Morningstar® CEF Report™

Templeton Emerging Markets Investment Trust TEM

Morningstar Analyst Report Fund Report for F0GBR05WML Templeton Emerging Markets

by Jackie Beard, 10/09/12

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Morningstar's Take TEM

Morningstar Analyst Rating™

Last Price

639.00

Current Discount

-9.06%

Last Actual NAV

702.64

Latest NAV Date

16/05/2013

Gross Gearing

100

Net Gearing

1 Year Z Stat.

-1.02

Ongoing Charge (2012)

1.31%

Average Daily Shares Traded (1 Yr)

0.35m

Role in Portfolio

Niche player. Emerging-markets funds can be used in small doses to diversify a broader portfolio, but they’re usually too risky to play a larger role.

Executive Summary

Process: The process is primarily bottom-up but with a top-down check; the team focuses on the long term when making an investment.
NAV Performance: The team has outperformed its peers over the long term.
People: A stable, experienced team led by Dr Mark Mobius.
Parent: A solid steward of shareholders' capital.
Board: The board has had a full refresh in recent years; it’s a little on the large side with seven members.

Morningstar Opinion

Templeton Emerging Markets has weathered several storms and we think it’s well placed to continue.

Our confidence is due in part to the management team at the fund’s helm. Dr Mark Mobius has been at the firm since 1987 and he has built a strong and loyal team there. It’s a team that comprises more than 30 and is spread globally to enable on-the-ground research. Mobius is assisted in the day-to-day running of the fund by Allan Lam, Dennis Lim, and Tom Wu and in reality those three are making the investment decisions, although Mobius has oversight of these. All three have worked with Mobius for more than 20 years so the origins of his style and process are well and truly embedded in their approach.

This process focuses on finding long-term value in a company that’s not yet priced in. Each team member is encouraged to become an expert in their sector globally and then to expand this through regional knowledge. Meeting with management is a key factor in determining the quality of the business. The team doesn’t ignore the macro and it doesn’t stop investment in a particular country, but they try to look beyond short-term noise.

Indeed, this is borne out in the fund’s turnover, which, in three of the last five years, has been in the single digits. That stability of approach has translated through into strong returns for the fund. This is evident in the performance since the fund’s launch in 1987, but also more recently through the financial crisis and beyond.

These returns haven’t been plain sailing for shareholders, though. Despite the lack of gearing here—the board is naturally very cautious—the fund has exhibited notably more volatility than its average Morningstar Global Emerging Markets Equity category peer. Granted, the returns have compensated investors for that volatility over the long term, but the extremes may be too much for some to stomach. For example, in 2009, the fund outperformed its average peer by more than 30%, but it lost 13% more than its peer in 2008.

Volatility hasn’t been high when it comes to the discount, though. The board has a formal—but undisclosed—policy and they will buy back shares to manage this. In 2008, a tender offer saw 30% of the fund bought back. Since then, the discount has stayed fairly tight, with the help of more buybacks. It’s a well resourced and well remunerated board—one of the highest in the investment trust sector. The ongoing charges are competitive, if not cheap, and we think there could be some economies of scale that could be passed on.

Our main concern centres around key man risk: We’re comfortable that it’s not just Mobius running the show, but should he eventually step down it will likely impact every fund at which he’s named manager, and there are a lot of them, despite the breadth of resources and skills in the team. The fund receives our Bronze rating.

Portfolio Process Approach

The fund invests primarily in large-cap, emerging-markets companies or in companies that derive a significant share of revenue from emerging markets. The aim is to produce superior long-term, risk-adjusted returns over a full market cycle (expected to be five years). Meeting company management is crucial to identifying the long-term drivers of a business. The team will assess the quality of management, the products/services, the customer base and competitors, and the sustainability of competitive advantage. The analyst will also consider the country, market, and economic environment before preparing a detailed document. The process is very collaborative and begins with the analyst producing documentation and buy/sell targets on a newly covered company. This information is fed into a global database and is automatically distributed for cross-checking by three regional colleagues (not from the same office) and the relevant global sector analyst. The analysis relies on looking at five years of past data and projecting five years ahead. Valuation methods vary depending on the country and company and it is up to the analyst to use the most relevant methodology. The peer reviews will result in the price targets being adjusted upward or downward, and once the buy/sell targets are agreed, portfolio allocators for the relevant funds trade the portfolio accordingly.

Portfolio Positioning

The fund has a pronounced bias to large-cap stocks and places right at the top of the Morningstar Style Box from a size perspective. Mid- and small caps still feature but to a limited extent and, relative to the average category peer, the fund was underweight in both at 30 June. At a country level, the fund was overweight Thailand, Indonesia, India, China, and Hong Kong and underweight Korea, South Africa, Mexico, Brazil, and Russia. The team keeps the list of stocks relatively tight at around 50 names as they prefer to have strong-conviction bets rather than a long tail of names. From a sector standpoint at 30 June, the fund was overweight energy and materials, along with consumer discretionary names. Conversely, it was underweight financials and technology. The team’s long-term focus results in turnover that is very low--it’s common to see annual turnover in just single digits here.

Dividends

While the investment objective doesn’t target income at this fund, the investment style has resulted in the board being able to pay a modest dividend every year since the fund’s launch. The amount of that dividend has increased in recent years and, in addition, the board has built the revenue reserve account such that the dividend is covered, at its current level, for nearly five years. That’s a high level of cover, but that’s because the fund’s yield is modest at around 1%. Nonetheless, the dividend helps to smooth out the volatility of returns that’s associated with emerging markets.

Discount

The board has shareholder approval to buy back shares at their discretion. They used this heavily in 2007 and 2008 when the discount widened at the time of the financial crisis. They also had a tender offer in June 2008, which followed prolonged discussions on how best to give shareholders the opportunity to exit the fund. This saw them buy back 30% of the company. Over the last three years (to 31 Aug) the fund’s average discount has been a little less than 7%, and over six months this figure is little different. The board has a formal policy to which they manage the discount but do not disclose the exact level. That said, it’s rare to see it breach 7% and the discount volatility is fairly low overall.

NAV Performance Analysis

Since inception to 31 Aug, the fund has returned more than 14% annualised and doubled the performance of its average category fund. That’s come with some volatility but nonetheless it’s an impressive result. The fund lost more than peers in 2008, falling some 44% compared with the average loss of 31%, but in 2009 it rallied hard and gained more than 91%, compared with its category average fund’s 56% gain. The team has shown its ability to add value across a range of market cycles. In the last 12 months, their bet on resources and oil stocks has hurt the fund’s performance but it hasn’t detracted from their view at a company level, where prospects are still encouraging. Political turmoil doesn’t prohibit an investment if the case is sound—Korea being one such example—but it will make for a bumpy ride in the fund.

Risk & Return

This fund exhibits a risk profile that’s higher than its category average peer and that’s without the use of gearing. Its three-, five-, and 10-year Morningstar Risk rating is high. That said, the Morningstar Risk-Adjusted Returns show this risk is being used to good effect and the fund has outperformed its category average on that basis over both the long and short term. While the fund tends to lose more in down markets, as shown by the downside capture ratio, it tends to outperform in rising markets, as shown by the upside capture ratio. Its standard deviation, a statistical measure of risk, is higher than the average category fund over the short, medium, and long term.

Fees

The fee structure is very simple and comprehensive. There is a base management fee of 1% of net assets; in addition, there is a secretarial and administration fee of 0.2%. This results in ongoing charges in the region of 1.3%. While that’s not in the cheapest quintile of its Morningstar Global Emerging Markets Equity category, it’s competitive and is considerably lower than the median fund. That said, given the scale of assets run by Franklin Templeton and specifically by Mobius’ team, we think there is room for some economies of scale.

Gearing

It’s unlikely that shareholders at this fund will see any form of gearing in action as both the board and the investment manager are cautious over its use. Their general view is that emerging markets are sufficiently risky that they don’t want to compound this risk unduly. The manager is permitted to borrow up to 10% of net assets but in practice we have yet to see this used since the fund’s launch in 1989. The board is mindful of keeping this fund simple as they believe this is one of its key attractions.

People

The Templeton Emerging Markets Research Team is led by Dr Mark Mobius, a pioneer in emerging-markets investing. Mobius joined Templeton in 1987 as president and manager of the Templeton Emerging Markets Fund, Inc. He started managing dedicated emerging-markets portfolios in the late 1980s and continues to be involved in the day-to-day fund management activities and oversees the investment process. Although Mobius is listed as the investment manager, he is assisted by Allan Lam, Tom Wu, and Dennis Lim in day-to-day activities. The team is spread across four continents and comprises more than 30 dedicated portfolio managers and analysts with an average of more than 10 years in the industry and eight years with the firm. Research is organised on global industry lines, with most analysts also having portfolio management responsibilities. The analysts are encouraged to change their sectoral focus every five to seven years in order to give individuals exposure to a wide range of industries and to encourage challenging discussions at team meetings. In the weekly analyst meeting, the analysts are responsible for formulating stock views but Mobius continues to oversee the process to ensure it is being adhered to. Overall the team's credentials are impressive: Many team members have been with the group for a number of years and have experienced different market cycles.

Parent

Franklin Resources traces its roots to 1947, when Rupert H. Johnson Sr. named his brokerage firm after Benjamin Franklin. It has always run proprietary mutual funds, but it also has grown through acquisition. It bought Templeton, Galbraith & Hansberger from Sir John Templeton in 1992, adding an array of international funds. Four years later it bought Heine Securities, investment advisor to the Mutual Series funds. Franklin Resources now centers on the Franklin, Franklin Templeton, and Mutual Series lineups. A Johnson still runs the firm. Aspects of the firm are appealing. Most offerings levy below-average fees and are typically run by long-tenured managers who invest more than USD 1 million in their funds. The firm has a sensible compensation plan, and the US funds are overseen by experienced boards of directors. That said, this global organization is complex. The firm's subsidiaries have distinct cultures employing different strategies. Mutual Series is value-oriented while Franklin Templeton is more growth-focused. Because the subsidiaries don't share investment resources, retention within each is vital. In 2009, Mutual Series lost several managers to PIMCO. In 2007, a number of Templeton managers jumped ship. While those defections are rare, another wave would be a red flag. Overall, the concerns here don't overshadow the firm's broader merits.

Board Of Directors

This fund has one of the largest boards for a UK-listed fund, but at nearly GBP 2 billion, it’s also one of the largest UK-listed funds in the market. The board has been refreshed fairly recently: The average tenure is nearly six years, but the longest-serving member only joined in 2004 and there were three further appointments in 2007. Those three joined at a difficult time in the fund’s life, made worse by the ensuing financial crisis. In 2007, the board put forward proposals to split the fund into two parts—a tracker and new ordinary shares—but shareholders didn’t approve this change. In 2008, they did approve a tender offer for 30% of the company, which saw some GBP 620 million fall in the fund’s value as the board bought back shares. What’s more, much of the fund’s prior history went as the former directors stepped down. Nonetheless, with Mobius as a constant from a management perspective, and chairman Peter Smith on the board since 2004, our concerns are abated to some extent. Five of the seven directors are shareholders in the fund. Six are independent; Gregory Johnson is president and CEO of Franklin Resources. There is limited direct experience of emerging markets on the board, either from an investment or commercial career perspective and this is likely to evolve with future appointments. We note the director remuneration is on the high side for an investment trust; only four serve on the boards of other listed companies.

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