Wednesday, January 31, 2007

Regional Risk - Latin America

The indexes representing the broader Latin American markets have recently been hitting new highs; however most investors do not understand the increasing political risks relative to their investments in this region. There is a significantly increasing likelihood that the stock markets in these countries will reverse course and decline.

What is the key risk --- nationalization. Many of the governments in the region have leaders who are focused on nationalizing key industries in these countries. Public companies involved in the oil, gas, mining, electric, water, telecommunications, mining, and transport industries are at risk. In the natural resource focused region, these activities represent over 80% of the economy in many countries. Recently presidents Hugo Chavez of Venezuela, Evo Morales of Bolivia, and Rafael Correa of Ecuador have implemented plans to nationalize these industries. Further comments from these leaders have been made recently which make it clear that they do not plan to properly compensate the current owners of these firms at anywhere near market value in their push towards "21st Century socialism".

So there are other countries in the region that are still committed to free markets; why should investors be concerned if just a few countries representing only a portion of the market in Latin America appear to be walking down the path of seizing assets for nationalization.

The answer is cross-ownership; many of the industries in the region are partially owned by public companies in neighboring countries. Despite the rhetoric from some of the leaders about "kicking the Yankees out"; the largest impact of nationalization is on their direct neighbors in the region. Due to the large amount of cross-ownership and joint ventures of the firms in Latin America, continued nationalization is likely to lead to a widespread conflagration and regional market melt-down.

For example, when Bolivia announced plans in 2006 to nationalize its gas and oil industry; this immediately caused a political crisis with Brazil. Brazil, which is heavily dependent on energy from its neighbor, was enraged by Bolivia's decision to nationalize its energy sector, including local operations of Brazilian state energy company Petrobras. An agreement to resolve this flare up over the disposal of energy assets owned by large publicly traded firms is still being worked out.

The U.S. newspapers have focused on the impact on U.S. publicly traded companies. For example the recent announcements in Venezuela regarding nationalization of the telecommunications and electricity sector generated headlines regarding telecom carrier Cantv (NYSE ADR: VNT) and power company EDC. CANTV is controlled by New York-based Verizon Communications Inc., which holds the largest minority share. In April 2006, Verizon agreed to sell its 28.5 percent stake in Compañia Anónima Nacional Teléfonos de Venezuela, or CANTV, to América Móvil and Teléfonos de Mexico, for $676 million; this deal unraveled on the news from Venezuela. Chavez said Sunday that shareholders in CA Nacional Telefonos de Venezuela, or CANTV, will not be compensated at market value when the company is nationalized. Similarly AES Corporation of Arlington, Va., is suddenly facing the potential of hundreds of millions of dollars of losses related to its ownership of EDC in Venezuela. Despite the media focus on the losses to U.S. firms, the real impact will be on other public companies in the region that have ownership stakes in firms that are nationalized.

There are strong investment ownership links in the Latin American region that bind public companies across national boundaries; which explains why the Latin American stocks fell to their lowest levels in a month as Venezuela's plan to nationalize of telephone and electric companies was announced recently. Markets in countries that support a free market system such as Colombia, Mexico, and Brazil fell 1.9 percent or more after Venezuelan President Hugo Chavez stated he would nationalize these industries. Individual stocks of firms such as Petrobras in Brazil, which owns significant assets in other countries in the region, continue to drop with each negative news item from the nation’s neighbors. The world’s second largest mining company Cia. Vale do Rio Doce in Brazil also has many regional binds and the stock price drops each time Bolivia or another country indicates plans to seize mines. The valuation stock price in the Mexican market of both America Movil and Telefonos de Mexico has been impacted by the inability to purchase the CANTV minority stake from Verizon. There are a continuous string of cross-ownership relationships that can be cited in the markets in the Latin American region. No single country is an island; all are bound together in a common regional market and economy.

There is also strong potential that owners of Venezuelan steel, banking, cement and hotel companies will be impacted by the nationalization trend. One media report even stated that the cable car operator that takes tourists to the top of the Ávila mountain could be affected by the push toward nationalization. A few press outlets have focused on the impact to smaller private firms that nationalization threatens. The increasing gloom relative to political risk regarding investing in the region, whether demonstrated by large publicly traded firms or smaller private enterprises, should be a huge stop sign to investors.

There is also concern that more countries in the region could jump on the nationalization bandwagon; this would increase the investment risk. One recent article quoted Horacio A. Valeiras, who oversees $14 billion as chief investment officer of Nicholas- Applegate Capital stating “He'll nationalize everything he can. We've been avoiding Latin America because of the nationalization issues in almost every country south of Mexico.'' This demonstrates the investment communities concerns over regional conflagration.

In the recent Davos summit, Mexico's Calderon urged the region to reject turn to it’s failed past. He warned that Latin America is splitting into two economic camps, one embracing a failed past of state control, the other seeking growth with foreign investment. Only time will tell if voices such as Calderon’s will be persuasive in stopping the slide of the market economy in the region.

Clearly the Latin American stock markets have climbed significantly during the past several years. The high returns have driven many investors to jump on the band-wagon and purchase mutual funds and index ETFs (such as ILF) which focus on Latin America. What should these investors do now in view of the increased political risk in these markets? The answer is to sell your holdings and invest this component of your portfolio in other emerging markets. Should you sell all of your holdings in one transaction? No, if your investments in ILF or a Latin American fund are sizeable then I would urge that you sell it over the course of several months in portions. This reduces the market timing risk, and demonstrates that regional investment risk is not an immediate crisis but a problem that will materialize over a longer period of time as particular governments nationalize industries.

Back-up material and articles:
ILF - ISHARES S&P LAT AM40 : Two Year Chart

Latin Stocks Fall on Venezuela Nationalization Concerns, Oil

Venezuelan plan alarms investors

Chavez to nationalize electric, telecom firms


Some Venezuelans fret about Chavez plans

Free trade no longer star of Latin summit

Govt looking at Entel nationalization – Bolivia

Morales says Bolivia to nationalize mining sector

Mexico's Calderon Urges Region to Reject Turn to Failed Past

Chavez to Get Powers to Remake Venezuela

Analysis: The negative impact of Cantv nationalization

Bolivia's populism steps on Brazil

Tensions ease in Brazil-Bolivia energy dispute


Srikanth said...

Hi Greg:
good article. A couple of point:
Per MPT, diversification includes investing in REITs. As per William Bernstein ( author of The Four pillars of investing), if an investor had 20% of the portfolio in REITs, the portfolio return would have been a positive number in 2001.

The other point i would like to make is that Fidelity Spartan Intl Index fund would be a better option to Fidelity Discovery Fund from the expenses stand point.

Philippe said...

Very informative posting!

A couple of questions/comments:

1- Data:
What time frame did you use to calculate the historical mean return and SD? Were you able to find enough historical data for actively managed fund?

2- Expected return:
What did you use for the expected return? There are some discussions that the future equity return may not be as high as the historical one. What is your opinion?