Latin America's Export Engine and Stock Juggernaut

U.S. retail investors wringing their hands over the Chinese and Brazilian stock marketsduring the past couple of years might have looked closer to home for an emerging market to ride.

Stock Exchange Building, Mexico City
Mark Lewis | Stone | Getty Images
Stock Exchange Building, Mexico City

Mexico. Yes, Mexico. And though its violent crime problem has scared away visitors, it has been an inviting location for investors.

Year to date, the Mexican IPC Index has matched the S&P 500, gaining slightly more than 8 percent while easily outpacing the Shanghai Composite and San Paolo Bovespa.During the past two years, Mexico's outperformance is more stunning.

"It's pretty dramatic," says Alec Young, international equity strategist at S&P Capital IQ. "Mexico has been crushing Brazil for a long time."

Mexico has long benefited from the NAFTA trade pact,its huge trade relationship with the United States and a steady flow of U.S. foreign direct investment. But portfolio managers cite a litany of additional positives.

"It's a confluence of a lot of things," says Geoffrey Pazzanese, co-manager of the Federated InterContinental Fund, which counts nine Mexican stocks in its portfolio.

Recipe for success

Among Mexico's fundamentals: a diversified economy, solid GDP growth, competitive labor costs and favorable inflation and unemployment rates.

Fund managers also cite pluses at the government level: a strong central bank and stable currency, healthy federal balance sheet with low debt-to-GDP and current account ratios, plus large foreign exchange reserves.

"The government is very transparent and it's a very open economy, especially compared to its Latin American peers," says Richard Hoff, who co-manages the Euro Pacific Latin American Fund, which has been adding to its Mexican holdings in the past six months and is now over-weight. "An open government breeds stability."

Portfolio managers, who had pulled out of the Mexican market in the past decade, jumped back in during recent years. (More:How to Get a Piece of Mexican Stocks)

"I had been negative on Mexico for some time, then about two years ago when Brazil had reached a secular peak, sentiment was extreme and valuations difficult to justify, (and) I noticed that a lot of Mexican companies had become quite cheap and the cost competitiveness of the country had improved a lot," says Adam Kutas, portfolio manager for Fidelity's Latin American Fund , which has a weighting of about 24 percent.

Mexico, Brazil, China

Comparisons to China and Brazil come up frequently among analysts, who cite labor costs, valuations and even non-performing loans at banks.

"Mexico competes head to head with China on labor prices — they're about equal — but when you start factoring in shipping costs, China's are probably higher," says Hoff of the Euro Pacific Latin American Fund. Mexican exports, on the other hand, are truck oriented, which "works a lot better for just-in-time manufacturing," he adds.

As a result, companies that previously outsourced work to China are now considering relocating to Mexico.

Mexico, not Brazil, say analysts, is the export engine of Latin America, thanks to dozens of trade agreements.

"Manufacturing competitiveness with China helps," notes Luis Carrillo, co-portfolio manager for the JPMorgan Latin America Fund , which has 15 Mexican companies in its portfolio. "The main advantage is more sustainable. All the trade agreements make it easy to export."

What's more, Mexico, unlike Brazil and other emerging economies, is not dependent on trade with China and thus is immune to the economic giant's current slowdown — which may help explain why it is an outperformer.

Young of Standard & Poor's notes the earnings outlook for Mexican companies on a 12-month forward basis is 21.1 percent, versus an average of 10.2 percent for emerging markets in general.

What's the NAFTA affect?

NAFTA pays off

If Mexico has been spared China's trouble, it has clearly benefited from America's relative strength in the dicey world economy, giving it what Hoff of the Euro Pacific Latin American Fund calls "a defensive quality."

Though the U.S. share of Mexican exports has fallen from 90 percent to 77 percent in the past two decades, the health of the American economy — which some describe as fragile and subject to another recession in 2013 — will have a lot to do with how long and far the good times roll.

An employee works on the production line of the new generation Volkswagen AG Beetle at the company’s assembly plant in Puebla, Mexico.
Susana Gonzalez | Bloomberg | Getty Images
An employee works on the production line of the new generation Volkswagen AG Beetle at the company’s assembly plant in Puebla, Mexico.

The rebound in the auto sector, for instance, has been a boon for Mexican suppliers and manufacturers. (Mexico is on the verge of becoming the world's fourth-largest auto sector producer.)

"The outlook is mixed," says Kutas of Fidelity. "Mexico is still very tied to what's happening in the U.S., especially housing," adding that the many Mexicans employed in the sector send money back home.

For all of its progress since the 1994-1995 peso crisis, Mexico needs to undertake more structural reform, say analysts.

Though hopes are high for new president Enrique Pena Nieto, like his predecessors he will be challenged in pushing through much-needed land and labor reform, which should foster growth and investment.

That includes a public stock offering for the state oil company Pemex, which would require a constitutional amendment to allow non-Mexican owners.

The government also needs to facilitate more initial public offerings in general, increasing the pool of stocks for both domestic and international investors. (The recently announced IPO of Grupo Financiero Santander, a unit of Spanish bank Santander, has created a stir.)

Supply problem

Fund managers often refer to a "scarcity" of stocks, limiting investment choices for individuals and institutions.

For fund managers, there are basically "20-25 companies to choose from", says Pazzanese of the Federated InterContinental Fund. (More:Is This the Right Time to Invest in Mexican Real Estate?)

"There are many sectors that are not represented," says Carillo, noting that utilities fall into that category.

That scarcity, say analysts, is one reason why some consider the Mexican market frothy at this time.

"The market's had a very strong run," says Kutas of Fidelity. "Valuations are very expensive."

Other fund managers counter that quality companies in a favorable corporate structure as well as a positive economic outlook make Mexico a place to be in the years ahead.

"It depends on your time horizon," says Carrillo of JPMorgan. "We tend to take longer term views. For us, Mexico has been 15 years of consistent management."

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