The fund had a poor quarter, returning -2.5% compared to the +1.9% of the MSCI EM index. The largest negative detractors over the period by some way were 2 of the Indian Financials, Yes Bank and Indiabulls Housing Finance, which together detracted 2.3%. Other notable detractors were JD.com (-1.0% impact), Magnit (-0.6% impact) and Naspers (-0.5% impact). Having no commodity exposure (either energy or basic materials) also detracted (-1.5% total impact) in what continued to be a good period for commodity prices. On the positive side, Tencent (which the fund doesn't own, and which declined by 18% over the quarter) was the largest contributor (+0.9%) followed by Kroton (+0.7% impact due to appreciating by 20% over the quarter after falling significantly in the first half of the year), Ping An (+0.4%) and Adidas (+0.4%). Since inception the fund has generated a return of 9.3% p.a. compared to the 8.2% p.a. return of the MSCI EM index.

With volatility at above average levels in emerging markets, we were more active than usual, having made 5 new buys during the quarter. Four of the new buys were Chinese companies (a number of Chinese stocks have experienced sharp falls recently) with the 5th being Brazilian. As a result of new buying being focused in Chinese stocks, the fund's China exposure increased from 17.6% at the end of June to 25.4% at the end of September.

The largest new buy over the quarter was a 1.6% position in New Oriental Education, one of the leading after school tutoring businesses in China with over 1,000 learning centres, 28,000 teachers and operations in 75 cities in the country. In our view, the leading Chinese tutoring businesses are very good businesses with attractive long-term prospects. Demand is driven by the importance of getting good marks for entrance into the best high schools, local universities (the Gaokao exams) and international universities. In China, children's education is amongst the highest priorities in terms of discretionary spend. Increasing disposable incomes over time and urbanisation are additional long-term drivers, as is the recently introduced two-child policy. The businesses are reasonably defensive, very cash generative (well north of 100% free cash flow generation due to upfront payments and low capex needs) and generate high returns on capital.

After meteoric share price increases over the past few years the Chinese education companies lost half their value over the past few months which brought New Oriental Education into buying range. The recent share price declines were driven by a number of factors. Firstly, Chinese equities have generally performed poorly over the last few months (concerns over the economy/trade wars). Secondly, their high ratings made them vulnerable to any small disappointment or change in outlook, and thirdly this indeed came in recent months in the form of increased regulation of the sector. In summary, the Chinese government is tightening up regulation of the sector which includes all operators having to obtain business and educational licences for all learnings centres, all teachers having to write qualifying exams by the end of 2018 and classrooms having to be of a certain size. In this regard, New Oriental and TAL (being the 2 largest tutoring companies) are well placed relative to the numerous smaller operators, and the increased regulation, while having a shorter-term impact in terms of new learning centre roll-out, will only increase their competitive advantage relative to the smaller operators who lack the resources to meet the new requirements. At time of writing, New Oriental trades on c. 19x forward earnings and c. 14x forward free cash flow and with over 25% of its market capitalisation in net cash. Additionally, operating margins currently (c. 11%) are almost half of where they have historically been (c. 17% three years ago and as high as 20% several years ago) due to the large number of new centres rolled out in the last few years that are yet to contribute materially to profits.

The 2nd largest new buy during the quarter was a 1.2% position in Wuliangye Yibin, the 2nd largest premium baijiu (a local Chinese white liquor) company in China. The baijiu spirits market in China is a large subset of the overall market and makes up c. 90% of all spirits (whisky, brandy, white spirits, etc.) consumption in China. As can be seen in the graphs above, the baijiu market leader (Kweichow Moutai) is the 5th largest spirts company in the world by sales (even though they only operate in China), with Wuliangye being the 6th largest. On a free cash flow basis, the gap between the 2 global spirits leaders (Diageo and Pernod Ricard) and the 2 main baijiu producers (Kweichow and Wuliangye) is far smaller than the sales gap as a result of the higher margins of the baijiu companies as well as their higher free cash flow conversion. For the most recent financial year, Kweichou Moutai almost generated as much free cash flow as Diageo ($ 3.2b vs $ 3.4b) and Wuliangye almost as much free cash flow as Pernod ($ 1.4b vs $ 1.7b).

Within the baijiu market, the ultra-premium brand is Moutai (priced at c. $ 150 a bottle), followed by the regular Wuliangye brand (priced at c. $ 100 a bottle). As simple reference points to provide context, a bottle of Johnny Walker Black sells for around $ 25 globally, Macallan 12-year old single malt for $ 40 and Macallan 15-year old single malt for $ 70. The ultra-premium baijiu market in particular is very attractive, with age old heritage and very high desirability. Wuliangye's baijiu offering covers the whole market (with price points as low as $ 5 a bottle), but a shift over time to the ultra-premium and premium Wuliangye products provides both higher revenue and higher margins. Wuliangye generate a c. 20% return on capital and over the past 5 years have cumulatively converted 100% of earnings into free cash flow. After a 25% share price decline this year it now trades on c. 15x forward earnings with a strong balance sheet (c. 20% of market capitalisation in net cash). We have also done detailed work on Kweichou Moutai (which the strategy doesn't own), but prefer Wuliangye's broader mix, lower government related sales and lower starting valuation (c. 15x forward earnings vs Kweichou Moutai on c. 19x earnings).

There were smaller buys in Li Ning (0.8%), NetEase (0.8%) and Itau Unibanco/Itausa (0.6%). Li Ning is the 2nd largest domestic sportswear brand in China (after Anta Sports) and the 4th largest overall in China. Nike and Adidas are the leaders in the market with c. 20% apiece, followed by Anta with 8% market share and then Li Ning with c. 6%. The fund has owned Nike and Adidas for large parts of its history (and today still owns Adidas and only recently sold Nike) and in our view the sportswear industry is an attractive one, being the beneficiary of rising disposable incomes and the age-old wealth effect that results in the desire to own brands. More recent drivers include an increased health awareness globally (and specifically encouraged by the government in China) and of casual dressing (moving away from a more formal dress code generally). While Nike and Adidas are the clear leaders in China (and will continue to take market share over long periods of time in our view), there is also place for a 2nd tier due to affordability, and Li Ning and Anta are the 2 clear leaders in this area. Li Ning is part of the way through a hitherto successful turnaround but profitability is still well below peers (Li Ning have current EBIT margins of c. 7% compared to Anta at 23% and smaller peers all in the 13-17% range) and besides double-digit sales growth (which is already happening) we believe there is room for margins to expand from current levels, with the big drivers being more direct to consumer (DTC) sales, lower wholesaler rebates and operational gearing. Li Ning trades on c. 16x forward (below normal) earnings and has a very strong balance sheet with 22% of its market cap in cash. We have done detailed work on both Li Ning and Anta (they are after all competitors to each other) but only bought a position in Li Ning due to a number of concerns we have with Anta at this point. These concerns include a stagnant core Anta business (ex Kids) with revenue being driven by the more fashionable (and hence potentially cyclical) Fila brand, peak operating margins, a recent large international acquisition as well as concerns on the board/management structure.

NetEase is the 2nd largest online gaming company in China after Tencent (gaming is c. 70% of NetEase's revenue) and have a fast-growing e-commerce business (c. 20% of revenue). We have owned NetEase twice before in the past 10 years and the c. 40% decline in its share price this year brought it back into buying range. Unlike Tencent, who mainly licence games, NetEase develop their own in-house games with a focus on higher quality, more technical games, with the resultant intellectual property that goes with this. The founder, who remains CEO, owns a 40% stake in the business and the company has bought back shares on a number of occasions, and is doing so again. The share trades on c. 17x forward earnings and has 15% of its market capitalisation in net cash, which we believe is an attractive valuation for what is a high-quality asset.

Itau Unibanco is the largest private bank in Brazil (3rd largest bank overall behind the 2 large State banks), and the highest quality one in our view. Concerns over the Brazilian elections as well as general emerging market concerns resulted in a large share price decline to the point where we were able to buy this asset on less than 10x earnings with a 6% dividend yield. The bank is a leader in digital, is conservatively managed (Tier 1 capital of 15% and a coverage ratio of 200%) and has attractive long-term prospects in our view due to potential market share gains (State banks still make up over 50% of the banking system) and ongoing digital development (the cost/income ratio of a digital branch is 30% compared to a bricks and mortar branch of 70%).

Members of the team continue to travel extensively to enhance our understanding of the businesses we own in the strategy, their competitors and the countries in which they operate, as well to find potential new ideas. In this regard, over the past 20 months we have done detailed work (modelling, fair value and research report) on 43 new companies, 10 of which have made it into the portfolio, making up 24% of the strategy today. In the quarter there were 2 trips to China as well as trips to India and Russia. The coming months will see further China trips (2) as well as trips to India and Brazil. The weighted average upside to fair value of the strategy at the time of writing was approaching 70%, well above its long-term average of c. 50%.

The fund appreciated by 5.3% in the past quarter, slightly behind the 6.9% increase in the MSCI EM index. The largest negative detractors over the period were the Brazilian education stocks, Kroton and Estácio, which together detracted 2.3%. The main positive contributors were YES Bank (+0.7%) contribution), Baidu (+0.5%) and Airbus (+0.5%). Since the fund launched 10.5 years ago it has appreciated by 9.8% per annum when compared with the 8.2% per annum return from the MSCI Emerging Markets Index.

The Brazilian education stocks, after being significant positive contributors in both 2016 and 2017, have been large detractors in 2018 so far. We wrote extensively about Kroton in the March 2018 commentary but given continued poor performance of the Brazilian education stocks and their impact on the fund's returns, we believe it worthwhile to briefly touch on them again. Even after appreciating by 20% so far in July, Kroton is still down 39% (in BRL) year to date and down 23% over the past 1-year period. In contrast, Estácio - while having declined by 20% this year - has appreciated by 70% over the past one-year period. Estácio's performance this year has been broadly in line with the average Brazilian consumer stock - in other words its poor performance is largely due to macro factors (rising US rates, Brazilian politics/economic concerns driven in part by the truckers' strike and upcoming elections in October). Kroton's performance, besides being impacted by macro factors, has also been impacted by company specific factors, as one would expect to be the case given the differential in performance between Kroton and Estácio. During the quarter, Kroton reported their Q1 results, and while these results were in line with expectations they reduced their earnings guidance for the year (in contrast, Estácio's results and outlook were ahead of expectations). Kroton also announced the acquisition of an education publishing/K12 school business (Somos Educação) at what appears to be a high price. These two events as well as general economic concerns (and resultant education industry concerns) resulted in the share coming under more pressure. Kroton is already far more efficient than Estácio (c. 30% EBIT margins vs. c. 15% EBIT margins for Estácio) and as such don't have this lever to pull.

As is typically the case when a large fund holding is going through a tough period and is impacting the fund's performance, we spent a significant amount of time on Kroton over the past several months with the aim of assessing whether the investment case still holds or not. Besides spending half a day in Sao Paulo meeting with several individuals from Kroton's management team earlier this year, in the past few months we have had separate calls with Kroton's CEO (twice), CFO, Head of Campus and Head of K12, in order to assess the Somos transaction as well as discuss both the shorter and longer-term challenges and opportunities for Kroton. In addition, over recent months we have spoken with competitors (Estácio and others), former industry executives as well as three local Brazilian funds (two are shareholders and one is negative on Kroton as we believe there is value in hearing and understanding views on differing sides).

Our conclusion from all this work is that while Kroton are facing a tough year or two ahead, the long term prospects remain very attractive: an underpenetrated market in a fragmented industry with the biggest players (Kroton is #1 and Estacio #2) having the opportunity to take market share in what is a scale business, and a new growth driver in the form of entry into the K12 schools market where the market size is more than double that of the tertiary education market. On the Somos acquisition, while the price does look high at face value, there are synergies that can be extracted to bring the acquisition multiple down. Somos's most recent results (post the announcement of the acquisition) showed a 40% increase in profits, which brings the acquisition multiple down further. Additionally, the asset brings diversification to Kroton as well as good cash generation with lower student defaults than in the tertiary sector. Somos provides a platform for a quick leap into Kroton's planned K12 expansion as it takes Kroton from having two schools to having 44 schools, which in turn makes it the largest operator in the K12 private market.

Kroton now trades on less than 10x 2018 earnings with a 4% dividend yield (Estácio's valuation is not dissimilar) which we believe is very attractive given its favourable long-term prospects. Today 5.4% of the fund in total is invested in the Brazilian education companies, with 3.5% in Kroton and 1.9% in Estácio.

Magnit (#1 Russian supermarket retailer by profits) has been the other main detractor from performance over the past several months, although it was a positive contributor over the quarter. During the quarter the company announced the potential acquisition of a pharmaceutical distributor, owned by a related party. The proposed acquisition was a big concern for us as a) we feel that management's time is better spent on addressing current issues in the core food retail business, which is underperforming; b) we question whether it is necessary to own a distributor in order to start rolling out a pharmacy fund(which was the rationale given by Magnit management at the time of the announcement); and most importantly c) we had corporate governance concerns on the transaction (the distributor for sale is owned by a related party, who had only recently bought a 10% stake in Magnit). As a result, we had calls with a few other large shareholders and drafted and sent a co-signed letter to the board expressing our collective concern about the transaction. We also held calls with the (independent) Chairman and Vice Chairman of Magnit as well as another independent director. We were encouraged by their constructive response to our concerns and how they intend to approach this and other issues. At the subsequent board meeting a few weeks ago, the CEO of Magnit (Khachatur Pombukhchan) tended his resignation and Olga Naumova was appointed in his place. Naumova recently joined Magnit as an Executive Director from X5 Retail, where she was head of X5's convenience business (Pyaterochka, which makes up c. 80% of X5's group revenue) and is largely credited with turning around this business (and hence the X5 Retail Group) over the past 5 years. With a new board, a new management team (besides the CEO, the new highly regarded CFO is also from X5 and one of the new director's [ex-Lidl UK CEO] is also involved in an executive role) and a still fragmented Russian food retail market, we believe that Magnit is very attractively valued at current levels and it remains a top 10 holding.

There were three new buys during the quarter: Phillip Morris International (4.8% of fund and the largest new position), Anheuser Busch InBev (1.7% of fund) and YUM China (0.8% of fund). For the c. 10.5-year period since inception of the fund in December 2007 and until January of this year, we had on average 1% exposure to the tobacco companies. The reason for this was two-fold: a) concern over the very long-term prospects for these businesses (declining volumes, increasing regulation and even more health awareness and b) valuation (they had benefited from the general upward re-rating of all consumer staples). Over the more recent past there have been 2 key changes. Firstly, the development of successful reduced risk products (vaping and 'heat not burn' [HNB] devices) has meant that for the first time in decades far safer alternative products are available and as a result total tobacco/nicotine consumption has started to increase instead of decline. And secondly valuation: sharp declines (c. 25% this year) in the share prices of both British American Tobacco (BAT) and Phillip Morris International (PMI) have brought their valuations down: BAT to c. 13x Dec 2018 earnings and a 5.1% dividend yield and PMI to c. 16x Dec 2018 earnings with a 5.3% dividend yield. As such, we believe that for the first time in several years these stocks are now very attractive and BAT and PMI (both of which have high emerging market exposure: 43% and 55% respectively) are 5.4% and 4.8% positions in the fund.

The tobacco companies still have many of the qualities that have always made them very good businesses - most importantly pricing power, stable earnings, very high return on capital and high free cash flow conversion. In addition, they now have attractive long-term growth prospects in our view, due to having reduced risk products in their portfolio that provide an attractive healthier alternative to traditional cigarettes. In summary, the 2 main categories of reduced risk products (vaping and HNB) do not involve burning, and it is largely the burning (combustion) and subsequent release of chemicals of traditional cigarettes that create the health issues. By avoiding combustion, the risk reduced products eliminate the biggest issue with traditional cigarettes, which in turn is what makes them appealing.

Both BAT and PMI have vaping and HNB products, with BAT being the global leader in vaping and PMI the global leader in HNB, with their IQOS (I Quit Ordinary Smoking) product. In our view, there is room for both products as they have different appeals, and being global leaders respectively, there is a high probability of BAT and PMI taking disproportionate incremental market share and hence increasing their overall global market share.

If one looks at BAT's historic and estimated UK revenue split between traditional cigarettes and vaping products, the key point is that for the first time in many years, revenue is increasing. PMI's next generation products (NGP) already contribute 13% of the group revenue and PM have an aspiration to grow that to c. 40% of revenue by 2025 through a c. 4-5x increase in NGP total revenue from $ 4 billion to c. $ 18 billion. To put this $ 18 billion into context, PMI's total group revenue was $ 29.7 billion in 2017.

In terms of other new buys within the fund, Anheuser Busch InBev (AB InBev) has gone from being a market darling ('great management team') to being very much disliked ('only cost-cutters'), and the share price has followed this sentiment. Perhaps the truth is somewhere between these two extremes, but in our view global beer remains a very attractive industry (oligopolies in many markets, strong brands, premiumisation opportunities, stable earnings, high return on capital and amongst the best free cash flow generation of any business), and within this industry there are 2 gorillas AB InBev and Heineken, both of which have attractive long-term prospects. We continue to rate the AB InBev management team highly, and believe that what they may not know about branding/segmentation, etc. (which is very little according to the bear view) can be learnt from the SABMiller (SAB) assets that they acquired or be brought in. AB InBev have a globally diversified business, with a strong presence in Africa (both South Africa and the rest of Africa), Brazil, Colombia, Mexico, China and the US. Almost 60% of profits come from (lower consuming and hence faster growing) emerging markets. AB InBev trades on c. 19x 2018 free cash flow (with SAB revenue and cost synergies still coming, Brazil profits being below normal, Africa and China amongst other regions growing at a rapid rate, etc.) and with a 4% dividend yield, which we believe is attractive for an asset of this quality.

YUM China is the Chinese business that was spun out of YUM Brands (global owner of KFC, Pizza Hut and Taco Bell). The company has c. 8,000 outlets in China (McDonalds as a reference point have 2,600 outlets and Burger King have 800) and continues to roll out 500-600 new restaurants a year. The vast majority (80%) of these outlets are KFC, with the balance largely being Pizza Hut. The royalty percentage paid by YUM China to its parent is far lower than industry norms, which in turn means higher margins and a higher return on capital can be achieved. The fundamentals of a big brand fast food restaurant chain are generally attractive (convenient and affordable, defensive earnings stream and very good free cash flow generation). In addition, with still low penetration, YUM China can continue to roll out stores in China for many years to come in our view. The fast food groups have been successful at addressing the needs of a more health conscious consumer (a clear long-term risk) with expanded menus, and home delivery has also become an important driver (16% of KFC's and 23% of Pizza Hut's sales in China are now deliveries). The company has a strong balance sheet (net cash c. 10% of market cap) and will continue to generate a lot of free cash flow in the years ahead - a large part of which could be applied to share buybacks. There is also opportunity for margins to expand in our view. All-in, we believe that YUM China is a high-quality business, that can grow earnings by c. 15% p.a. over the next 5 years and at around 22x free cash flow one year out is attractive at current levels.

Members of the team continue to travel extensively to enhance our understanding of the businesses we own in the fund, their competitors and the countries in which they operate, as well to find potential new ideas. In the quarter there were trips to Russia, South Korea, Taiwan and Singapore. In the coming months different members of the team will visit China on a few trips with a focus on the Chinese internet companies which remains the industry where the fund has its main exposure to China. The weighted average upside to fair value of the fund at the end of June was an attractive c. 53%.