An investor's paradise

IFR Latin America 2008
11 min read
Americas

Latin American markets are more popular than ever and investors agree they display a degree of maturity suggesting allocations will be stickier than in the past. But with the more developed markets experiencing a rocky 2008, it will not be long before this theory is put to the test. Solomon Teague reports.

Investors are flocking to Latin America like never before. But while prospects are very good for the longer term, the short term may provide a bumpier ride, warned Ricardo Maxit, founding partner of Copernico Capital Partners, the Argentine hedge fund group.

Maxit believes the popular theory of decoupling between Latin American markets and those of the US and Europe is exaggerated. Money is likely to be reallocated to North America as the markets there continue to be hit and valuations look increasingly attractive, which is likely to hurt South American markets, he noted.

For now, investor enthusiasm continues unabated, and Brazil is the biggest beneficiary, said Will Landers, portfolio manager for Blackrock’s Latin America funds. Blackrock manages around US$7.5bn in Latin American assets, around US$6bn of that in the Luxembourg-based Sicav MLIF Fund, with the remaining capital in two other funds: a US mutual fund and a closed ended, London-based fund. Around 70% the MLIF portfolio is allocated to Brazil, making it around 6% overweight its benchmark.

Investors can access Brazil either through locally listed shares or American Depositary Receipts (ADR). Both offer very satisfactory exposure to Brazil, Landers said, with very little arbitrage opportunity between them.

ADRs have been dismissed as not offering local currency exposure, but Landers rejects this notion, and ADRs are Landers’ preferred method of investing in Brazil if both securities have equal liquidity because they are cheaper. Around 65%–70% of the MLIF portfolio is invested in ADRs, he said.

Copernico manages around US$315m in four funds, including US$170m in its flagship Copernico Latin America Strategic Fund and $55m in the Copernico Special Situations Fund, which is currently attracting the most attention, Maxit said. Taken together, Copernico’s funds delivered around 10% in 2007 though 2008 has seen a slower start, staying flat in January and February. It had made 1% in March at the time of writing.

Latin America has matured considerably in the last 10 years, said Maxit, who believes the region’s years of boom-and-bust economics are over. The long-term prospects for the region are very good, he said, but in the short term Copernico is moderately net short Latin American equity, and only slightly net long fixed income.

Copernico’s remit is to be as diversified as possible – both in terms of strategy and geography. The largest allocations are in Brazil, Mexico, Chile and Argentina, but allocations to the smaller countries have been rising, and will soon be around 10% the portfolio.

Brazil offers the most opportunities in IPOs and equity issuance, Maxit noted, but he points to more opportunities for debt investments in Mexico, as banks are less willing to lend to second and third-tier corporates. Copernico makes direct loans to companies, such as those in consumer finance, positioned to benefit from this trend, he said.

In Argentina and Chile the trend in the market is less clear cut and opportunities exist in both areas on a case-by-case basis, he added.

Big in Brazil

Brazil is certainly the most popular country for Latin American hedge funds, boasting approximately 1,600 hedge fund-like vehicles – funds using short selling and leverage – according to Christian Benigni, co-founder & partner of First Avenue Partners (FAP). Most of these, he noted, are macro funds, though FAP, a London-based merchant bank, invests in a broader range of strategies via the diversified Arsenal Fund, a fund of Brazilian hedge funds managed by Arsenal Investimentos. Arsenal has allocations to equity hedge, discretionary trading, special situations, fixed income, equity arbitrage and long/short equity hedge funds.

“In the old days macro was the best way to make money and it was where the liquidity was, and there is still a large concentration of funds in macro and equity long/short,” said Maxit. “I think there is going to be change in the near future and we will see new strategies develop.” If strong market performance in the first quarter does reverse, he noted, many of these strategies will lose money and investors will look to managers of more sophisticated strategies, such as credit hedge funds.

Of the numerous funds currently trading in Brazil, many are proprietary vehicles managed within banks, Benigni said, but there are around 400 independent shops, around 280 of which are what he calls investable quality. These funds are fuelled by assets which, between December 2000 and June 2007, have grown 94.8% to R$1.039trn – or US$539bn – outstripping the growth in the Brazilian long-only funds industry.

Mexico is the continent’s second biggest market and home to MLIF’s second biggest country allocation – with 20% it is 2% underweight. Mexico displays higher correlation with the US than other Latin American countries, notes Landers, and from a top down perspective he does not find the investment case for the country compelling.

A large proportion of Blackrock’s Mexican exposure comes courtesy of a single position in America Movil, with most of the remaining exposure in homebuilding and infrastructure. (For more on Latin American infrastructure see pages 16-17.)

Brazil and Mexico are the only two markets with sufficient liquidity for significant investment, Landers said: Brazil has a market capitalisation of around $1trn and trades at around US$3bn a day, while Mexico, at around $200bn, turns over around $1bn daily.

Chile, the third most liquid equity market on the continent, has a capitalisation of around $60bn and trades tens of millions of dollars daily, disqualifying all but the most compelling and liquid stocks.

For investors with smaller portfolios there are compelling investment cases all over the continent, Maxit said, and the increasing sophistication of the market allows Copernico to hedge its positions more effectively than in the past. Its equity exposures can be hedged using ETFs, available for all the countries it invests in, while it is possible to short individual positions with stock borrowed from local brokers, not just in Brazil but also in Chile.

The CDS market is big enough to easily hedge several hundred million dollars of exposure on the fixed income side, Maxit added.

“Latin America has become a real market,” he said, “and this always has pros and cons. The cons are it is harder to make money because the markets are more efficient.” However, pockets of inefficiency can always be found, he noted, not just in the smaller markets but in Brazil and Mexico too, if you know where to look.

While the markets have become more efficient, management has also seen massive improvement and standards of corporate governance in parts of Latin America are very high, said Landers, especially in Brazil. ADRs offer exposure with New York Stock Exchange regulatory oversight, while many Brazilian IPOs are launched with stricter rules governing them than are found elsewhere, he said.

Factors such as provision of corporate information and minority shareholders rights are taken very seriously in Brazil, Landers said, which acts as a beacon to other emerging markets – in Latin America and beyond. By emerging markets standards other LatAm countries are also good in corporate governance, particularly Columbia. Maxit agreed: as governance has improved Copernico’s investments have become less opportunistic with commensurately longer holding times on investments.

From a macro economic perspective Latin America is a compelling case for investment, Landers said. Inflation has, in most instances, come down in recent years, for example, in Brazil, Mexico, Chile and Columbia, as have debt levels. The key LatAm countries have freely traded currencies and current account surpluses, reducing volatility in their markets.

Brazil, in particular, has brought its historically high inflation under control. Around 10 years ago Brazil was battling inflation levels of 2%–3% per day, but has now tamed the beast to a rate of 4.5% – higher than in most developed economies, but significant lower than the rates in the other BRIC countries (Russia, India and China). This has allowed interest rates to normalise. Wages are growing at a rate that gives Brazilians a continually improving purchasing power, Landers said.

The fall in interest rates has encouraged Brazilian institutional investors to take money out of the bond markets and participate in the equity markets, which has boosted valuations in recent years, said Landers. In Mexico, too, valuations have been boosted by institutional investors, after regulatory changes allowing a higher proportion of portfolios to be invested in shares.

Foreign investors have also been looking more closely at Latin America as valuations improve, particularly as the region shows clear signs of increased political stability. Around 40% Copernico’s investors come from outside Latin America. Investors of all types are sticker than they were in the past, Maxit added.

In Brazil, widespread concern in business circles about the intentions of Luiz Inacio Lula da Silva before his election led many to predict disaster for the economy in the event of his victory. But there, as in Mexico, the coming to power of opposition parties had no adverse impact on the countries’ respective markets. Brazil is growing faster under Lula’s premiership than it has ever grown before.

This is expected to be rewarded in the near future with a rerating to investment grade status. If Brazil achieves this goal it will give extra momentum to the virtuous circle it has established of increasing liquidity and higher valuations, as foreign institutional investors take the opportunity to make allocations to the newly investment-grade country.

There are, of course, countries in Latin America where political risk acts as a major impediment to growth. Landers is very cautious about investments in Venezuela, and also counts Argentina as an unacceptable political risk, as well as having insufficient liquidity for his sizable portfolio. This has been priced in to equity valuations: in Venezuela, price to earnings ratio’s are around five, compared to around 11.5 in Brazil. In Venezuela earnings growth is in the low teens, while in Brazil it is in the 20s.