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Field Notes: Latin America

Nick Niziolek

Members of the Calamos Research Team recently traveled to Latin America to meet with company management teams from Brazil, Mexico, Chile, Colombia, and Peru. We came away with valuable first-hand insights about the regional macro environment and how companies are capitalizing on this landscape.

The feedback was fairly uniform, with most company management teams expecting a challenged consumer in 2014. The optimists expect a pick-up in consumer activity during the second half of 2014, and most are more positive on 2015. Despite this headwind, there are other regional secular trends and company-specific catalysts that may result in growth opportunities for select companies, and the Calamos portfolios.

Mexico. Uncertainty around the recent "sugar tax"* and the increase in the maximum tax rate to 35% make it more difficult to forecast consumer activity, but most management teams expect weakness at least through 2014. The tone is more optimistic about recent reforms, but managements are realistic that these policies will take time to implement and their benefits will likely be a 2H2014 or 2015 story. Read my earlier post on Mexico.

Our consumer exposure within Mexico continues to be around bottom-up growth opportunities with company-specific near-term catalysts. As Mexico has become a consensus overweight among global investment managers, attractive valuations have become more scarce. We are taking an opportunistic approach, and when Mexico has sold off alongside the broader emerging markets region, we have bought selectively.

We have exposure to Mexican financials, which we believe will realize more near-term benefits from reform initiatives. Select companies offer attractive bottom-up growth potential, as credit penetration increases in this country. We have also identified industrial and materials companies that feed into the energy supply chain, while further benefiting from Mexico's close ties to the improving U.S. economy.

Brazil. The consumer remains highly levered. Actual debt-service costs are likely 1000 basis points higher than what the central bank reports because popular installment loans are excluded from its calculation. While debt-service costs began to fall in the second half of 2013, the central bank has been forced to increase interest rates as inflation remains above target levels. This in turn should negatively impact debt-service costs. Economic growth has now become the Brazilian government's third most important policy outcome, behind inflation targeting and maintenance of the country's credit rating, although the government understands the need to keep growth a very close third.

Despite this dreary economic outlook, there are still opportunities. Most of the macro concerns are already priced into valuations. The Brazilian index is off nearly 50% from its 2011 peak, with currency depreciation playing a significant role.

Within the Brazilian financial sector, we believe there are many underappreciated growth companies that can benefit both from recent changes in government policies and from incremental economic improvements. Where else can you invest in emerging market banks that consistently return more than 20% on equity with loan-book growth in the low-double digits—for less than two times book value?

In recent years, private banks have faced challenges, including a crowding out by public banks that were providing credit more indiscriminately in an attempt to spur economic growth. This resulted in lost market share and slower growth for the private banks. As government has adjusted its policies in 2014 to focus more on inflation and the country's credit rating, private banks can remain selective in their underwriting policies and potentially see an improvement in growth as the lending environment becomes more rational. Despite these positive developments, valuations for the private banks remain attractive. Many global portfolio managers utilize these liquid institutions as proxies for country exposure and are significantly underweight Brazil, given its negative near-term economic outlook. We are also underweight, and while we are monitoring macro developments for a potential inflection point, we maintain some exposure through companies that also have significant near-term bottom-up catalysts that we believe could result in outperformance regardless of exactly when the economic backdrop improves.

We continue to see a strong secular growth opportunity within the Brazilian education industry. With college graduation rates nearing 20%, Brazil remains far behind other Latin American countries, such as Mexico (about 40%) and Chile (about 60%). This is due in part to Brazil's less-developed education system, with some state-run universities reporting lower acceptance rates than Ivy League institutions. Given the limited supply of college-educated workers, the unemployment rate for these grads is effectively 0%, and wage inflation is above average. This has provided a powerful tailwind for private education companies, a tailwind that strengthened when the government began providing subsidized student loans at negative real rates two years ago. Although enrollment has increased, many students are not yet aware of the program's benefits. We expect the program to provide a longer-term catalyst for companies in the education industry, with improving utilization rates in the next two years as initial classes work through their four-year degrees, as well as longer term as a higher graduation rate brings Brazil more in-line with many Latin American peers.

Colombia. We heard universal optimism about Colombia's economic potential, including predictions that Colombia will become the second "rich" Latin American country, joining Chile. Colombia continues to move up in the Heritage Foundation's Economic Freedom Index—the result of recent improvements in trade, business, and fiscal policies. Colombia has moved into the "mostly free" category, ranking behind only Chile within the region.

The opening of peace negotiations with the FARC insurgency has contributed to optimism about further improvements in national security, although only two of five agenda points have been agreed to thus far. Colombia also has strong ties to the U.S., the destination for nearly 35% of its total exports. Better U.S. economic growth prospects could have a positive knock-on effect for Colombia.

To date, our exposure to Colombia has been primarily indirect, as many of our Brazilian, Mexican, and Peruvian holdings generate revenues from this country. However, we are researching several new growth opportunities that may warrant an allocation of capital later this year.

Conclusion
While economic policies and inflationary headwinds create near-term headwinds for Latin American companies, we believe we are getting closer to an inflection point for the region. Meanwhile, our team has identified growth companies we believe can outperform regardless of the economic environment. Drawing upon the insights we've taken from our recent meetings with strong Latin American corporate management teams, we are comfortable allocating capital to select bottom-up growth opportunities. As the economic situation improves, we believe these companies are positioned to benefit from those tailwinds as well.

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*Tax on sugar-sweetened beverages and related products.

The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Information contained herein is for informational purposes only and should not be considered investment advice.

The information in this report should not be considered a recommendation to purchase or sell any particular security. The views and strategies described may not be suitable for all investors.

As a result of political or economic instability in foreign countries, there can be special risks associated with investing in foreign securities, including fluctuations in currency exchange rates, increased price volatility and difficulty obtaining information. In addition, emerging markets may present additional risk due to potential for greater economic and political instability in less developed countries.

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