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
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
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
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
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 regions 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 companys 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
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 companys 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
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
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 8090% 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
The consensus call in 2010 is for Brazil to outperform
Mexico due to buoyant household consumption and investment in
Latin Americas 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 2008s net
outflow of 24.6 billion.
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
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 Brazils 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 regions 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 countrys 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 BlackRocks
But Alberto Bernal, head of research at Bulltick Capital
Partners, says the Mexican Bolsa will outperform regional
benchmarks, as growth will overshoot the 34% market
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 regions
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
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.