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Equity investor scorecard: Bargain hunters

May 1, 2013

Not everyone has fallen in love with LatAm’s domestic demand story. For equity investors, finding the turning point is the route to success – even for unloved large caps

By Katie Llanos-Small

At the start of the year, few international portfolio managers would have named Petrobras their favorite stock. The oil firm's weak equity performance had for many months weighed down portfolios and fund managers had resorted to underweighting its shares.

But in single a day in early March, news of a diesel price increase and new oil finds pushed its share price up 15%. The underweights were left out in the cold.

Petrobras's sudden reversal of fortune is unlikely to impact the underlying trend in equity investing in Latin America, where in recent years large cap stocks have largely fallen from favor. Investors have instead flocked to consumer industries, favoring them to metals, mining and oil, on the promise of Latin America's burgeoning middle class.

Yet as Petrobras shows, there are still returns to be found - even among industrial giants, Brazilian corporates, and non-consumer sectors - but only when stocks become cheap enough to buy again. A range of fund managers interviewed by LatinFinance say they are now grappling with identifying precisely that point.

Dean Newman, manager of Invesco Perpetual's $890 million Latin America Fund, which ranks fourth in this year's scorecard, says that in Brazil, there is a contrast between the "mega cap" stocks such as Petrobras and Vale; banks, which have performed poorly in recent years, but where the valuations look cheap; and domestic companies, which outperformed, but where the valuations are no longer cheap.

"It's going to be a big call for all of us investing in Latin America," he says. "We are in a bit of the transition towards putting money into those bigger companies. They look cheap."

Managers are quick to rattle off their concerns about Brazil. These include: requirements for locally produced inputs in industry; taxes; exchange rate uncertainty; low growth; and inflation.

Adam Kutas, portfolio manager at Fidelity, says his skepticism on Brazil dates back to late 2010: when the country was named host of the 2016 Olympics, valuations leapt "off the charts" for a number of companies.

"I was already feeling uncomfortable regarding earnings expectations," he says.

"That was the first time I could create a bear case on Brazil, having been visiting the country since 2000."

The fund lightened up on Brazil, focusing instead on Chilean and Mexican stocks. "Last year the big risk that emerged was political risk in various sectors. It manifested itself more significantly than expected," says Kutas. "Valuations now are better, but the fundamentals are still mixed at best. Brazil is still a country in transition."

Despite their concerns, the best performing funds in LatinFinance's 2013 equity investor scorecard still have heavy allocations to Brazil. As the largest market by a long way, investors need plenty of conviction for any other country to dominate their portfolio.

But the allocations go beyond simply falling in line with the index. The country's low growth and lackluster indicators may offer a potential entry point. Christopher Palmer, director of global emerging markets at Henderson, says that while "Brazil is a problem" it is "also probably a buy, because of the depth of the problems".

"Sometimes it's best to invest when things looking a bit uncertain," he says, adding that the administration is now demonstrating its commitment to addresses underlying economic problems. "The best time to buy other global emerging markets was when people weren't so sure about things: when Colombia was emerging from the FARC problems; Peru, when president Humala was elected. People had a lot of concerns, but we've moved on from there."

Fidelity's Kutas also looks for opportunities to pick up stocks when others take fright. His fund holds stocks for around five years on average - trading costs can be high and liquidity can be tough in these markets, he says. That contrasts with the strategy of many crossover investors who play for quick growth rather than long-term value. The volatility those accounts create can present opportunities, he says.

"I try to be cognizant of how fundamentals and valuations look relative to global peers and developed markets," says Kutas. "When these investors exit they're very price insensitive."

Worries that surfaced about Brazilian utility companies in 2012 are one example. "That can create a lot of downside momentum, but if you know the companies and the fundamentals, you can pick up stocks at fire sale prices."

Mexico sits at the other end of the spectrum. The best performing equity fund managers are upbeat about the country's economic fundamentals.

"One can have a high degree of confidence that Mexico will do the right thing from an orthodox fund manager perspective," says Invesco's Newman. "If they have to take a tough decision, they will take it."

Still, only a fifth of his fund is invested in Mexican stocks - compared to nearly two thirds in Brazilian ones. That is an underweight of the MSCI benchmark, and reflects relative valuations. "Some [Mexican] stocks are a bit expensive - you have to focus hard on stock selection," says Newman. "In Brazil, the aggregate market is cheap. It's generally unloved by international investors and sentiment is poor. That creates an opportunity. If valuations are cheap and sentiment negative, it doesn't take too much improvement in the news to move things the other way."

Consumer bias

A rapidly expanding middle class has put Latin America's consumer sectors in favor. Henderson's Gartmore Latin America fund was overweight consumer staples at the end of February. Brazilian banks Bradesco and Itaú Unibanco accounted for over 12% of the fund's allocation, while Pão de Açúcar, América Móvil, Ambev and Coca-Cola FEMSA were also among its 10 largest investments.

"Right now our favorite sectors in LatAm revolve around the consumer," says Palmer, who manages the $1 billion fund.

"So that would be straight sector - we're overweight the consumer. We had been adding more money to financials in recent months and mainly in property related areas - real estate developers and real estate investment companies, like REITS or companies with REIT-like characteristics."

That strategy is one that others echo. Henderson's fund is underweight materials. Others are similarly bearish. JPMorgan's Latin America fund had a 9.6% allocation to materials at the end of February, in contrast to a 26% allocation to consumer staples and discretionaries, and 31% in financials.

JPMorgan allocates its Latin America fund according to expectations on how the region will look over the next five to 10 years. In 2010, the firm took a view that China's structural slowdown would have a long-term impact on Latin American economies, says portfolio manager Luis Carrillo. Heavy demand for natural resources from Latin America would wane as the Asian nation rebalanced its economy.

"As that transition happens we expect less consumption of raw materials," says Carrillo.

In the past, the Latin American equity index has resembled the commodities index. "That's not necessarily the best way to have exposure to the Latin America of the future," says Carrillo.

Today, rising domestic consumption is buoying GDP growth across the region. That is likely to push commodities out of the picture as the main economic driver - and alter the make-up of the index.

"Smaller companies not even part of the index today will become part of the index in the future," says Carrillo. "The bigger components today, the commodities firms, will be a smaller percentage the index in the future. We expect the index in the future to resemble more the GDP make-up today."

But not everyone loves LatAm's consumer story. Fidelity's Kutas worries that consumption in Brazil is driven by credit, and adding to inflation.

Although Fidelity's Latin America fund is overweight consumer staples and financials, it allocates just 2.79% to consumer discretionary companies. That's a sharp underweight of the 5.34% allocation in the fund's benchmark, the MSCI EM Latin America.

"The average guy walking down the street in São Paulo has never seen these rates before," says Kutas. "The ability to borrow is a lot better than it has been. But that can also put pressure on food and oil prices, which are very important for the average consumer. Pressure on the consumer from inflation is not reflected in many of the consumer discretionary stocks today."

Fundamental analysis

Beyond sector favorites and geographical bias, the top managers say they prefer to focus on the performance potential of individual companies. That involves examining the company's strategy and its management team.

Nicholas Morse, who manages Schroders' Latin America Equity Investment fund, says he looks for management teams that understand their industry well enough to anticipate upcoming trends.

"We try to find companies that are well run and that are winners in their sectors," says Morse. "If you find a well-run company that can continue to add value and think cleverly within the sector, you can do well."

The detailed, bottom-up approach has the fund weighted differently to some other top performers. It was underweight consumer staples, and marginally overweight materials, at the end of February, for example. But it has driven impressive returns: averaging 3.4% annually over the past three years, the fund is fifth in LatinFinance's scorecard.

"A lot of the companies we have are domestically orientated and have higher than average return on capital employed," says Morse.

"They might well trade at a premium to the market, but they have normally significantly better earnings growth than the peers in their sectors."

Realistic on returns

As portfolio managers jostle for next great performing Latin stock - scrutinizing spreadsheets and investigating on the ground - alarm bells are being sounded on investor expectations.

JPMorgan's Carrillo says that as economies mature, the risk-reward balance will change. "I don't think that the Latin America of the future is anything at all like the Latin America of the past," he says.

"The risk has changed a lot. In 2000, we had basically one country that was investment grade. Now every country is investment grade. The level of risk has changed, so it's difficult to get the same valuations of the 1990s. Some are looking at Latin America with expectation of 30%, 40% [annual] performance. We see something closer to 10%."

Henderson's Palmer is similarly cautious on the scope for outsized returns. It is "incredibly tough" to beat the benchmark over the longer term, he warns.

"It's interesting to see how many managers feel that they have cracked the code and can take big benchmark-related risks and somehow feel that they're going to outwit the benchmark," he says. "As time has shown us, it's really tough." LF



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