The fund returned 2.1% during the third quarter of 2019, slightly behind the 2.8% return of the MSCI Emerging Markets Index (both in rand terms). The cumulative performance for 2019 remains very pleasing, at 25.9%, which is 14.2% ahead of the index return of 11.7%. Over one year, the fund has returned 14.3% (9.5% alpha) and, over three years, 9.1% p.a. (-0.4% p.a. alpha). Although we are very pleased with these strong short-term returns, the long-term nature of the fund makes longer-term returns more meaningful for assessment. In this respect, while the five-year return is behind the benchmark (-1.9% p.a. alpha), the seven-year (0.3% p.a. alpha), 10-year (0.3% p.a. alpha) and since inception figures (1.8% p.a. alpha) are all pleasingly positive.

The largest positive relative contributor to the fund during the quarter was New Oriental Education (New Oriental). The share was up by 21.7% in rand terms during the quarter after delivering positive full-year7 results (their financial year end is 31 May) and reinforcing the guidance that margins will improve in the years ahead as their heavy investment in new capacity starts to mature. New Oriental currently earns operating margins of 12%, well below the 18% they used to earn three years ago before they started investing heavily to grow their capacity, which has since doubled. Members of our team met with management in Beijing in August and our positive long-term view on potential was reinforced – the margins on mature operations exceed 20% and unsuccessful sites can be fairly easily shut down if they are not meeting expectations. Were the business to stop growing today, the rampup of their already-opened learning centres (which are not fully contributing to revenues), combined with the increase in margins that accompanies this (they are incurring the full cost of employing teachers and paying rent), could see profits double within three years. This is in addition to the substantial organic opportunities available to New Oriental, whose market share is still in the single digits, despite being the largest operator of on-site after-school tutoring facilities in the country. New Oriental contributed 0.5% of alpha during the quarter; however, the strong share price performance did reduce the relative attractiveness of the share and we reduced New Oriental from a 3.0% position to 2.3% as a result.

The second-largest relative contributor was Wuliangye Yibin (Wuliangye), the Chinese baijiu spirits brand. Up by 13.3% in rand terms, Wuliangye contributed alpha of 0.4% to the fund. Over the quarter, one of our analysts visited the company at its headquarters in mainland China for the second time this year, a visit that reinforced the positive steps the company is taking to improve its pricing ladder and increase the share of premium baijiu within its portfolio. Over the last year, Wuliangye has returned 98.9% and has contributed 2.53% to the relative performance of the fund. It remains a top 10 position in the fund despite this strong performance, as we believe it is a unique asset, capable of compounding earnings at 20% p.a. for the next few years, and this is not yet reflected in the share price.

Other meaningful contributors during the period were British American Tobacco (+13.5% return for 0.37% alpha), Brazilian education company Estácio (23.2% return for 0.36% alpha) and global brewer Anheuser-Busch InBev (+16.2% return for 0.21% alpha). The big news in the tobacco industry was the aborted merger attempt between Philip Morris International (PMI) and Altria. As PMI shareholders (2.6% of fund), we were vehemently opposed to the deal and communicated this strongly through a letter to the board immediately upon announcement of the merger talks. The market’s reaction to the deal (PMI fell as much as 9% on the day of the announcement) clearly sent the same message to the affected parties. We were against the deal for a variety of reasons, not least of which is the very negative regulatory environment for combustible cigarettes in the US currently, to which PMI would have been exposed through Altria’s US operations. Furthermore, Altria’s shareholding in electronic cigarette company Juul is problematic as Juul is a potential competitor to PMI’s well-received Heat- Not-Burn (HNB) IQOS product, which will be launched in the US shortly (by Altria, with a royalty payable to PMI). Juul has come under significant regulatory scrutiny due to the prevalence of teenage vaping, which itself has been partly driven by the dubious marketing tactics and an array of flavours that give the impression that vaping is harmless. We believe IQOS has tremendous long-term potential in many markets (it has been very successful in Japan, Korea and parts of Europe already) as a means of reducing the consumption of far more harmful combustible cigarettes. We did not want any exposure to Juul, so, as PMI shareholders, the failure of the merger talks was, in our view, a very positive development.

On a less positive note, the biggest detractor for the quarter was Chinese classifieds business 58.com, which fell 14.9% for a -0.85% impact. The two biggest “verticals” within 58.com are property and jobs (blue collar), both of which are (in theory) affected by the broader macroeconomic slowdown being experienced in China. Trade war fears have intensified negative perceptions of stocks exposed to the broader economy and, with 58.com viewed in this light, it has fallen for reasons of sentiment rather than fundamentals. Toward the end of the quarter, 58.com fell significantly after a competitor Meituan Dianping (Meituan) (a new fund holding, which we discuss in more detail lower down) moved into the blue-collar jobs market. One cannot dismiss this development, given Meituan’s disruption of other internet-based platforms; however, in our view, Meituan’s jobs platform is more suited toward matching users of its delivery services with advertisers in the restaurant and service industry. This is a specialist niche within the broader market and, we believe, is unlikely to materially impact on 58.com’s appeal for jobs postings. 58.com’s EBITDA margins (mid-20%s) are below most peers in other countries, despite earning similar gross margins. Over time, as the business continues to scale up and investment declines, profits should grow at a rate materially higher than revenue growth. 58.com continues to deliver operationally, with revenue up 21% and operating profit up 24% in the first half results to end of June 2019. It now trades on a 12% free cash flow yield (to enterprise value), which is very attractive in our view, and so it remains one of the largest positions in the fund.

Other big detractors for the quarter were the relative underweight in Taiwan Semiconductor Company, which returned 26.8% in the quarter and cost the fund 0.49% in relative performance. Chinese wealth manager Noah Holdings declined by 24.9% in the quarter and the 1.23% position (at the start of the quarter) therefore cost the fund 0.35% in relative performance. The ongoing political strife in Hong Kong weighed heavily on Hong Kong-listed life insurance group AIA, which fell 5.5% and cost 0.28% in relative performance. AIA generates about 40% of new business in Hong Kong and it is estimated that half of this comes from mainland China. In addition, 30% of new business is originated directly in China. Although it was only a small detractor in the quarter (0.21% negative contribution), the fund’s Ctrip holding was also negatively affected by China/Hong Kong developments, as travel bookings are a large part of its business, and China-to-Hong Kong travel makes up around 30% of outbound ticketing volumes processed by Ctrip. The fund’s other baijiu holding - Jiangsu Yanghe - fell by 11.9% to cost the fund 0.27% in relative performance.

There were several new buys in the fund, the largest of which was Meituan, mentioned above. Meituan is a platform business offering food delivery services (such as Uber Eats), hotel booking and in-store services such as restaurant bookings, movie tickets and hairdressers (to name but a few examples). Meituan has a number one or two position in its various business niches and leverages its massive scale to gain a cost advantage over weaker peers. In food delivery, it competes primarily with Alibababacked Ele.me, while in hotel bookings it has surpassed Ctrip in the lower end of the market (when measured by room nights, but not by revenue, since Ctrip targets mid- to higher-end hotels). Online penetration in most categories remains quite low, so there is still substantial room from the market leaders to take share from offline over time, which will further enhance their cost advantage over time.

Another new buy was Indian online travel agency (OTA) Make My Trip. We have met this business several times over the years and believed it had significant potential, as it has many similarities to Ctrip, which has been in the fund for some time. The Indian market is, however, several years behind China’s. India is also a far more cost-conscious market with lower per capita incomes. The airline industry is dominated by low-cost carriers and the hotel industry is also focused mostly on lower-tier hotels. Travel is still predominantly domestic and for leisure, which is more price sensitive. With more than half of air tickets still booked offline and perhaps 80% of hotels booked offline, the runway for online to take share from offline is significant, and Make My Trip already has more than 50% market share in the online space after acquiring the second-largest OTA in India (Ibibo). The relatively faster growth of the non-air ticketing part of the business in recent years has resulted in air ticketing revenues making up only a third of revenue from more than 50% a few years ago. In addition to airline tickets and hotels, Make My Trip offers a variety of value-add services such as train ticket bookings (the state-run railways in India are not easy to book online), car hire, full package holidays, travel insurance and assistance with procuring visas. As these higher value-add services grow in the mix, we believe Make My Trip’s profitability will be significantly enhanced, as it is currently loss making. Naspers was previously the largest shareholder in Make My Trip, followed by Ctrip, but a recent shareholding structure change has resulted in Ctrip becoming the largest shareholder, with Naspers becoming a material shareholder in Ctrip. We believe that Make My Trip will benefit from having a dedicated OTA as its largest shareholder, since Ctrip has been through a similar development and learning curve in China.

Another new buy in India was Axis Bank, the third-largest private bank in the country. We have previously highlighted the investment case in the private banks in that country as they take market share from the poorly run public sector banks in what is still a fast-growing market overall. Axis is a previous fund holding that we sold when it started to approach our assessment of fair value. Like many of its peers that grew too fast, the book quality deteriorated and some time was needed to clean up the bad debts. A highly regarded new CEO was brought in and the share price recovered strongly. Axis is increasingly becoming a more retail-focused bank, which, in our view, is significantly more attractive than focusing on corporate loans, which are more competitive and can have a bigger negative impact on the book (as we have seen in the bank and its peers historically). More recently, the (relative) slowdown in the Indian economy, the liquidity issues within the banking sector as a whole and the aggressive provisioning of old loans under the new CEO saw the Axis share price decline by around 20% (in rupees) from its second-quarter peak. At these levels, we believe Axis offered significant upside and we started to build a small position toward the end of the third quarter. As the bank is growing quite fast it also needed to raise capital, and we were able to purchase most of the position during this capital raise at a discount to the prevailing market price. Subsequent to purchasing the position, the Indian government reduced corporate tax rates, which will be positive for shareholders of Axis and shareholders of some of the fund’s other Indian pure domestic holdings, like HDFC and HDFC Bank.

The last new buy was a repurchase of Turkish discount retailer BIM, one of the best-performing businesses anywhere in the world over the last two decades. We had sold out of BIM in mid-2018 due to the economic crisis in Turkey and a loss of confidence in the country’s government, which looked to be operating in an increasingly populist and haphazard fashion. BIM has continued to grow its store network through all of this and has gained share by limiting price increases in an environment of very high inflation within the Turkish economy. The Turkish lira, which was one of the worst-performing currencies in 2017-2018, has stabilised, and with interest rates and inflation declining, we believe that BIM will continue to deliver high returns on capital in an improving economy in the years ahead.

Two small positions were sold to zero in the quarter – Global Mediacom in Indonesia (we still retain a small position in free-to-air TV operator Media Nusantara, which is majority owned by Global Mediacom) and bank holding company Itaúsa in Brazil. Members of the team travelled extensively during the quarter, meeting management of over 100 companies in various locations as well as conducting site visits to holdings in Russia, China, Hong Kong and Macau. The travel will continue in the fourth quarter, including a visit to Brazil, whose weight in the fund has declined to 6.8% - the lowest it has been in several years.

The fund had a very good quarter, returning 21.6% compared to the MSCI Emerging Markets Index return of 11% (both in rands) and in doing so outperformed the market by 10.6%. This made it the fund’s best quarter of outperformance since inception over 11 years ago. Its previous best quarter was the one to end September 2008 (9.4% outperformance) in the midst of the 2008 GFC.

During the quarter to end March 2019 there were a number of stocks that contributed positively, with all of the 15 largest positive stock contributors appreciating by more than c. 20% in USD. At the top of the list was Wuliangye Yibin (+92%, 1.8% contribution), New Oriental Education (+62%, 1.2% contribution) and Yes Bank (+53%, 0.9% contribution) followed by British American Tobacco (+29%, 0.8% contribution), Ctrip (+60%, 0.7% contribution), JD.com (+36%, 0.7% contribution) and Philip Morris (+34%, 0.6% contribution). A number of these stocks were poor performers in 2018 (specifically in the last few months of the year) and so the fund’s strong performance to date in 2019 is partly a reversal of a poor 2018. JD.com, Yes Bank, British American Tobacco, Philip Morris and Ctrip would all fall into this category. In addition, a few of the new buys in late 2018 were strong performers, most notably Wuliangye Yibin and New Oriental Education. Lastly, a number of long-held positions contributed positively, including Airbus (+38%, 0.6% contribution), Ping An Insurance (+28%, 0.4% contribution) and 58.com (+16%, 0.2% contribution). At the same time there were few large negative contributors with only one detractor of more than 0.5% (Alibaba’s -0.6% detraction). Since inception over 11 years ago the fund has outperformed the market by 1.7% p.a.

There were 5 new buys during the quarter. The 2 largest new buys were that of Jiangsu Yanghe Brewery (1.6% position) and LVMH (1.7% position). The 3 other buys were small: a 0.9% position in NetEase (#2 online gaming company in China after Tencent), a 0.5% position in BM&F Bovespa (Brazil’s dominant vertically integrated multi-asset [equity, bonds, derivatives] exchange) and a 0.4% position in Eastern Tobacco (Egypt’s monopoly cigarette manufacturer). In total, the 5 new buys represent 5.1% of the fund. During the quarter, we sold China’s #1 search engine, Baidu (a 1.5% position at the start of the year) due to increasing concerns about the core search business as well as the uncertain future return from the numerous other areas where the group is investing significant capital. In terms of other portfolio activity, we reduced the positions in New Oriental Education, Ctrip, Noah, Li-Ning and Adidas (all on strong share price performance and resultant less upside to our estimate of fair value) as well as Indiabulls (largely due to a reduction in our fair value and a less attractive risk/return profile). From a buying point of view, most of the activity was in the 5 aforementioned new buys but we also added to the existing positions in HDFC Bank and Pão de Açúcar.

Jiangsu Yanghe Brewery is the largest premium brand baijiu (the dominant white spirit in China) company, in contrast to the main ultra-premium (very high end) baijiu companies Kweichow Moutai (not owned in the fund) and Wuliangye Yibin (a 3.3% position in the fund). We bought a position in Wuliangye Yibin late last year and subsequently continued to do additional work on the industry, including a week’s trip to China solely focused on the Baijiu industry which led us to Jiangsu Yanghe.

Over the past decade, Jiangsu Yanghe have grown sales by 27% p.a., making them the fastest growing baijiu company over this period. Both net profit and free cash flow have grown by 35% p.a. over the past 10 years and today the company generates over $ 1b of free cash flow. The company is a beneficiary of the premiumisation of baijiu (their main premium brand ‘Dream Blue’ series has gone from being 2% of sales a decade ago to contributing over 20% of sales today) and we expect this to continue, together with further expansion to regions outside of their home base, Jiangsu (which today still contributes 53% of sales). A unique feature of Jiangsu Yanghe that also attracts us is the fact that management own c. 21% of the company. Just like Kweichow Moutai and Wuliangye Yibin, the financial metrics of Jiangsu Yanghe are impressive with operating margins of c. 45%, return on capital of c. 20% and high free cash flow conversion (over 100% of net profit in the past 3 years has been converted into free cash flow). The share trades on c. 18.5x forward earnings with a 3% dividend yield, which we believe is attractive given its long-term prospects.

The other new buy of note was a 1.7% position in LVMH, which we have covered for several years and have owned in the Strategy in the past. LVMH (Louis Vuitton Moet Hennessy) is the largest global luxury goods company and the owner of the Louis Vuitton brand (c. 50% of group profits) and many other global brands including Moët & Chandon, Hennessy, Christian Dior, Fendi, Bulgari and Tag Heuer. Over 40% of sales come from emerging markets and the Chinese consumer alone (purchasing at home as well as while travelling) is responsible for well over 50% of incremental growth.

LVMH has an enviable track record (over the past 20 years EPS has compounded at c. 12% p.a.) and today is well placed to be a key beneficiary of the growing emerging market middle and upper class and the wealth effect. The barriers to entry possessed by the true global luxury brands (Hermes, Louis Vuitton and Gucci) are amongst the highest in any industry in our view: in the case of Louis Vuitton, a 150-year history and investment in the brand for a start. The resilience (of both the topline and profitability) of the Louis Vuitton brand in particular in tough economic periods is also unparalleled: in 2009 (post the GFC) sales of the Fashion & Leather division (with Louis Vuitton making up the lion’s share of this division) of LVMH grew by 2% and EBIT grew by 3%. In 2002 (post September 11th) the Fashion & Leather goods division experienced 16% sales growth (and this after double-digit sales growth in 2001 as well) and 5% EBIT growth. The fund bought LVMH on c. 20x forward earnings and a 2% dividend yield, which we think is attractive for what we would consider to be one of the best businesses in the world.

Members of the Global Emerging Markets 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 as to find potential new ideas. In the first quarter, there were 2 trips to China and 2 to India. The coming months will see a further trip to China as well as one to Brazil. The fund’s weighted average upside to fair value at the end of March was c. 40%, which we feel is compelling. We would also consider the overall quality of the stocks held in fund currently to be above average when compared with other points in the fund’s 11-year history.