Brazil suffered a severe recession in 2016, experienced anaemic growth in 2017 and will likely continue this trend through 2018. Therefore the fledgling recovery is yet to visibly reduce unemployment and kick-start cyclical growth. Indeed, the market is pricing in a continuation, and even deterioration, of this difficult environment.
We are, however, constructive on the country, currently 58% of our Latin America portfolio, as we find it extremely attractive from a technical, business cycle and valuation perspective.
Concluding thoughts
The market is deeply sceptical and has heavily discounted asset prices on the basis of dysfunctional politics. We believe this view ignores the realities; the political class are under no illusions that fiscal reform is required, despite the roadblocks Brazil’s recovery has been delayed rather than reversed and valuations already discount a significant deterioration. In short, we see similarities to 2002, 2009 and 2016, years in which a massive change in Brazilian politics coincided with a violent drop in risk premia and sharp equity market rallies. Our positioning reflects our optimism and is biased towards out of favour, high quality companies that in some cases offer over 100% potential returns.
In the last few weeks, we toured 3 major Mexican cities: Mexico City, Monterrey and Guadalajara, to meet with 17 companies and measure the pulse of the economy before this weekend’s presidential election. This trip was taken with an open mind; aiming to stress test our investment thesis for the country, which has been among the lowest allocation in our portfolios since Q4 2016.
Concluding thoughts:
The outlook for Mexico is less bright compared to the past 8 years and material risks are not totally discounted by the FX and equity markets, in our opinion. Earnings growth for most Mexican companies remain uncertain and valuations do not price in the risks we identified.
Having said that, I met with some exceptionally well-run companies, mostly in the consumer and infrastructure sectors, that benefit from structural growth trends, have built sustainable competitive advantages and are executing a well-thought strategy. Thus, would certain equities experience price corrections that more than discount the risks, we are ready to be contrarian and buy high quality companies trading at a discount to their intrinsic value.
The purpose of my trip to Brazil was to evaluate the potential momentum of its economic recovery, the risk of an adverse outcome to the upcoming presidential elections, and companies’ outlooks and investment plans.
Concluding thoughts:
Lula will not be able to run as the appeals process for his criminal conviction will get stalled in the courts beyond the elections. His party, the PT, has until mid-April to submit a candidate and most other candidates are compromised in one way or another. Regardless, this party is rudderless and has no natural alternative leader to capitalise on Lula’s popularity. The risk of Bolsonaro, the extreme right candidate, is also remote given his lack of a national political machine and his low allocated TV advertisement. It is also likely that he
is his own worst enemy; he is known to make vulgar and demeaning comments.
The candidates from the centrist parties have the best chance of winning, and I would currently estimate this to be an 80% probability. Companies unanimously agreed that Brazil is changing, applaud the reforms and are investing for the future. Interest rates are significantly lower, inflation is under control and they believe the reform agenda will move forwards after elections. The equity and currency market recovered from their crisis lows, but in our opinion, the medium-term earnings potential for Brazilian companies continues to be underestimated.
A two-week trip to Latin America, travelling through Argentina, Chile and Peru, gives our fund management team food for thought as change is underway in the region.
Piura is located about 400km north of Lima with a population of 500,000 people. We came to Piura to visit Cementos Pacasmayo’s brand-new cement plant and Ferreycorp’s workshop.
Our day began early, and we woke up at the crack of dawn to avoid the sweltering heat, with our journey taking us through the city’s main retail artery. It was mostly populated by local retail operations characterised as simple stores, though the regional behemoth and a holding in our fund Grupo Falabella, was well represented with Tottus, its supermarket operation, and Falabella, its department store.
Driving out of the city involved dodging the swarm of three-wheeler taxi cabs, which we learned was the most popular taxi type and an easy alternative for self-employment. Upon exiting the city we were surrounded by the desert environment of Piura, a perfect location for a cement plant due to the expansive and uninhabited location.
Retail sites in Piura
The plant took 3 years to build costing US$ 370million. Using the most advanced German technology the plant was built with the goal of limiting its environmental impact. It sources its raw material from a nearby quarry, avoiding having to import clincker (a critical binding agent for cement).
The 1 million square meter operation was truly impressive. Health and safety procedures were evident from the moment we entered the facility as each one of us had to pass a breathalyser test to ensure we would not put anyone at risk. Cementos Pacasmayo has been on our watchlist since the launch of the fund, as a high quality company benefiting from a local dominance and high barriers to entry.
By the time we ended our visit the temperature had risen to 30C, so a good time to make our way in an air-conditioned minivan to Ferreycorp’s regional offices. We were welcomed by the group treasurer, who travelled especially to Piura to host our visit, and the local sales and operations team.
The sales team presented the firm’s positioning in Piura, which is endowed with a high level of industrial diversity in the form of agricultural, mining, fishing and infrastructure activity. The past few years have been lean years for the sector, with many players exiting and/or lacking commitment to the local market. Ferreycorp’s long term commitment and strategy led to them increasing their regional market share to 70%. The presentation was followed by a visit to their parts supply room, not only was this a superbly organised meeting, it also showed their adherence to ‘just in time’ practices with carrying parts that they know will be in demand according to their programmed maintenance schedule of the regional fleet of machines. One of their key comparative advantages is having highly skilled personnel that undergo significant amount of training throughout their Ferreycorp careers. Being a 5-star rated Caterpillar dealer is one of the major reasons why companies select Ferreycorp and reinforces their market leading position. We currently have 2.9% of the fund in Ferreycorp and we estimate it is currently selling at a 35% discount to intrinsic value.
Meeting the Ferreycorp team
We left Piura with a better understanding of Pacasmayo’s long term vision and Ferreycorp’s regional opportunity. Continuation of the city’s development will come through the development of its natural resources, both in the soft commodity and bulk materials area. Its low cost profile and high productivity potential will continue to attract entrepreneurial investment, which we believe will lead to a strong and sustainable level of growth.
A two-week trip to Latin America, travelling through Argentina, Chile and Peru, gives our fund management team food for thought as change is underway in the region.
After 4 years of poor political management, corporate Chile is eagerly looking forward to a new political cycle. Based on our discussion with company managers, clients and bankers, the last local elections outcome and Bachelet’s approval rating of less than 15%, we can safely say that change is on the horizon. Their hope is that the elections this year will extend the structural political swing from populist left to a more pro-business right, following in the footsteps of Argentina, Peru and Brazil.
Over the last few years, the companies we’ve met have scaled down investment in Chile, using their highly cash-generative domestic base to re-invest in more investor-friendly and growing markets in the region: namely Peru, Colombia, Mexico. For example our holding Falabella has increased its share of business in Peru, Colombia, Argentina and Mexico combined, from 26% in 2009, to 45% in the latest 2015 results.
Chile is not a typical emerging market; it enjoys first-world type of infrastructure, has sophisticated consumers and world-class industry. Our tour of Las Condes, the Costanera Center and Valparaiso provided ample evidence if this was needed.
Our holdings in Chile are supported by very strong fundamentals and capable managers leading world-class operations as illustrated by our visit to the Embotelladora Andina plant a few miles away from Santiago (3rd largest bottler of Coca-Cola in Latin America, with concessions in Chile, Argentina, Paraguay and Brazil). With a strong track-record of capital allocation over several cycles, delivering good returns to shareholders like us. All this comes at an undemanding valuation as they suffer from the “Bachelet discount”, despite most of their growth coming from neighbouring countries.
Visiting the Embotelladora Andina Plant in Chile
The election later this year may well be a catalyst for a re-rating of Chilean Equities after 4 years in the doldrums (-9% as measured by the MSCI Chile over the last 4 years in USD). But this will just be the cherry on the cake as the fundamental earning power of the multi-latinas will keep delivering over the long term.
A two-week trip to Latin America, travelling through Argentina, Chile and Peru, gives our fund management team food for thought as change is underway in the region.
Touring the Bohemian area of Palermo Soho in Buenos Aires, with its eclectic collection of trendy shops and restaurants, it doesn’t feel as though the country is in a recession. It’s been over one year since Mauricio Macri was elected president of Argentina and we came to meet with industrial and consumer companies to gauge the position of Argentina’s economic recovery.
The view over Buenos Aires
Since Macri took power he has reached an agreement with sovereign bond holdouts, removed capital controls and amended the regulated tariffs. This has allowed institutions to regain trust and begin to act responsibly, by being transparent about fiscal challenges and the real economy.
This move away from the farcical “Kirchner” economic model is increasing business confidence andwillingness to invest in growth. For example, the country’s largest mall operator is looking to finally receive municipal approval for a 10 million square meter residential project, for which they’ve been waiting more than 10 years.
The economic adjustment is well underway and was further confirmed by meeting with our holding Pampa Energia, whose electricity distributor Edenor, saw its electricity tariffs increase allowing them to capture a proper return on assets and invest to expand. The average household’s electricity bill in northern Buenos Aires rose from US$3/month to US$16/month, but is still among the lowest in Latin America. We hold 4.5% of the fund in Pampa Energia, and its value has climbed 350% since we initiated our investment.
The consumer sector in Argentina is not doing well, in large part due to the high level of unemployment (8.5%), and a still high, though declining, level of inflation.
Both these factors are symptoms of an economy going through its cyclical adjustment. The main factor to follow, which will over time improve both employment and consumption, is a resumption of infrastructure investment. This is crystal clear to Macri and will be the pathway to prosperity.
The economic adjustment is well underway and was further confirmed by meeting with our holding Pampa Energia, whose electricity distributor Edenor, saw its electricity tariffs increase allowing them to capture a proper return on assets and invest to expand. The average household’s electricity bill in northern Buenos Aires rose from US$3/month to US$16/month, but is still among the lowest in Latin America. We hold 4.5% of the fund in Pampa Energia, and its value has climbed 350% since we initiated our investment.
The consumer sector in Argentina is not doing well, in large part due to the high level of unemployment (8.5%), and a still high, though declining, level of inflation.
Both these factors are symptoms of an economy going through its cyclical adjustment. The main factor to follow, which will over time improve both employment and consumption, is a resumption of infrastructure investment. This is crystal clear to Macri and will be the pathway to prosperity.
