy also entered this crisis in a strong position. Although it is still recovering from the shock of the recession that followed the invasion of Ukraine and an oil-price crash in 2014, the country’s finances had improved to the extent that it had a huge surplus in its national wealth fund which it was planning to distribute even before the current crisis. This net cash position and ability to spend counter-cyclically should help the Russian economy in any global recovery from the pandemic. That said, the region is strongly linked to the wider global economy, so Matthias recognises that a prolonged recession would impact Eastern Europe too.
BEE’s investment process aims to generate alpha from stock selection rather than country or sector allocation, and (as we discuss in the Performance section) this has been achieved, with Matthias having a strong record of outperformance against the benchmark. Matthias and his co-managers Maria Szczesna and Adnan El-Araby look for companies with above-average growth and quality and which they think are attractively priced – a ‘GARP’ approach. Stock selection uses a consistent analytical framework with a scorecard approach, awarding companies ratings of one to five on metrics across growth, quality and valuation aimed at determining relative attractiveness across sectors and countries.
However, this is supported by top-down macroeconomic analysis that supports the understanding of the prospects for the individual countries and how they affect the underlying companies (including as inputs into company-specific ratings). That said, portfolio weightings primarily reflect where the best stock ideas are being found, and then the team’s extensive expertise in portfolio construction is used to ensure the portfolio maximises its risk budget towards the stock-specific while minimising the unintended macro risks which come as a consequence of building a portfolio.
In recent years the managers have unearthed a wealth of ideas in Russia, with BEE’s weighting currently standing at 68% in comparison to 62% within the MSCI EM Europe 10/40 Index. Until the current crisis Russia had been enjoying a recovery from a deep recession after the international imposition of sanctions following the 2014 invasion of Ukraine. This has been felt in improving corporate earnings and return on equity, which BEE has been well positioned for.
A key theme has been improving corporate governance, which has been felt in rising dividends on many of the large caps. Matthias believes this could be a catalyst for a re-rating of these stocks, and strong returns in recent years bear this out. Russian authorities have recognised that in order to counteract the effects of political confrontation with the West on their economy, they have to do more to attract private capital from abroad and keep it in the country, in effect choosing to take a ‘best in class’ approach. The state therefore has an interest in reducing corruption in its largest companies and preventing profits from being siphoned off into private hands rather than distributed to shareholders. To that end, in 2017 the government made a non-binding recommendation to state-owned companies to pay out 50% of their profits in dividends each year.
The push for higher dividends has seen payouts on the market as a whole more than double in US-dollar terms since 2016. A good stock-specific example is BEE’s second-largest holding Sberbank, which paid out 36% of profits in 2018 and 44% in 2019. Other attractions for the stock include the fact it has the largest share of the retail banking market in Russia, and that it is developing digital banking at a faster rate than many Western competitors. It has also pioneered ‘lifestyle banking’, with innovations such as applications that will book and deliver entertainment tickets to clients electronically.
The chart below shows the sector allocation of BEE. While energy makes up the largest weight, it is actually below the index weight of 37%. Materials are also an underweight, while financials and communication services are significant overweights.
In response to the crisis, Matthias has been increasing his exposure to both communication services and select financials, aiming to identify sectors which are actually seeing their outlook improve as a result of the crisis. As in the West, this is often those businesses with strong digital offerings. In financials, this means the team have been adding to Tinkoff, the digital-only bank. Tinkoff was set up only ten years ago and has, in Matthias’ view, been shrewd in expanding only into the most profitable areas of banking. It now has around 12% of the credit-card market, so it is a significant player and has achieved this without a costly branch network. Its digital-only offering is perfectly suited to a world of social restrictions.
The team have also increased their holdings in Mail.ru and Yandex. They have long invested in these companies, which are the local leaders in online services such as search, email and even delivery. Delivery is an area which is expanding under the pressure of the pandemic, with Yandex in particular looking to offer deliveries of small-value grocery items at very short notice. E-commerce has traditionally been a very small part of the Russian grocery market, but is expanding thanks to the current situation. The computer-game sector has also benefitted from the crisis, including the games developer CD Projekt, the highest-conviction Polish stock in the portfolio. The company published the highly successful ‘The Witcher’ series of games, and is gearing up to release ‘Cyberpunk 2077’, mooted to become the highest-grossing release of all time, having already won a slew of awards before release. Matthias tells us its major competitors have shifted their release schedules to avoid competing with the game, which the team believe will be supportive of sales when released. CD Projekt is now a top-ten holding.
top ten holdings
|MMC Norilsk Nickel||6.3|
|CD Projekt S.A.||3.6|
Source: Barings, as at 30/04/2020
Other opportunities from the crisis come from more prosaic sectors like supermarkets. Matthias has long held X5 Retail, the largest supermarket operator in Russia. He believed that it was well placed to benefit from the improving finances of the state and its people. He believes the current crisis should allow it to strengthen its position, as the less well-organised players will struggle thanks to their inferior logistics infrastructure. Meanwhile the shares offer a 6% yield.
In addition to Eastern Europe, BEE has the ability to invest up to 15% outside its benchmark index into the Middle East and sub-Saharan Africa. It has used this only in a very limited fashion to date, but will likely do so more in the coming years. One reason is that the huge secular uptick in dividends in Russia is largely complete, in Matthias’ view. This means that dividend growth in that market will come mostly from future earnings growth. While his outlook is positive on EPS, he does believe it is important to diversify in the interests of maintaining the yield. Furthermore, Matthias believes there are a number of interesting investment opportunities with useful diversification benefits in the Middle East and Africa. Given that Barings has a large frontier-market team with experience in these fertile hunting grounds, it is a natural place for the trust to expand.
BEE’s portfolio is currently 2.9% net cash after Matthias paid back the modest levels of gearing he had employed prior to the crisis. The gearing policy is currently under review, given the current market volatility. In recent years the trust has employed modest levels of gearing in the range of 5% to 10%, taken through a short-term revolving credit facility. Matthias can also use futures to invest in the three largest markets (Russia, Poland and Turkey). This is sometimes a cheaper and more liquid way to invest, and it effectively gears the portfolio.
The board has set a range of 90% to 110% of market exposure within which to operate, including the effects of going long or short on futures. Whatever the result of the review of the gearing arrangements, in the past the board has made it clear that it only views modest gearing as appropriate given the volatility in the underlying markets.
Over the past five years to 05/06/2020, BEE has generated an impressive level of outperformance against its benchmark. BEE’s NAV total return of 51.3% is ahead of the MSCI Emerging Markets Europe 10/40 Index, which has returned just 38.2%. BEE has also outperformed the average IA Global Emerging Markets trust despite the recent precipitous falls in Eastern European markets – much of which is explained by currency moves. Over that period the generalist trusts have averaged returns of just 11.1%.
In fact, over that period BEE is top quartile for alpha and Sharpe ratio within an expanded peer group including all generalist emerging-market trusts and emerging-market single-country specialists, being one of the few trusts to generate a positive alpha. In keeping with the aim of the strategy, good stock selection has tended to dominate relative returns. The trust has also benefitted from sterling weakness at times, particularly in 2016 after the Brexit referendum. In 2020 emerging Europe’s currencies have been weak versus the pound as well as the dollar.
Last year saw a strong rally in the Russian market, which helped the trust given its overweight there. Matthias tells us that he thinks that some of the long-term value opportunity he saw in large-cap Russian stocks some years ago has finally played out, as their strong cash generation and improvements in corporate governance (which have led to sharply rising payout ratios) have been rewarded by the market. For example, Gazprom generated total returns of 50% in USD terms in BEE’s financial year ending September 2019.
In recent months, as well as the moves in currency, emerging European markets have also suffered thanks to the coronavirus crisis. Over one year, the NAV total return for BEE is now -11.3%, compared to -5.7% for the benchmark and -8.9% for the generalist-sector average. Versus a broad emerging-market investment, the lack of exposure to China and North Asia has hurt, as that region has recovered relatively quickly from the virus. Being geared into the crisis hurt returns relative to the benchmark, as did an underweight to gold miners which prospered in troubled economic conditions.
BEE’s shares trade on a historical dividend yield of 5.2%. Dividends everywhere have been under pressure around the world as a result of the pandemic; however, BEE’s portfolio looks to be in relatively strong shape. The interim dividend for 2020 (for the financial half-year ending 31 March) has been held at last year’s 15p. Earnings per share were down only 8%, but the majority of the effect of the pandemic is likely to come through in results after March, and it is in the second half of the year that most of BEE’s income is earned. Matthias tells us that he expects to see a reduction of only around 25% in portfolio income for the financial year, which would be a good result in comparison to some other markets. Generally speaking, Eastern European countries have had less severe outbreaks of the virus than those in the West, while governments have not made the same level of commitments to support the private sector or the same restrictions on dividends. Matthias stresses that many of the companies in his portfolio are used to dealing with tough circumstances and maintaining payouts through these. The dollar earnings on the oil and gas giants in Russia also help.
Dividends were fully covered by earnings last year. While it is the board’s decision, and much will depend on the progress of income in the second half, the ability to pay 1% of NAV in capital means the board has considerable flexibility even if a reduction in income is likely this year. The graph below shows the progress of BEE’s dividends over the past five years. The dividend policy changed in 2017, leading to a rise in dividends which were not fully covered by earnings for the first two years but depended on a contribution from capital, unlike in 2019. It is likely we will see a reversion to the trust paying an uncovered dividend once again.
The fund is managed by Matthias from London as head of Baring’s EMEA Equity team. Matthias has managed the trust since January 2009 and was appointed to the head of the desk in 2016. He is supported by co-managers Maria and Adnan, who joined him in January 2017. Matthias has run EMEA portfolios since 2001, having previously worked as a market maker and prop trader in Central and Eastern European equities in Austria; as such, he has two decades of experience in the region. He also runs the US$800m open-ended Barings Eastern Europe Fund.
In total, the EMEA team is comprised of seven members, all of whom have responsibilities for researching stocks across both emerging and frontier markets, supporting opportunities for the trust in due course given its mandate allows it to invest 15% outside the emerging Europe region. The team can also call on the research of the broader equity teams at Barings, including the three global sector teams in healthcare, resources and technology.
BEE’s discount widened dramatically following the outbreak of the current pandemic. It then narrowed to around 8% before drifting out to the current 12.6%. This compares to its pre-crisis one-year average of 10.7%. By contrast the average AIC Global Emerging Markets trust is trading on a discount of 11.3%.
Emerging Europe markets are volatile, however, with the progress of the pandemic critical for confidence. The board has regularly conducted buybacks. Although these halted during the worst of the crisis, they have since resumed, and tend to come when the trust trades on a double-digit discount persistently. The trust has a 25% tender provision that may be triggered following the company's September year end if either of two conditions are not met. These are both calculated over the four years prior to this date, and are either if the average discount is higher than 12% during the entire period, or the performance of the Company's portfolio on a total return basis does not exceed 1% of the Benchmark annually over that period.
BEE’s OCF is 1.49%. After the winding up of BlackRock Emerging Europe in November 2018 there is now no strict comparator, but this compares to an average of 1.1% in the broader AIC Global Emerging Markets sector. The management fee is only 0.8%, however, with the rest of the fees being variable costs (there is no performance fee). BEE is quite small at £93m net assets, so it is not surprising that its variable costs are higher than those of a sector with an average size of c. £600m net assets. Fees and costs are 80% allocated to capital and only 20% allocated to income, in line with the growing focus of the board on delivering dividends. The KID RIY cost is 2.13%. This compares to a weighted average of 1.48% for the generalist emerging-market trusts, according to JPMorgan Cazenove, although methodologies can vary.
The investment team embed environmental, social and governance (ESG) evaluations into each company they analyse. This has a direct influence on both their assumptions of each company quality, a key input when understanding the strength of a company’ model, and the company valuation. A company’s performance on ESG metrics is included in the scorecard built up during the research process, and influences the risk premium (or discount rate) used to value stocks – i.e. a company’s valuation is directly influenced by their approaches to ESG, either by penalising or rewarding a company based on their scoring.
BEE uses Barings’ in-house ESG analysis in all its work rather than relying on the assessments of third parties, preferring to rely on their own proprietary analysis. Here the team meet with management teams, visit operational facilities and analyse industry competitors to gain an insight into the company’s business model and sustainable competitive advantage. Analysis focuses on identifying the direction of travel, with companies rated on improvements or deterioration in three key themes: the sustainability of the business model, the quality of the management and the hidden risks on the balance sheet. The team feels this approach is highly complementary as ESG unearths risks not apparent from traditional analysis, serving to anticipate capex/litigation risks not captured within standard analysis.
While some may object to investing in fossil fuels, Matthias tells us that he views natural gas as an important fuel that is much cleaner than coal, important in the context of Russia’s ambition of growing to be the dominant global player in Liquefied Natural Gas (LNG), a cleaner energy source. With about 38% of global energy production still reliant on the much dirtier coal, countries switching to natural gas can make a real contribution to reducing emissions. Furthermore the board highlighted in its 2019 annual report that the carbon profile of BEE is lower than the benchmark index, albeit in a market with relatively high carbon intensity. We think that those investors who value ESG highly but believe the challenge is to reduce carbon emissions over time rather than divest immediately, could find this approach appealing.