Barron's Cover

SATURDAY, NOVEMBER 2, 2013

The New Latin America

By RESHMA KAPADIA

Latin American stocks are down 8% after a decade of solid returns. Think small and forget the biggest stocks in Brazil and Mexico.

  

 Blame it on Brazil. Or China. Heck, you can even blame it on the Fed. Emerging markets are doing terribly this year, with Latin America leading the way down. But the changing landscape has opened up some new opportunities for intrepid investors.

After growing at an average pace of 6.4% a year over the past decade, emerging markets are expected to expand by 4.5% this year, with Brazil's economy slowing even further, according to the International Monetary Fund. That's a bitter pill for investors who flocked to these countries for growth, and their dissatisfaction is evident in the market. Following a decade of returning 15% a year, the MSCI Emerging Markets index is down 2% so far this year, with Latin America down 9%. Compare that with the S&P 500's 23% return, and it's clear something is afoot.

For starters, there is China. The powerhouse nation has been a massive catalyst for growth in Latin America, gobbling up the region's commodities, from Brazil's iron ore and soybeans to Peru's copper. Between 2006 and 2012, Brazil's exports to China quintupled. But as China's economy slowed and its appetite for commodities waned, Brazil's exports to China fell for the first time since 2000, down 7% last year.

[image] Matthew Furman for Barron's

Left to right: Luis Carrillo, Adam Kutas, Lewis Kaufman and Jim Carlen.



Brazil's economy is now expected to grow just 2.4% this year -- a far cry from 7.5% three years ago. The nation is now importing more than it exports, creating a current-account deficit that has made investors wary and contributed to a 50% decline in the Brazilian real over the past two years. With credit cheap around the world, thanks to the tone set by the U.S. Federal Reserve, Brazilian consumers went on a credit-fueled shopping spree and are now dealing with the aftereffects, as debt payments rise alongside interest rates.

President Dilma Rousseff has tried reforming the nation's infrastructure and reducing the high cost of doing business in Brazil by pressing electric companies to cut prices and banks to lower rates. But these measures spooked rather than comforted investors because of their interventionist tones.

With Brazil making up 58% of the MSCI Latin America index, its misfortunes weigh on the entire region. More than $8 billion has left Latin America mutual funds this year, according to EPFR Global. But Latin America still has plenty to offer, such as an abundance of farmland and the fact that the middle class' consumer purchasing power of LatAm's five major countries is larger than China's, according to HSBC.

The opportunity, however, is fragmented. We asked four money managers to assess the current situation and tell us where they're putting their money. (For even more investment ideas, see "Latin America: Four Ways to Play.")

Adam Kutas has covered Latin America for nearly a decade and currently manages the $1.4 billion Fidelity Latin America fund (ticker: FLATX). After growing wary about Brazil a couple of years ago, Kutas is finding better opportunities now.

Mexico-born Luis Carrillo, manager of the $141 million JPMorgan Latin America fund (JLTAX), veers toward smaller companies with long-term growth prospects.

Jim Carlen, a former international economist at the U.S. Treasury Department, manages the $796 million Columbia Emerging Markets Bond fund (REBAX), which has one of the larger helpings of Latin American exposure among peers at 30% of assets. One attraction is the relative strength of many of the countries' balance sheets and favorable reforms in countries like Colombia.

Lewis Kaufman, who manages the $1.3 billion Thornburg Developing World fund (THDAX), shies away from debt-laden companies and countries, and leans toward consumer-oriented stocks. While he can invest anywhere in the emerging world, four of his top-10 holdings are in Latin America.


Barron's: It has been a rough year for Latin America. What's going on?
            
Carlen: Over the past 12 to 18 months, the problems are twofold: The Fed's continued injection of massive amounts of liquidity played a big role in running up asset prices in emerging markets, and made investors much less risk averse.

[image] Matthew Furman for Barron's

Jim Carlen sees opportunity in Colombian and Guatemalan bonds.


In other words, money was pouring into Latin America in part because people didn't know where else to put it. What's the other issue?
           
Carlen: Demand for commodities isn't stimulating the economic growth it once did, and consumer spending is down. As a result, some of these economies are slowing down. That's been a challenge for some of these governments, too.

Kaufman: We are on an inexorable march toward higher interest rates. Countries with current-account deficits that have to be financed with stock and bond flows are going to suffer. Countries that don't require foreign investment to balance their budget are more structurally sound.

What does that mean from an investment standpoint?
           
Kaufman: For the first group, we'd like to be tactical. If Brazil falls sharply, that would be a good buying opportunity, to lean against the grain in a country and currency we find to be less structurally sound. Structurally sound countries, primarily Mexico and the Andean region -- specifically Peru and Colombia -- have healthier external accounts. We'd look to buy when correlations are high and the market is treating Mexico or Central America like Brazil.

What happens to the "structurally unsound" countries when investors pull out?
           
Kaufman: When countries need to finance deficits with stock and bond flows, it pressures the local currency, which can cause inflation. The surprise to investors in the next 12 to 18 months will be the effects of this on growth. As Brazil fights these pressures with higher interest rates, it could slow growth further.

Latin Americans have been on a credit-fueled consumption spree over the past couple years. What's the state of the middle-class consumer there?
           
Kaufman: Consumption goes up when there's job growth, real wage growth, increased access to credit, and a falling savings rate. [Many Latin American countries have very high savings rates. As consumers feel more confident, they reduce their saving and increase consumption.]

Each of those factors is very resilient in emerging markets. In places with lower credit penetration, like the Andean nations, the outlook is much better. Even in a country like Brazil, we are seeing consumption hold up.

Kutas: We see strains in the consumer in Brazil. And its central bank is facing stagflation, with slowing growth and rising costs. You don't understand how many [company] meetings I have in which flat margins is the new up. If you can maintain margins, you are pretty excited.

That's pretty depressing from a stock perspective, isn't it?
           
Carrillo: When Brazil's stock market fell in 2011 and 2012, everyone thought the glass was half-full and it was a big opportunity to jump in. But the question should have been, "Is the glass the right size?" Brazil needs a smaller glass because of slower growth prospects. Now that expectations have corrected, with the market and currency falling, we feel more comfortable coming back in.

[image] Matthew Furman for Barron's
 
Adam Kutas is skeptical of the scope of Mexico's government reforms.

Given the problems you've raised, is there a good reason to invest in Latin America at all?

Kaufman: It's still a very undeveloped place. For example, in Peru, 20% of retailers are chain stores; the rest are mom-and-pop stores. Compare that with the 40% of chain-store retailers in Brazil. Brazil may not be a high-growth area, but LatAm as a whole is. Look at Peru. Even with a commodity slowdown, it is looking at 4.5% to 5% gross-domestic-product growth. Chile is probably around there; Colombia is still growing on the back of oil production.

And Brazil?
           
Kaufman: I don't necessarily need to be bullish on Brazil's economic development to buy Brazilian stocks. Brazil is easily the deepest capital market in Latin America.

By deepest, you mean...
           
Kaufman: Breadth and liquidity. It's possible to find opportunities because the market is so much more developed. My biggest holding is a for-profit postsecondary education company, Kroton Educacional (KROT3.Brazil). It has the best earnings momentum, not just in Brazil but in my entire portfolio.


What about fixed income?
           
Carlen: Latin America had a great period of growth because of a big commodity tail wind, bringing up the level of consumption in these economies. People forgot how much of that was commodity driven and not sustainable in the long term, but that doesn't mean a lot of good things haven't happened.

Like what?
           
Carlen: Net debt to GDP has come down from 50% to the mid-30s. Fiscal deficits are consistently much lower, certainly compared with developed economies. And the amount countries can grow until running up against inflation constraints is higher than a decade ago. Many of these countries, like Brazil, became impatient with the level of growth and pushed the accelerator too hard and have run up against constraints. Inflation is higher. Central banks have to address those issues, but that doesn't detract from the long-term potential, which is why we still see good upside.

Carrillo: There are issues, but it's not 2000. Now 73% of the Latin American bonds in the JPMorgan EMBI Global Diversified bond index are investment grade. A decade ago it was just Mexico and El Salvador.

Investors have often treated emerging markets all the same. How should they look at Latin America now?
            
Carrillo: During the first decade of this century, China helped all emerging markets. In the second decade, engines of growth are likely to be different everywhere. For us, this means stockpickers have a better time than in the previous 10 years because there are structural problems in the index.

Because the MSCI Latin American index is commodities-heavy?
           
Carrillo: Yes, along with other companies that don't represent the real economy. In 1994, oil, energy, and mining companies were privatized in Brazil. Those are the biggest companies with the longest track records, and have a big impact on the index. Brazil's weighting went as high as 71% in 2009 and is currently 58%.

How is the market changing?
           
Carrillo: There were very few listings in the 1990s through 2005. We've seen probably 300 initial public offerings in the past three years.

Kutas: Look at recent transactions. Colombian companies are buying assets in Central America. They have maxed out market share in their own markets and need capital to go international. That means more investment options.

Carrillo: S.A.C.I. Falabella (FALAB.Chile) started in Chile and dominates that market. It has moved to Peru, Colombia, and now Brazil. Lima, Peru, has about half the GDP/capita of Santiago, Chile, so the prospect for growth in Peru is a lot longer-lasting.

[image] Matthew Furman for Barron's
 
Lewis Kaufman prefers Peru's banks to Brazil's.

There are 74 Latin American companies that trade on U.S. exchanges as American depository receipts. Is that a good way for individuals to get into Latin America?
           
Kutas: ADRs tend to be Brazilian, cyclical, and more resource-oriented. In the past, an ADR was a sign that you had arrived. Now, there are $2 trillion of assets managed in Latin America, growing at 10% to 15%. As a local Brazilian company, your cost of capital is much cheaper if you can sell to the locals versus coming to the U.S. as an ADR.

What about exchange-traded funds?
           
Carrillo: ETFs are easy competition for us. They have to look at the index. The Peru ETF doesn't include any consumer stocks, but Peru's economy is 60% consumer-driven.

Emerging-market bond funds have taken in an unprecedented $111 billion since the beginning of 2008. Is there still an opportunity in bonds?
           
Carlen: Absolutely. More of these countries developed their local debt markets, supported in part by past pension reform. Such reform is one of the key steps an emerging market needs to undertake to develop a deeper, local capital market that can finance private and public debt placements. This is important because it gives government entities and local companies more financing options and makes them less exposed to swings in the exchange rate.

It gives you a wider playing field?
            
Carlen: Yes. More issuers have come to the market, including quasi-sovereigns -- which are majority-owned by national or regional government that are often in strategic sectors like energy -- and emerging-market corporate bonds, both in dollar and local currency. Picking countries is important but so is finding the best way to express a view on a particular country. Having a greater variety of bonds to invest in helps that.

Lets talk about Brazil. What's on tap for the economy and currency?
           
Kaufman: Brazil is the country with the greatest degree of imbalances. There's been too much easy credit for too long. The government has created jobs to produce things people don't want to buy, so unemployment is pretty low. Brazilian companies are lacking inputs for production and have to import them. It all makes the current-account deficit negative. Because the investment outlook is not good, the foreign direct investment to finance it is not there. So there's Brazil and the not-Brazil markets of Mexico, the Andean markets, and Central America.


But you still own Brazilian stocks?
           
Kaufman: Let's say the credit cycle in Brazil has run its course, and things are going to look up in 18 months. You could play that through a bank, but ultimately the Brazilian consumer is relatively more indebted versus consumers in the rest of the region. So we prefer Brazilian health-care broker Qualicorp (QUAL3.Brazil), which benefits from a rising middle-class spending more on health care but isn't tied directly to the consumer. Regulation prevents insurance companies from raising prices if they sell directly to individuals, so they sell through affinity plans, like professional groups such as doctors. It's a faster-growth business that's less capital-intensive than banks and ultimately a better business.

[image] Matthew Furman for Barron's
 
Luis Carrillo says investors should expect slightly slower growth rates.

Carrillo: Since we think long-term, we try to stay away from companies or sectors the government influences. We find companies that don't have to raise prices to make money, like Localiza Rent A Car [RENT3.Brazil], which has increased prices just 8% in 10 years. Competitors die amid the pricing pressure, and Localiza gets a bigger portion of the market just by controlling cost and being efficient.

Kutas: Brazilian companies have to pay 8% to 10% wage hikes, denting profitability. That's also the opportunity. We find companies focusing not just on revenue growth but also on profits through cost reductions. How can they do that? Become more automated.

Who benefits from more automation?
           
Kutas: Indústrias Romi [ROMI3. Brazil] is a $400 million Brazilian capital equipment company hurt in the last few years by the weaker economy, stronger exchange rate, and nonperforming loan issues. But they have cut head count by 40% and hiked prices by 15% and are buying back stock.

Carrillo: Weg [WEGE3.Brazil] is a Brazilian industrial that makes electric motors with gas and water pumps and turbine generators. About 85% of the engines in Brazil are theirs; I don't think that even Siemens has that market share in Germany. Weg has had a 20-year record of not losing money. No one gets paid bonuses if return on equity is not 20%.

What about banks?
            
Kaufman: Brazilian banks are probably underpriced if you have a longtime horizon. There are two things I like better about the Peruvian banking market: It is very consolidated, with the top five controlling 85% of the market. And I prefer the Peruvian currency, the new sol, over the Brazilian real. One Peruvian bank I like is Credicorp [BAP]; it grows fast but with stable margins.

So the Andean markets offer good growth, but these are small markets. How do you deal with illiquidity?
           
Carrillo: If you are willing to put money there for a very long time, it's a good opportunity. Peru's financial system and regulation is the strongest. They have the best credit bureau in LatAm, so the banks have not only the potential for growth, but also a better view into the cash flow of their borrowers.

Jim, are some of the smaller countries also attractive from a bond perspective?
           
Carlen: Uruguay has some great things to recommend it from a macro standpoint. Its Treasury has 1½ years of financing needs sitting in the bank, and it runs small fiscal deficits. They restructured their debt 12 years ago after Argentina's default, so debt to GDP has fallen from 60% to 40%. The mix has changed from all dollar-denominated to half local currency. And they have been able to attract significant foreign direct investment to a variety of industries. Agriculture and beef are big drivers.

What about liquidity?
           
Carlen: The consumer price index–linked bonds we favor do have some liquidity issues and can cause volatility. But for a long-term investor with a three- to four-year horizon, it's a good opportunity.

We haven't yet touched on Mexico. The market rose 29% last year while Brazil's market fell 5%. What's going on?
            
Kutas: Mexico underperformed for nearly 10 years, until mid-2011, while Brazil stole the show. In 2012, President Rousseff did a lot to scare away foreign investors and hurt sentiment and prospects.
 
Contrast that to Mexico?
           
Kutas: At the same time, Mexico elected Enrique Peña Nieto president. He promised a lot of reforms people have waited a very long time for, including energy reform. He promised too much too soon, and the economy entered recession in the second and third quarters this year. From what I can see, the pact he had among the key political parties has fallen apart, so now he's scrambling. All I can see is higher taxes on the rich and a watered-down energy policy.

Carlen: I don't agree with that. All of us fall into the trap of expecting the political process to be smoother and more rational than it ever is. In Mexico, we fell into the trap that they were going to do education, energy, and fiscal reforms -- boom, boom, boom -- and it would be nirvana tomorrow. Of course, that's not how it happens -- a lot of sacred cows need to be slaughtered. We saw education reform, and that was a great step.

What was the education reform?
           
Carlen: A change in funding and how they measure performance, which upset teachers. Politicians realized the steps were going to cause domestic volatility, and slowed things down. But they are still moving forward with energy and political reform and fiscal reform.

What's the fiscal reform?
           
Carlen: Raising [sales, property, and top income] taxes to make up for lost revenue as a result of energy reform, which will reduce the amount of tax revenue that state-run oil firm Pemex sends to the government. It's also an incentive for skeptical congressmen to vote for the energy measures.

But the market doesn't like that?
           
Carlen: Unfortunately, the actual proposed reform had more spending to stimulate growth and perhaps to attract votes, and wasn't strong enough on keeping the deficit in check by just raising alternative revenues. As a result, the market does not see this as fiscal reform but rather as an expansion of government expenditures. But the energy and fiscal reforms are somewhat linked; if you don't get one, you may not get the other.

Mexico also has a lot of residual credibility from years of strong fiscal performance. I think they'll have reform progress by the end of the year.

Carrillo: The expectation is that the reforms are going to take off like a spaceship. It's not. It's just a plane.

Kaufman: It's worse than that. Consumer-oriented businesses in Mexico have missed earnings estimates quite substantially, because the government has struggled to disburse money. That hurt consumption at exactly the moment investors expected it to pick up. Also, the Mexican stock market, especially compared with Brazil, is shallow.


How is the Mexican stock market shallow?
            
Kaufman: There simply are not a lot of good consumer-oriented opportunities. Big banks like Grupo Financiero Santander Mexico [BSMX] or Grupo Financiero Banorte [GFNORTEO.Mexico] are two multiple-points more expensive than Credicorp with a similar penetration story, so they don't make sense. Big stocks like Walmex [Wal-Mart de Mexico, WALMEXV.Mexico] and Mexican bottler and retailer FEMSA [ Fomento Economico Mexicano, FMX], both of which I own, lack earnings momentum for economic and company-specific reasons. The main point: Be creative. You can think about Mexico as "not-Brazil" and extend that to include companies in Central America or based elsewhere -- like U.S.-listed pawnbroker First Cash Financial Services [FCFS].

Kutas: First Cash is a $1.6 billion [market value] company that gets 60% of its earnings from Mexico. Most collateral historically has been jewelry, so many investors view it as a play on gold. But more customers on the margin are bringing in smartphones as collateral.

Carlen: And they want them back.

Kutas: Phones have become indispensable, especially in emerging markets where people can't afford laptops or PCs and don't have cable or land-line connections. So like grandmother's jewelry, they are reluctant to lose it and, therefore, pay off the loan. Growth comes from new stores in Mexico and maturation of existing ones. In the U.S., they are acquiring smaller pawnshops and benefit from the difficulty in accessing credit. Revenue growth is 15%. They generate 16% return on assets. If an average bank can do 2%, that's pretty amazing. It has no leverage and buys back stock.

Mexico is also benefiting from the U.S. recovery and a rise in labor costs in China. How do you play that?
           
Carrillo: All the industrials, like petrochemical company Mexichem [MEXCHEM.Mexico] and conglomerate Alfa [ALFAA.Mexico].

After running up 42% in 10 months, the Mexican stock market is down 17% since its April high. Is it a good time to get in?
           
Carrillo: No, it hasn't fallen enough. Expectations were too high.

But in the long term, the outlook for Mexico's economic growth is healthy?
           
Kutas: This is a far better backdrop than 10 to 20 years ago. If the biggest issue is that reforms are not happening fast enough, that's way better than not happening at all.

Should investors in Latin America have lower expectations going foward?
           
Carlen: The days of saying, "I'm going to throw my lure out to stream, and I'll catch fish" are over, at least for now. In bonds, it's a country-picker's market. Countries that have a current-account surplus or a deficit completely funded by foreign direct investment, and decent growth and macro policies, are the sleep-well-at-night bunch.

Which countries does that describe?
            
Carlen: Peru and Colombia. We see a lot of potential in Colombia's sovereign debt, and more so, agency debt. We own an electrical company and a state-owned oil company, in both dollars and local currency. It's done a better job of structural reforms in the midst of its commodities windfall, such that they can continue to attract a lot of foreign direct investment. That creates a virtuous cycle and lifts its growth prospects, which in turn draws more foreign and domestic investment.

What were some of the reforms?
           
Carlen: They opened up the oil sector to foreign investment. Peace talks with FARC [rebel group Revolutionary Army Forces of Colombia] helped, and they made fiscal policy more sustainable by creating a rainy-day fund and a sovereign wealth fund. All in all, it puts Colombia on track to follow in the footsteps of higher creditworthy countries like Chile.

Guatemalan dollar-based bonds are also sleep-well-at night-[bonds], with very good policies and valuations that haven't caught up with how positive that story is. Mexico will be in that category next year when it gets out of the basement in terms of growth.

Who is in the middle camp?
           
Carlen: Countries with issues but that we have confidence in their governments' ability to react. That's where policy becomes important; that's where you make your money. Whether Brazil is in this group is the big question. They will ultimately do the right thing -- after they have exhausted all the options. The good news is the political interference with the central bank has decreased. They raised rates in the midst of slowing growth. That has credibility.

So what's the takeaway?
           
Carrillo: LatAm will still grow faster than the developed market, just not as much as 10 years ago. Really, it's Brazil dragging everything else down. Chile, Peru, Colombia are all having nice growth.

Kutas: Mexico and Brazil have moved down the development path. That's positive over the long term for less volatility and currency risk. In the shorter term though, Brazil is facing structural problems. They just have to work through them. But it's a region of more than half a billion people, so it's funny to hear people say it's over. There are still a lot of growth opportunities, but it's more about stock-picking than country calls now.


Thanks, everyone.