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Tuesday, 8 September 2009

In Global Investing, Seek Value, Not Growth

By Ryan McLean

How often have you heard "economic growth" in relation to international investing? And how often have you heard "price" referenced in the same discussion? We suspect that instances of the former far outnumber the latter. This mismatch underscores a common but perilous fallacy: that economic growth drives investment returns.

As distinguished investor Jeremy Grantham pointed out in a recent video interview, the key question is not which economies will grow fastest, but which offer the greatest value. "It isn't about top-line growth," Grantham explained. "Stock market returns are overwhelmingly related to return on capital. Value matters in everything, including country selection."

You Get What You Don't Pay For
China--a perennial favorite among international investors--offers a sobering example of the distinction between growth and return. With an economy growing at upward of 8% a year, China certainly appears enticing at first glance. After all, a Chinese company with stable market share should enjoy growth that is at least commensurate with the broader economy's. But viewed through the focused lens of value, the country's much-hyped GDP numbers lose their cachet; economic expansion is irrelevant if it's already accounted for in asset prices. Indeed, high-flying China has yielded low-flying stock returns. At the turn of the century, the price/earnings ratio of the Chinese stock market hovered at a stratospheric 50 times. The country's growth prospects were hardly a secret, and they had been more than priced into stocks. In the ensuing eight years, Chinese equities delivered a meager 3.3% compound annual return. Like a carriage that had gotten ahead of the horse, security prices had to pause while actual growth caught up.

In contrast, Brazil's P/E ratio has historically averaged a more modest 12-13 times. From 2000 to 2008, the country's stock market appreciated at an 11% compound annual rate. Having not been bid up excessively at the outset, Brazilian equities rose closer in line with nominal GDP. As these examples illustrate, growth and return are not inevitably correlated; price, growth, and return are.

The history of U.S. stock market returns provides another useful illustration. Stocks have tended to perform well following periods of low P/E multiples, when expectations of future growth have been overly pessimistic, and poorly on the heels of high multiples, when expectations have been overly optimistic.

The point is not that growth doesn't matter, but that it's only half of the valuation puzzle. The other equally critical half is price paid. Just as a menu without prices would be uninformative to a diner, so too are the growth profiles of the world's various economies, sectors, and businesses to an investor without a sense for cost. Only by combining these two variables can we gauge an investment's merit.

Three Latin American Stocks for Your Radar
The focus of this quarterly series is Latin America, whose economies we think will expand at a respectable clip in the years ahead. Be this as it may, our decision to invest will hinge on our estimate of value, not growth. And at the moment we think the region is neither over- nor under-priced relative to its growth potential. We are therefore inclined to remain on the sidelines for now. This stance could change quickly; in a previous article we outlined a few possible catalysts that could lead to better values. In the meantime, here is a short list of high-quality Latin American businesses to keep in your sights.

CPFL Energia (NYSE:CPL - News)
Scale and natural monopoly status confer a sustainable competitive advantage upon CPFL, Brazil's largest private power distributor. The firm's difficult-to-replicate distribution networks, which are concentrated in the economically vibrant southern states of Sao Paulo and Rio Grande do Sul, represent a sizable barrier to entry. We expect that CPFL will build further scale as it acquires local utilities in the fragmented Brazilian market. Rising per capita consumption (currently one fifth of U.S. levels) should also help drive CPFL's top line. Operating costs, meanwhile, should remain in check, as Brazil's reformed regulatory system rewards efficiency.

On the downside, a widespread drought could necessitate power rationing in Brazil's hydro-dependent electricity market. Rationing would squeeze CPFL's margins, as revenue would fall while costs would remain largely fixed. Today's economic downturn has created similar challenges. However, we think CPFL's investor-oriented management, attractive service territories, and operating scale bode well for long-term investors.

Embraer
We think low-cost Brazilian jet maker Embraer has a leg up over its one serious rival, Bombardier. Demand for regional jets is trending toward larger aircraft. As Bombardier races to bring larger models on line, we expect Embraer will capture incremental share with its market-ready planes, some of which seat as many as 118 passengers. Meanwhile, high barriers to entry should keep prospective market entrants in the hangar.

Though Embraer's maintenance and repair business should help take the sting out of the current cyclical downturn in aerospace markets, the firm's bread and butter will remain new aircraft orders. And in today's low-credit, low-growth economic environment, new orders are facing serious head winds. Still, we're confident in the firm's long-term staying power and profitability, and at the right price we think it would make an attractive holding for internationally minded investors.

Femsa
Narrow-moat Femsa comprises three strong subsidiaries. The group owns a majority stake in Coca-Cola Femsa , Latin America's largest Coke bottler. In a market dominated by mom-and-pop stores, Coca-Cola Femsa wields strong bargaining power and has the profit margins to prove it. Geographic diversity, a robust brand portfolio, and Coke's marketing muscle further enhance its appeal.

A second subsidiary, Femsa Cerveza, forms half of the Mexican beer duopoly and boasts such iconic brands as Dos Equis, Sol, and Tecate. Last but not least, the Femsa Comercio subsidiary owns Oxxo, a fast-growing convenience store chain that provides a key outlet for the company's beverages. The same fragmentation that benefits Femsa's bottling operations has helped Oxxo shore up retail market share. The chain now has more stores than any other retailer in Mexico.

While we think Femsa is less exposed to macro-level risk than some of its regional peers (customers tend to consume beverages and frequent corner stores through thick and thin) several factors cool our enthusiasm. First, Coke has a history of strong-arming its bottlers. Second, high commodity price volatility threatens margins. Finally, consolidation in Mexico's fragmented retail sector could harm the small stores that Femsa relies on to ensure high profitability. These threats aside, we expect Femsa's success will endure for years to come.

1 comment:

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