MARKETS: A cap on desire

22/03/2010 | Sid Verma

Latin stocks have surged over the past year, but the market remains acutely vulnerable to external shocks

Latin stocks have staged an unprecedented recovery.

With consumption and industrial production roaring back to life and foreign investors diversifying into less crowded stocks, the Latin American Small Cap stock market returned 175% in 2009 to become the best performing equity market worldwide.

And more generally, emerging equities are rebounding against the background of cheap cost of capital, a global economic rebound and resilient corporate earnings. A new record for developing world equities was set in 2009, with the MSCI index returning 79%.

By this February emerging market equities outperformed developed markets by 69% from the market trough of October 2008, despite having recorded their biggest yearly drop of 53% at the height of the global financial crisis. Yet despite this decoupling of equity returns in developing versus developed markets, regional stocks are acutely vulnerable to external shocks.

In mid-February the benchmark index for the region, the MSCI Latin America, tumbled 15% from the year-high on January 11. The sell-off was sparked by the Greek sovereign debt crisis and fears over liquidity tightening in China. This was the fourth correction, defined as a drop of 10% or more, since November 2008.

The wild swings in Latin bourses – in tandem with volatile developed markets – are now causing investors to take stock of the relative value of the region’s equity markets, following the gains in 2009. According to research from Citigroup, the MSCI Latin America index trades around 17 times over the reported earnings of its companies, more than the 13.7 monthly average of the past decade.

“Latin American stocks, and emerging market equities in general, are fairly valued at the moment,” says Antoine van Agtmael, chairman of Emerging Markets Management, which oversees up to $14 billion of stocks globally.

But Agtmael, who coined the term “emerging markets”, says valuations in Brazil, Mexico and Chile are unattractive for value investors: those that buy stocks that are a discount to a company’s book value. He says developed markets are likely to outperform while investors, benchmarked to the MSCI, are set for single-digit returns – and only if global market conditions remain benign.

BULLISH OR BEARISH

Agtmael joins a growing breed of investors in 2010: secular bulls morphing into cyclical bears. Even veteran emerging market enthusiast Mark Mobius, executive chairman at Franklin Templeton Investment, fears “massive money supply” and herd behaviour among investors may trigger investors “to go beyond themselves and stretch valuations”.

Geoffrey Dennis, head of Latin America equity research at Citigroup, says the equity bull market is here to stay, and neither valuations, fund flows nor the momentum of the rally, signal a bubble is brewing.

According to Citi, regional equity prices posted a forward price earnings (p/e) ratio of 18.3 times at the market high in early January. “This trend in stock prices is typical of the first year of a bull market, when prices move early and far ahead of earnings, and p/e ratios expand,” says Dennis.

He says the market high p/e of 18 was identical to peak valuations in the first year of the last two bull markets in the region in early-2000 and mid-2003. But he says growth in corporate earnings typically outstrips rising stock prices in the second year of a bull market, triggering p/e multiples to contract and boosting investor returns on equity.

Mobius says, however, even on a price to book basis, which compares a company’s stock capitalization to its balance sheet, emerging markets are, in general, now fully valued. “At the top of the market, emerging markets were selling at three times book value; at the low it was one times book value. Now it seems to be between 2.1 to 2.2 times, so we are at fair value,” he says.

Agtmael is underweight Brazil, Mexico and Chile because, despite being regional heavyweights, they are trading at a premium to global emerging markets on a price to book basis.

Dennis says pricey Latin stocks are justified by the typically higher returns on equity (ROE) on offer this year at a projected 13% versus 11% for the emerging markets globally and the worldwide average ROE of 5%.

Sell-side strategists and bullish investors are banking on resilient corporate earnings this year due to the solid rebound of commodity prices, the return of the Latin consumer and production. Moreover, according to Emerging Portfolio Fund Research, inflows into emerging equities totalled $64.7 billion last year – a 60% jump from the previous record of $40.8 billion set in 2007.

“Whenever something is in fashion, there is a danger of a bubble caused by large-scale investor holdings – and emerging market equities are certainly in fashion,” says Eduardo Câmara Lopes, CEO of Ashmore Brasil.

But despite the exuberance for emerging markets, Dennis argues that investors are still structurally underinvested. Relative to the 13% weight of global emerging market equities in the MSCI All Country Index, analysts say global portfolio managers are underweight, and average allocations could be as low as 5%. Moreover, the February panic over the Greek debt crisis may have helped take the froth out of the Latin stock market.

At the January 11 peak of the MSCI Latin America index, which was up 158% from its trough in late November 2008, 96% of stocks in the regional benchmark were trading above their 200-day moving averages – a historic peak.

Some 80–90% of Latin stocks are trading above their 200-day moving average, indicating how the momentum of the rally has slowed without triggering investor panic, says Dennis.

The consensus call in 2010 is for Brazil to outperform Mexico due to buoyant household consumption and investment in Latin America’s largest economy and the recovery in commodity prices. But after notching huge gains in 2009, investors are awakening to a new reality of modest returns. The BM&FBovespa index, the biggest gainer in the MSCI Emerging Markets index, surged 83% last year, thanks to a record net inflow of 20.45 billion reais compared with 2008’s net outflow of 24.6 billion.

VULNERABILITIES

Lopes at Ashmore says the index still offers value as valuations trail China and India while markets have priced in an expected hike in the Selic rate by year-end. But Agtmael notes: “This year may frustrate investors as US and global growth may disappoint while monetary tightening in China will be negative for emerging markets, especially the commodity producers.”

If Chinese demand for raw materials wanes, Brazilian energy and iron ore shares, which have a large weighting in the Bovespa, will be hit.

Mobius – who is overweight retail banking stocks in Brazil but underweight Latin America in favour of frontier economies – says the bullish sentiment for Brazil belies the risk of volatility later on. Specifically, he says many foreign investors in Brazil’s equity market are recycling their real-denominated liquidity in stocks onshore to avoid paying a 2% transactions tax, which was imposed in November to discourage hot money inflows.

This may have created the illusion of thick secondary market liquidity in smaller stocks and risks triggering dislocation in a flight-to-safety sell-off.

As the region’s single largest exporter to the US, Mexico has inevitably been vulnerable during the financial crisis to the economic weaknesses of its northern neighbour. Investors are cool on the country’s domestic cyclical stocks as the outlook for the labour market, services and retail sales remains weak. “Mexico will take more time to recover, so we remain underweight in favour of Brazil,” says Will Landers, senior portfolio manager of BlackRock’s equity funds.

But Alberto Bernal, head of research at Bulltick Capital Partners, says the Mexican Bolsa will outperform regional benchmarks, as growth will overshoot the 3–4% market consensus.

In addition, analysts predict the Mexican peso is likely to rebound strongly this year as exports pick up. Peso appreciation will boost nominal returns from stock prices and dividends while reducing the real value of dollar debt. In addition, foreign investor holdings of New York-listed ADRs (American Depositary Receipts) for Mexican publicly listed companies could be set for a boost as a stronger peso will increase corporate earnings in dollars.

Latin American stocks have been trading at a premium to developed markets despite the typically higher cost of capital and weaker governance standards in the region. That is largely because Latin firms have been hit by a slowdown in the global business cycle rather than a wave of systemic deleveraging, unlike their western counterparts.

So rather than repairing balance sheets, the region’s corporates have, in theory, the financial strength to focus on growth to boost equity returns. However, the debt crisis has also validated the approach of these corporates, who have relied primarily on internally generated funds to finance their daily operations and investments rather than debt, says Agtmael.

Emerging market corporates typically have excess cash on their balance sheets as underdeveloped financial systems force corporates to operate with conservative debt to equity ratios. This is typically a blow to shareholders and a boon for debt investors. “Having excess cash clearly limits equity returns, but a lot of Latin corporate treasurers are probably saying screw the shareholders: we just want to survive in these uncertain times,” says Agtmael.

But this is problematic. After overshooting fair value in the wave of deleveraging in 2008, Latin American stock prices rebounded to deliver massive returns in 2009. Now investors are paying over the long-term average price for Latin stocks, amid expectations of solid business expansion and high earnings. But in a world where contagion from the West is causing havoc in emerging markets, it may be safer to snap up undervalued companies in less correlated, frontier economies.

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