Latin American (“LatAm”) equity markets are the top performers in emerging markets this year. Brazil has been grabbing the headlines because of the ongoing political drama (i.e., the impeachment of now former President Dima Rousseff) and, of course, the Olympics. But, Brazil also carries the flag as the best performing emerging market year-to-date1 (following years of underperformance compared to broader emerging markets indices). The jury is still out on the sustainability of the rally in Brazil, however, given uncertainty around the new administration’s ability to execute promised reforms to improve the deteriorating fiscal situation. While Brazil is dominating the headlines, there are also abundant opportunities in other LatAm countries because of valuation gaps, dispersion, and fundamental drivers.
Given the outperformance in LatAm, the region is attracting inflows. According to J.P. Morgan Asset Management (J.P. Morgan Emerging Markets equity research “Herd Instinct” September 2, 2016), LatAm equity funds attracted $495m of net inflows since the beginning of the year. Given that flows tend to be focused on index names, valuation gaps between index names and off-index names can occur. This effect is pronounced in certain sectors within the investable (i.e., with minimum liquidity characteristics and analyst coverage) LatAm (excluding Brazil) universe of less than 200 stocks (188 currently). For example, as of August 30, the eight consumer discretionary stocks within LatAm (excluding Brazil) indices were trading at an average Price to Book (P/B) multiple of 3.33 versus an average of 2.04 for consumer discretionary stocks that are not in an index. A similar pattern can be observed in consumer staples (3.62 average P/B for 24 index names versus 2.25 for seven off-index names) and industrials (2.2 P/B for 20 index names versus 2.02 for nine off-index names).
When implementing LatAm exposure, it may be tempting to invest based on top-down country views using index investments. However, the largest potential source of alpha in the region comes from individual security selection, as the dispersion between companies has been larger than between countries over time. For example, in 2015, the range of returns between companies was 157% versus 27% for range of returns between countries. According to our analysis, this dispersion has been consistent since 2006. Country or regional specialists may have an advantage given their local insight/intelligence relative to global managers that may be visiting countries on an infrequent basis.
In addition to bottom-up opportunities created by valuation gaps and dispersion, we see top-down opportunities in Mexico, Colombia, Chile and Peru (which are constituents of the S&P Pacific Alliance2 MILA Index of 65 names) as well as in Argentina (which is considered a frontier market by the MSCI).
Specifically, Mexico is undertaking a variety of regulatory changes such as de-regulation of the telecommunications market and energy reform. It also offers a variety of opportunities to improve aging infrastructure within the country through increased spending. Additionally, there are opportunities in select consumer names that can benefit from fragmented industry structures and margin growth. Even though Mexico as a whole looks expensive when compared with other LatAm countries, Mexico merits this valuation premium because of its higher GDP growth potential following the 2014 reforms and its lower inflation.
In Chile, potential pension reform may have a significant impact on markets depending on which path the government takes. There is ongoing debate over whether the existing private pension scheme should be replaced with a state-funded, pay-as-you-go system offering defined benefits. Given that Chilean pension plans are significant owners of local equity shares, any potential change needs to be considered a critical factor when taking positions in Chile. Another important factor in Chile has been recent corporate governance-related scandals. Government initiatives have been implemented recently to improve governance standards, which should reduce this risk going forward.
In Colombia, the media is focused on the historic peace process – and the nation’s recent vote rejecting it – between the government and FARC rebels to end the more than 50-year old guerilla conflict. Investors, however, are focused on the Colombian equity market, which has been driven by a variety of other factors such as transitioning the economy away from the oil and mining industries, as well as the government-sponsored infrastructure program that will be in place in the second half of the year. This fourth generation road infrastructure program, announced last year, should be supportive to industries such as cement and construction. On the other hand, banks may suffer due to declining credit growth and higher non-performing loan (NPL) formation due to the slowdown in GDP growth, high consumer leverage and specific problems in sectors such as transportation.
In Peru, construction- and infrastructure-related names should benefit from the new government’s policies. It is widely expected that the new president, Pedro Pablo Kuczynski, will implement pro-business policies (e.g., cutting the VAT) and will look to diversify the country’s historic reliance on the mining industry. More efficient regulation to formalize the economy should also be positive for the country.
In Argentina, after a year of political transition, the country is stabilizing and on a path to normalization. It is also working to reintegrate itself into the global system not only by issuance of debt but also by possible inclusion to the MSCI Emerging Markets Index. Credit penetration is very low at just 15% of GDP, and there is ample room for credit growth that would benefit banks. Additionally, utilities would benefit from potential tariff increases.
While these smaller LatAm markets offer individual opportunities, it is also important to note that these markets tend to be less efficient both because of their smaller size/lower liquidity and because sell-side analyst coverage tends to be less consistent than in other EM markets. About 57% of the total investable universe (107 out of 188 companies) is covered by fewer than ten analysts and 22% (41 out of 188 companies) is covered by fewer than five analysts.
A number of factors support looking beyond Brazil and expanding allocations beyond top-down index investment when investing in Latin America: 1. valuation gaps between index and off-index names; 2. the higher level of dispersion between companies relative to countries; and 3. the limited sell-side coverage of off-index corporates. And, with an improving macro backdrop across the region, opportunities for active investors appear compelling.
1As of September 30, 2016
2Mexico, Chile, Colombia and Peru are linked under the Pacific Alliance, which is a trade pact created in 2011 to form a regional trading bloc and forge stronger economic ties with the Asia-Pacific region. The Alliance has a larger scope than free trade agreements, however, and involves the free movement of people as well as measures to integrate the stock markets of member countries. While these markets are linked under the Alliance, each market is different and often provides idiosyncratic opportunities across a variety of industries ranging from consumer stocks to infrastructure names.
Alper Ince, CFA, CAIA is a Managing Director and a member of PAAMCO’s Investment Oversight Committee. He is involved in all stages of the investment process.
Pacific Alternative Asset Management Company, LLC (“PAAMCO U.S.”) is the investment adviser to all client accounts and all performance of client accounts is that of PAAMCO U.S. Pacific Alternative Asset Management Company Asia Pte. Ltd. (“PAAMCO Asia”), Pacific Alternative Asset Management Company Europe LLP (“PAAMCO Europe”), PAAMCO Araştırma Hizmetleri A.Ş. (“PAAMCO Turkey”), Pacific Alternative Asset Management Company Mexico, S.C. (“PAAMCO Mexico”), and PAAMCO Colombia S.A.S. (“PAAMCO Colombia”) are subsidiaries of PAAMCO U.S. “PAAMCO” refers to PAAMCO U.S., PAAMCO Asia, PAAMCO Europe, PAAMCO Turkey, PAAMCO Mexico, and PAAMCO Colombia, collectively.
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