Year: 2016

In early October 2014, Saudi Arabia’s announcement that it would no longer support the price of oil had three unforeseen consequences: first, it triggered a collapse in the prices of the world’s main industrial commodities, such as copper and tin; second, it generated unprecedented levels of correlation among Latin American securities, which fell in unison regardless of fundamentals; and third, it ushered in the end of the ‘pink tide’ that has governed South America over the last decade (socialist governments are being either voted or thrown out of office across the continent).

As a result, we believe the balance of risks inherent in investing in Latin American securities is skewed to the upside. Valuations and credit spreads stand at multi-year lows, pragmatic incoming presidents carry the promise of better governance than their interventionist, ideology-driven predecessors, and the supply side of the commodity equation has adjusted by slashing capital expenditure and exploration, which has in turn contributed to a firming of prices.

The way to capitalise on this opportunity is via managers with on-the-ground presence, who possess the local knowledge to separate the wheat from the chaff. Simply buying ‘beta’, via either exchange-traded funds (ETFs) or index (or closet-index) funds, exposes investors indiscriminately to Latin America’s largest capitalisation securities. Many of the latter, in our opinion, do not constitute desirable investments and may not survive this downturn. The opportunity for long-term, fundamental investors lies in ‘second-tier’ securities, which have been hit disproportionately by the drying up of liquidity, and whose prices have fallen more than their fundamentals warrant.

An investment opportunity exists in discerning which Latin American securities have fallen more than their fundamentals would warrant

The pink tide recedes
The most obvious consequence of the commodity collapse is what the international media is beginning to refer to as ‘South America’s turn to the right’. This includes the highly visible cases of Argentina, where Mauricio Macri has staged a dramatic policy turnaround that enabled the country to return to the international bond markets, and Brazil, where Dilma Rouseff is mired in a corruption scandal and fighting to avoid impeachment.

A similar trend is also evident in Peru, where the leftist alliance, Frente Amplio, failed to place a candidate in the national election’s runoff stage; Bolivia, where Evo Morales lost his re-election referendum; and in the municipalities of Bogota and Lima, where the left lost key capital cities, and in the latter case was almost revoked entirely.

Finally, the Venezuelan crisis is rapidly becoming a humanitarian catastrophe, making Nicolas Maduro’s hold on power tenuous at best. Pragmatic, non-ideological candidates are being elected across the continent, and socialist presidents and mayors bent on interventionist policies are fighting for dear life.

The reasons for the collapse of the Latin American left are varied, but a key trend is evident: there is now a larger middle class, estimated at 200 million people, which is no longer willing to tolerate corruption, is demanding better public services and, thanks to social media, is much better able to inform itself and mobilise.

Rise of correlation
While the direction Latin American markets took following the fall in oil and industrial commodities was not surprising, the extreme correlation among Latin American assets was. Despite their differing fundamentals, in 2015 the Brazilian, Peruvian and Colombian equity indices performed within 102 basis points of each other. The volatility of the indices themselves was extreme – Colombia and Brazil fell 40.95 percent and 41.97 percent respectively, in USD terms, ranking among the worst equity markets in the world – but the difference between the indices was minimal.

In effect, Peru and Colombia traded as if they were provinces of Brazil, in a year when the Brazilian economy contracted by 3.8 percent, and the economies of both Peru and Colombia grew more than three percent.

At a regional level, the MSCI Emerging Markets Latin America Index (where Brazil and Mexico comprise 83.9 percent of the index) and the S&P MILA Andean 40 Index (which represents the equity markets of Peru, Chile and Colombia) fell 31 percent and 28 percent respectively, following an almost identical path (see Fig. 1). The behaviour of credit spreads from Latin American issuers has also been remarkably similar: in short, for the past year and a half, the overwhelming majority of Latin American securities have behaved as simple commodity plays.

These extreme correlations are the result of the rise of index investing and its close cousin, closet indexing; funds marketed as active, but whose positions closely mimic their reference indices. Indices and funds that do not engage in fundamental research tend to buy the largest capitalisation securities in each market, and when funds are liquidated, every security in the index is sold, regardless of its specific sector or country fundamentals.

Limited downside
Following this ‘commodity storm’, we believe Latin America now has much better footing, for three reasons.

First, leftist governments are in their death throes (Brazil, Venezuela), while pro-market governments are either in place and changing things fast (Argentina, Bogota), or will soon be in power (Peru). Most of the new presidents and candidates understand the importance of attracting foreign investment, reducing trade barriers, and maintaining disciplined fiscal and monetary policies.

Second, valuations are at multi-year lows. In late 2015, at least three major Latin American airlines were, by reasonable estimates, priced at less than the liquidation value of their respective aeroplane fleets. Value opportunities such as these are created by ETF liquidation, margin calls and, in general, foreigners leaving the region and selling everything irrespective of fundamentals.

Commodity prices are also much firmer than in 2014. While it is difficult to judge the demand side of the equation (also known as China), on the supply side commodity prices are now closer to marginal costs of production. The last year and a half has seen a dramatic fall in investment in commodities worldwide. Extractive industries are undergoing closures, and companies are going out of business, curtailing future production.

Picking up the (right) pieces
The easiest way to invest in the region is simply to buy an ETF or an index fund. Most of the region’s ETFs are market capitalisation-weighted; this has the effect of exposing investors to companies that are not necessarily attractive investments and, in many cases, are downright dangerous.

Most of the largest Latin American capitalisation securities are those of commodity producers, such as Ecopetrol, Pemex and Southern Copper. The fact their securities have fallen in price does not mean they are cheap now; in a way, they deserved to fall, given their sales price (an industrial commodity) fell dramatically, putting pressure on margins. There are also cases of large-cap companies embroiled in corruption scandals (such as Petrobras), and of bonds that may very well not survive in their current form (like those of Venezuela). Finally, there are companies facing an adverse regulatory environment, such as América Móvil, which have been hurt by Mexico’s telecommunications reform.

Rather than blindly buying the region’s largest companies, the Latin American opportunity lies in selecting securities whose prices have fallen not as a result of adverse fundamentals, but as a result of undifferentiated panic selling. Profiting from this opportunity requires on-the-ground knowledge. There are, for example, companies that benefit from the depreciation of the local currency, such as Chilean wineries, Brazilian meatpackers, and even certain Colombian construction companies.

A good way of assessing whether a fund is engaged in a differentiated strategy is to check its main holdings and its ‘active money’ measure, defined as the percentage of the fund that is different from its benchmark index. Credicorp Capital’s Colombian equity fund, Fonval Dinámico Acciones, has a 76 percent active money measure as of April 2016. Since inception in April 2012, the fund has outperformed Colombia’s COLCAP by 40 percent.

During this time, the main contributor to this outperformance was Empresa de Energía de Bogotá, a utility controlled by the municipality of Bogotá. This investment underscores another crucial point of the ‘on the ground knowledge’ advantage: understanding local politics, not only at the national level but also at the regional and municipal level, matters.

Unsurprisingly, this high active money strategy has resulted in significant tracking error relative to the indices. The fund currently has a negative exposure to the oil sector, as it is short shares of Ecopetrol, the county’s largest capitalisation stock, and risks underperforming the market if oil prices continue to rally. At Credicorp Capital, however, we believe that having the right investment strategy, and not minimising tracking errors, is the best way to serve our investors.

Forget tracking error
Over the past year and a half, the collapse of the commodity complex has created a set of ideal conditions for long-term, fundamental investors in Latin American securities. Countries have undergone dramatic changes in governance, and industries have gone into profound crises, while others have benefitted, while the advance of the Latin American middle class has continued unabated. In the midst of this turbulence, Latin American securities of dissimilar countries and sectors have behaved as simple commodity plays, their prices falling by remarkably similar amounts.

An investment opportunity exists in discerning which securities have fallen more than their fundamentals would warrant. At Credicorp Capital, we believe that profiting from this opportunity requires local resources, deep research and the philosophical conviction to invest in high active money (and, therefore, high tracking error) investment vehicles.