MORE BRAZIL WOE PULLS LATIN AMERICA DOWN
INCA Investments LLC
(September 2015)
MARKET PERFORMANCE
Latin American markets suffered through another negative month with the MSCI
Latin American Index declining 7.7%, bringing the market to a cumulative fall of
29.1% for the year. Latin America was led down by the 11.9% fall in the Brazilian
market, which has now fallen 39.4% for the year. The Brazilian economy
continues to weaken as growth forecasts have been revised downward again with
the resulting expectations that the country will experience another year of
negative economic growth in 2016. Current consensus expectations are that Brazil
will experience growth of -2.5% and -0.7% for 2015 and 2016, respectively. One of
the country’s primary problems is its large fiscal deficit, which is resulting in a rise
in inflation which is now expected to reach 9.5% for 2015.
Although the administration of President Dilma Rousseff has shown some
willingness to rein in spending, the political turmoil caused by the huge Petrobras
corruption scandal, that has involved many of the political parties supporting the
president, is making it difficult to create the political consensus needed to pass
legislation to reduce spending and improve the country’s fiscal situation.
Although Brazil has been the worst market performer in Latin America, all of the
markets of the region are experiencing a very negative year (see Market
Performance above). Most of the decline in the Latin American markets has been
caused by the fall of local currencies against the strong US dollar. For 2015 thus
far this year, 82% of the decline in the Latin markets has been attributable to the
depreciations of the local currencies. As a result, there has not been any refuge in
picking stocks since a currency devaluation has an equally negative effect on the
value of all stocks within a country.
While in the short term Latin American markets are expected to remain hostage
to global concerns (especially whether China experiences a hard landing), we
know that in the long term the currency devaluations that have an immediate
negative effect on a company’s share price, have positive long term consequences
for the economies of Latin America. As exporting becomes more profitable and
locally manufactured goods become more competitive against increasingly
expensive imports, the trade balance of Latin American countries will improve
providing a much needed boost to those economies. Notwithstanding Brazil, the
other principal Latin American countries (Mexico, Chile, Colombia and Peru) are
expected to fare much better next year according to consensus growth rates,
which are expected to increase to an average of 3.2% in 2016 from 2.6% in 2015.
Our focus is to buy those strong franchise companies which we believe have been
oversold in the current negative environment. As such, we continue to
concentrate on those companies which our experience tells us will benefit the
most from what we expect to be a significant market bounce once global jitters
subside.
COMPANY PERFORMANCE SUMMARY
One of the poorest performers in the month was Cemex (which accounts for 8.3%
of the WIOF Latin American Performance Fund’s portfolio), a cement maker with
primary operations in Mexico and the Americas. During the month the stock
declined 11.2% in US dollar terms. The market’s chief concern is the mismatch
Cemex has between its debt, which is 85% in US dollars, and the company’s US
dollar based operating profits which account for approximately 25% of total. Latin
American currencies have been under pressure with an average depreciation of
24% on a year to date basis across the region. Cemex’s two most important
currencies are the Mexican and Colombian Peso, which together account for 50%
of operating profits, and have depreciated 30% and 40% from peaks in the
summer of 2013. While we are not forecasting for an inflection in these
currencies, we believe the large depreciation of these currencies have largely
taken place and have brought the side benefit of making their local products
more competitive, which will provide an economic benefit going forward.
Our view on Cemex is centered on the company’s ability to generate cash flow
from its operations and continue to bring leverage down. Despite various
headwinds the company has faced since leverage levels reached a peak in 2010
(7.4x net debt to EBITDA), the company’s positive cash flow has been able to
bring down leverage to 5.7x net debt to EBITDA as of the second quarter of 2015.
Although the devaluation of its local revenue stream has increased the cost of
servicing its US dollar debt, we still expect the company to generate
approximately $500 million in free cash flow for the next 12 months, which yields
an attractive 5.3% free cash flow yield. More importantly, we expect the company
to benefit from an above average construction growth rate across its primary
markets while continuing to sell non-core assets, which we expect will
significantly double the company’s free cash flow by 2018.
Another holding which struggled in the month was Ternium (which accounts for
8.2% of the portfolio), which fell 13.6% in September as concerns over how the
slowing Chinese economic activity will further pressure steel prices downward
and negatively affect steel producers. China accounts for 53% of global steel
production and has excess production capacity and while the government has
stated it plans to close inefficient, high polluting steel plants, Chinese steel
production has remained relatively stable. The concern is that with a slowing
Chinese economy, Chinese mills will dump steel on global markets and further
depress the price of steel. Although we do not have any particular insight on the
direction of steel prices, we know that a significant decline in the price of steel
has already taken place and that any further price declines should be more
tempered. Steel prices have fallen 51% from a high of $890/ton in 2011 to the
current price of $435/ton. We also note that to protect its steel industry from
what they consider to be the dumping of subsidized foreign steel, the Mexican
government has recently announced a 15% increased duty on steel imports,
which will help mitigate any further declines in the price of steel in Mexico, which
is Ternium’s primary market.
Ternium volumes should continue to increase due to an increased demand from
Mexican manufacturing clients, since Mexico accounts for 60% of the sales of the
company. Their principal buyers are car manufacturers in Mexico, which have
experienced a boom in production as Mexico increasingly becomes a more
competitive global country from which to base manufacturing facilities to import
to the US market. Mexican Auto production has increased 43%, from 2.3mn units
in 2010 to 3.3 million units in 2015 (see Chart A). We expect this number to
continue to increase given the amount of capacity additions already underway by
global auto producers. Mexico is slated to add another 55% in unit capacity over
the next years. These capacity additions by Ternium’s largest customers continue
to result in higher volumes for the company. In the first six months of 2015 the
company has been able to grow volumes by 7%. We expect this positive volume
trend to continue as auto making capacity continues to ramp up.
While steel prices have come down significantly, we believe the 70% drop in the
price of Ternium since steel prices peaked in 2011 is a harsh overreaction since it
does not account for Ternium’s specific investment case. Due to the company’s
low cost structure and increasing demand for its products from Mexican
manufacturers, Ternium continues to make money and in particular generate
cash. Based on current conditions, the company generated $530 million cash in
the first half of 2015, after including its expenditures for capex.
Based on the company’s market capitalization of $2.4 billion, this means the
company yielded an astounding 22% free cash flow yield in only the first half of
2015. Although we expect its free cash flow yield to decline as the company’s
working capital improvements diminish, we still expect the company to generate
a normalized annual free cash flow yield of approximately 12% while trading at a
very low 2015 P/E ratio of 6.9x.
IMPORTANT NOTE: This report has been prepared for information only, and it does not represent an offer to
purchase or subscribe to shares. World Investment Opportunities Funds (“WIOF”) is registered on the official list of
collective investment undertakings pursuant to part I of the Luxembourg law of 17th December 2010 on collective
investment undertakings as an open-ended investment company. WIOF believes that the information is correct at the
date of production while obtained from carefully selected sources considered to be reliable. No warranty or
representation is given to this effect and no liability can be assumed for the correctness or accuracy of the given
information which may be subject to change at any time, without notice. Past performance provides neither a
guarantee, nor an indication of future performance. Value of the shares and return they generate can fall as well as
rise. Currency fluctuations, either up or down, may also affect value of the investment. Due to continuing market
volatility and exchange rate fluctuations, the performance may be subject to significant changes over a short-term
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