South of the Border

By Staff Writer

June 01, 2002 at 04:00 AM

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I will bet you a peso (okay, 100 pesos), that you think you know the answer to the following question: What is Latin America? But, if your high-net- worth client wants to cross the border with his or her hard-earned dollars, you might want to be able to answer the question with more than a shrug and an old joke about Montezuma's revenge. The truth is that Latin America is an attractive emerging-market landscape where some countries are worth a hard investment look, and some are worth avoiding at all costs. (Hint: The countries you'd be most likely to vacation in are the countries you'd most likely want to invest in. Colombia? I wouldn't vacation there with an M16; Mexico, I'd fish it in a minute.) But there are some investment vehicles that are detailed below that can help you take the bumpy road and back, with a high probability of putting money in your (U.S.) bank.

Latin America is generally considered to include Spanish or Portuguese-speaking nations of the Western hemisphere, usually not including the island nations of the Caribbean–which are relatively tiny economies and not particularly tied into the economies of the mainland.

This definition holds despite the protectionism of many of these nations, the fact that Mexico is a more natural trading partner to the U.S. than to the nations of South America, and in spite of the Central American economies being relatively undeveloped or small. Moreover, the regional concept is largely a matter of historical and language ties, combined with a largely shared emphasis on relatively low-wage, low-investment industries and agriculture.

The countries that predominate in any area-wide stock fund are, in order of market size: Mexico and Brazil, then Chile and Argentina, then Colombia and Venezuela. (The last two do not tend to be held in Latin portfolios; they are smaller markets, corruption and crime are rampant, drugs are the economic rampart, and they are even now actively at risk of violent insurrection.)

Latin America is cheap, and has the potential for great growth. Many stocks are selling for 12 times trailing earnings, prices not seen much in the U.S. in over a decade. But first the bad news: The unrealized potential of Latin America has long been notable. The old joke about Brazil holds that it's the country of the future, and always will be. The joke could be told about the region as a whole. In fact, per capita GDP has been flat for the past half-dozen years. (On the plus side, inflation rates have come down from about 20% in 1995 and 1996 to 5% in 2001.) The unrealized potential of Latin America has long been associated with unstable and economically illiterate governments.

Looking at the longer term, in the 1940s, Argentina was among the richest nations of the world, but political conditions have since led that nation into a long relative decline almost as significant as that of Cuba.

Feeding its instability, Latin America has much greater disparities of wealth than the U.S. or Europe. Significant industrial output coincides with problems of debt, inflation and weak currencies, rural and urban illiteracy, poverty, corruption, political instability, and Marxist and related philosophies. Even "right-wing" governments have generally favored, or at least did not oppose, protectionist policies and government monopolies in the transportation, minerals, and utilities sectors. (Apart from Chile, the military regimes of the 1970s and 1980s were as bad at economic management as they were at protecting human rights.)

Informal business sectors and land ownership, high tax rates that don't bring in much revenue, weak systems for obtaining mortgages and other loans, all are related problems–endemic to the region–that feed each other.

In many places (e.g., Argentina most recently), free-market reforms have aroused opposition from labor unions and leftists, while still leaving state control of the economy at European-style or higher levels. Naturally, there is some debate in Argentina whether the current troubles are due to excessive, or inadequate, reliance on free markets. But this should not surprise people who live in a country where some leading members of the left-leaning party blamed a recession on tax cuts.

Glass Half Full?

Let's put it this way, we think that you can drink the water. True, Latin American backwardness is a problem, but it's also the opportunity. Stock markets generally value corporations based on their current situations and their expectations of growth. If you know that a given manufacturer is selling for 12 times trailing earnings, the fact that vast populations can't yet afford that manufacturer's products is not a bad thing; it means that substantial growth is still possible. And as long as the situation of those who can already afford the products does not actually regress, such as in a recession or revolution, this manufacturer's position is pretty solid.

Latin America hasn't seen the advances of the Asian Tigers, but Latin America isn't Africa, either. First, GDPs are about $10,000 per person for the four most advanced Latin nations, versus about $1,000 for many sub-Saharan African nations (and $36,000 for the U.S.). Latin America's wars and coups also tend to be far less brutal (although recent low-intensity conflicts certainly aren't good for business in, say, Colombia). The end of the cold war means these nations have reduced leverage to obtain U.S. aid, but also means that Marxist rebels have less philosophical and tangible support. (Of course, drug money remains.) And a relatively shared culture, language, and markets will help keep these markets increasingly tied.

Still, the area is diverse, and there really are only four countries that count for most stock investors:

Mexico, due primarily to its NAFTA-freed trade and immigration ties with the United States, now dominates most lists of the region's publicly traded companies. While NAFTA is now quite popular in Mexico and with most U.S. businesses, much of the rest of Latin America–as well as U.S. politicians with large labor union support or from Southern areas with textile and other low-wage, low-tech industries–remains skeptical of the benefits of free trade, despite the Free Trade Area of the Americas (FTAA) regional trade agreement, which was proposed in 1994 and is supposed to arrive in 2005. Of course, it's absurd to put such a thing on a fixed schedule when so many issues have to be worked out. But at any rate, Mexico's acceptance now of trade seems permanent.

Brazil has a larger population than Mexico (175 million Brazilians compared to 102 million Mexicans), covers a lot of land, and has plenty of natural resources. But Brazil is well behind Mexico economically, with a 2000 GDP of $6,500 per person, vs. $9,100 in Mexico. Brazil's rural inhabitants in particular are substantially poorer and less educated than those of Mexico.

While Chile has fewer than a tenth as many people as Brazil (15 million), and is the nation farthest from the U.S., it's also the one closest to Western standards in terms of laws, accounting, currency, and political stability, and it may be welcomed into NAFTA before the rest of the region. Hence it is the third largest holding in most Latin American portfolios. Argentina's 37 million citizens are the richest of the group ($12,900 GDP per person). With a relatively bloated government sector, and governments falling to protesters who want even more government, it's fourth on most Latin stock lists.

Tools of Your Trade

Latin America's promise of growth, and its current low prices, give investments in the area a greater expected value over the long term than investments in the U.S. However, the uncertainty of return in this area is also high, and even aggressive investors should limit their exposure to the area to 5% or 10% of assets. Said investors will presumably put comparable or slightly greater sums in Europe, Japan, and East Asia, for perhaps a third of assets invested in foreign stocks.

ETF

Southern Exposure

The iShares Latin America ETF will give your clients a foot in the door down south

So where could you go to put a passport to Latin America in your portfolio? By and large, individual stocks will prove too hard to analyze or too volatile for most investors with less than $100,000 to invest in Latin stocks. The exception: A few of the largest firms may be considered for more aggressive clients who may prefer individual stocks and accept limited diversification within their Latin American holdings, presuming also that their total position in the area is under 10% of assets. For such a client, Telmex (see page 123) may be worth a look, if nothing else for its size and liquidity, as well as the growth potential for telecom in its service area.

But for most investors, the best option will be a Latin America fund. The region has a number of offerings, including exchange-traded funds (ETFs), closed-end funds, and open-end mutual funds.

We've covered exchange-traded funds in previous months; these relatively new securities may be the best way for most investors to purchase unmanaged index investments. For Latin America, my favorite ETF option is the iShares S&P Latin America 40 Index (ILF), which is sponsored by Barclays Global Fund Advisors. The ILF is quite new, with an inception date of October 25, 2001. That might be a problem for a managed fund, or for an untested concept, but the iShares ILF is close to a perfect market-cap-weighted index fund tracking the Latin American markets. Despite the fund's name, it currently holds 35 different stocks, primarily American Depositary Receipts, or ADRs, in companies based in four countries: Mexico, Brazil, Argentina, and Chile. The ILF recently had 98.9% of its assets in stocks; the remainder is cash, a reflection of stock dividends, which are paid out at least annually.

With just 250,000 shares outstanding, and a recent share price of $50, the fund has a tiny market capitalization of just over $12 million. However, as one expects of an exchange-traded fund, iShares' ILF has a low expense ratio (0.5%). Liquidity should not be a problem for most ILF investors, with a recent bid/ask spread of about 0.6%, trading volumes averaging about 5,000 shares per day, and market prices generally within 0.1% of net asset value, or NAV. Investors will be buying at a market-set price unless they can afford a 50,000 share creation unit, for about $2.5 million; the fact that institutions can create or break up ETFs in this manner does keep market prices close to NAV.

In addition to ETFs, there are other Latin American investment options. First, iShares also offers ETFs covering Mexico (EWW) and Brazil (EWZ). If you want an unmanaged single-country approach, these are the cheapest ways to get it. Furthermore, if you hold both countries, you'll have about 80% of the region's market cap.

The open-end Fidelity Latin America fund has been available (sold with a 3% sales load) since 1993, as has T. Rowe Price's no-load option.

There are also multi-class Latin America funds–with front-end loads of just over 5% for A shares–offered by Evergreen, Merrill Lynch, Morgan Stanley, and Scudder.

Many investors will instead opt for an "emerging markets" fund. These funds usually hold more in the Asian Tigers than in Latin America, and perhaps also hold stocks in Turkey and Eastern Europe. For many investors, a single fund with such a blend may be appropriate. However, if the client seeks greater flexibility or the ability to more closely manage taxable gains and losses, separate Latin American and Asian positions may be appropriate.

Mutual Fund

Discovering Latin America

For a Latin investment with a long track record, try the Latin American Discovery Fund (LDF)

If your client is bent on investing in Latin America, the next decision is whether to index, by purchasing the ILF, or to seek active management. There are two closed-end Latin America funds with records going back almost a decade: the Latin America Equity Fund (LAQ) and the Latin American Discovery Fund (LDF). I cover LDF here, preferring it primarily for its relatively stronger performance record.

With the lower expense ratios and market prices pretty much fixed to net asset value, ETFs are in many cases looking to make closed-end mutual funds obsolete, but closed-ends offer one thing ETFs cannot: active management.

Active management is, of course, a double-edged sword. Due to active management, the LDF fund's holdings change over time, and are known only on a delayed basis. But Latin American Discovery has a modest 32% annual portfolio turnover, so you generally know pretty closely what you're getting. Given the limited number of liquid Latin stocks, we would expect a low turnover; the fund is almost forced to hold most of its investment universe at any given time.

The price of a closed-end fund can deviate from NAV. The Latin American Discovery Fund was recently trading at a discount of about 15% below NAV. That's about average for a specialty closed-end, and such discounts are one reason one shouldn't buy a closed-end at the offering price, or near or above NAV. But a buyer today, who is getting a discount of about 15%, is not likely to get burned; the discount is at least as likely to shrink as to grow.

The LDF has 11 million shares outstanding. At a recent price of $10.50, that gives it a market cap of $120 million. A modest size in a managed fund like this does make for higher fund expenses, but also allows management to act quite flexibly. The closed-end fund structure also means that managers can concentrate on what stocks they like, instead of managing cash inflows and outflows, since there are none.

Performance? While LDF has been around since June 16, 1992, we can't directly compare this managed closed-end fund with the ILF index ETF since the ILF has only been around since October 2001. But we can judge LDF's Morgan Stanley Investment Management team of fund managers by comparing its returns with another unweighted market-cap index, a slightly broader index tracking about 170 stocks in 7 Latin American countries: The MSCI Emerging Markets Free Latin America Index.

Despite the LDF's expense ratio of 1.75% (versus the ILF's 0.5%), its portfolio (net asset value) has beaten the MSCI index each and every year since 1996 (inclusive), and its market returns have beaten the index every year except for 1998. Bueno.

ETF/Mutual Fund Holdings

Down Mexico Way

Telefonos de Mexico (TMX) has served investors well so far. What's next for Telmex?

Telecom stocks have been nothing but a slippery banana peel for years. And any advisor worth his fee knows that telecom investors have been slammed, unless that is, they dialed up Telefonos de Mexico, or Telmex (TMX) recently. It's the leading telecommunications company in Mexico, is very widely held, and is the largest holding in most Latin America-oriented funds (which is not surprising, since it has the largest market cap).

But before you touch the Telmex dial, let us address the question of diversification and why most investors interested in Latin American stocks should probably stick to the largest-cap offerings. Broadly speaking, buying the largest-cap stock in, say, the U.S. market is not a strategy that's likely to beat a more diversified, but still large-cap, portfolio. Whatever stock has the No. 1 market cap is not likely to remain No. 1 forever, and its share of total market cap is thus likely to shrink. If so, it must then lag a market-cap-weighted index that will give it top, but not sole, billing. That said, in a portfolio with very limited diversification, any mega-cap stock or small portfolio of stocks is apt to have less risk of complete failure than a portfolio of one or a few much smaller companies. Since most investors will have small portfolios in Latin America, a limited number of stocks will have to suffice.

Further, in a high-risk, potentially high-growth environment like Mexico, a large telecommunications firm like Telmex has a pretty good chance of keeping up with, if not beating handily, the market averages, which will include many companies in stodgier industries.

Buying just one Latin stock is not the way to go. But a Latin stock portfolio can be a lot smaller than you might think. A portfolio of just five Latin stocks may seem shockingly undiversified, but if the same customer has a similar portfolios of, say, five Asian stocks, five European stocks, and a couple dozen U.S. stocks, then the risk incurred from any individual Latin holding is ameliorated. Looked at from a broader perspective, whether the client's other areas are divided into stocks or funds, if just 5% of his total assets are in Latin America, and that's in five approximately equally weighted stocks, then each stock is of course just 1% of his total portfolio, and individual stock risk is not very significant.

Of course, if the client sees his Latin holdings as a "separate" portfolio, or if a given advisor is only handling a client's international positions, or harder yet, just the client's Latin holdings, then there may be a greater need for diversification. This is a psychological need, by the way, not really an investment need, but naturally the client's comfort level generally must be paramount. That said, there may be advantages in putting the client's Latin position into a small number of stocks, perhaps five off the top of the ILF's holdings list (see list below), or if the client has enough money to invest, in all 35 positions in the ILF.

Why would one want to recreate the ILF with separate holdings? Taxes. In a taxable account, the flexibility to take gains, or more likely, any losses as needed, is valuable. So the table of ILF holdings may be used in the creation of such a portfolio, whatever its size (up to 35 stocks). And if so, I would recommend working off the top of the list: Telmex is there.

Telmex has an ADR traded in dollars on the New York Stock Exchange (TMX), which is certainly the easiest way for U.S. investors to buy shares in the firm. Naturally, there are also shares traded in Mexico in pesos.

Telmex controls 95% of Mexico's local phone market, and is also the country's largest long-distance company and Internet service provider (it spun off wireless subsidiary America Movil, AMX, the 4th largest holding in the ILF index fund, in 2000). Formerly a state monopoly, Telmex was privatized in 1990, with a controlling share bought by billionaire conglomerator and industrialist Carlos Slim.

The firm has a useful web site at www.telmex.com. If you can get past the dancing figure of E.T. the Extraterrestrial saying "phone home" (actually "Llama a casa"), you'll find an English section with all the financial reports and investor relations materials you're apt to need.

The biggest risk to any utility investment, here or abroad, comes from changes in the regulatory environment–usually called "deregulation," but often anything but. Because telephone and other utilities have been seen as natural monopolies, most countries have an established dominant, or previously dominant, player, such as AT&T in the U.S. And varying conceptions of fairness and the need for newer companies for increased competition lead to varying rules concerning operations, and even active plans to hamstring some firms at the expense of others.

A bill that is headed to Mexico's Congress probably late this year would give the Mexican Federal Telecommunications Commission, or Cofetel, much more power to decide whether Telmex is overly dominant, and to force the firm to help its competitors, both by making customers' numbers portable and by requiring Telmex to rent infrastructure to competitors at Cofetel-set prices. On the other hand, the bill will apparently help Telmex by outlawing the growing practice of callers' bypassing expensive international phone calls on high-speed digital lines, and the bill will not end current restrictions (i.e., a 49% cap) on foreign investments in Mexican telephone firms. While President Vicente Fox appears to back the proposed law, no one yet knows exactly what will be in the bill, which has yet to be finalized by a committee of both houses. (Mexico has three major parties; otherwise this is much like the bipartisan House-Senate committees we see in the U.S., which have almost complete power to shape a bill, but cannot really force it into law.)

Certainly there are risks here, although there is little reason to expect that the Mexican government will deal as harshly and arbitrarily with Telmex as the U.S. has with AT&T. For one thing, Telmex is seen as a domestic firm battling mostly foreign-allied competitors. On the whole, I'd still like the position of being the dominant player in this market of great growth potential.

During the first quarter of 2002, Telmex added 230,000 phone lines, bringing its total to 13.6 million. For the past three years this phone line count has been growing by 10% per year–not something we're ever going to see again in the U.S. While first quarter revenues were down 2.8% from a year earlier, and operating income was off 6.8%–both due primarily to cuts in the real prices of local and long distance services–revenues from digital businesses were growing. As an example of that growth, the number of lines with at least one digital service was up 55%, to 3.5 million. These are all solid numbers considering the near-global slowdown in telecom and, to a lesser extent, economic activity in general (also known as a "recession").

With 13.6 million phone lines serving a Mexican population of over 100 million, there is no reason to see saturation in this market. By contrast, the U.S. has 200 million lines for 280 million people. Line counts will continue to increase. First Call's consensus estimate of 12 analysts who follow the company is for TMX to earn $3.68 for 2002, down from $3.90 in 2001. At a recent share price of $37 for TMX, we're talking about a price/earnings ratio of about 10.

Telmex will probably not hang on to its 95% market share, but the company doesn't have to in order to see considerable bottom line growth.

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