Emerging Market Opportunity Offering Low Risk High Reward

Jan.13.14 | About: iShares MSCI (ECH)

I recently published an article in which I identify Turkey as well as a handful of other emerging markets as investments for 2014 that investors should build positions in (article can be seen here). This article serves the purpose of discussing one of those countries that offers a relatively high return to low risk opportunity. When discussing emerging markets in Latin America many are quick to direct their conversations to Brazil and Argentina, some throw Mexico into the conversation as well. A country I feel is often overlooked and one that I feel will be one of the top investments in Latin America this year as well as over the next five years is Chile. This article will be divided into two parts. The first will be to provide facts, both positive and negative. The second will be to provide the reader with an investment recommendation. (Note: There are many more strengths and weaknesses. I only choose to write about the ones I currently deem as most relevant.)

Strengths

  • I first focus on copper because one can not discuss Chile without discussing copper. Copper is used everyday across the world. Copper is used in subscriber lines, wide and local area networks, mobile phones, personal computers, tablets, household appliances, and many other facets of day-to-day living. Demand for copper will continue to increase as the world population and global wealth increases. Also copper is an essential component of energy efficient generators, motors, transformers and renewable production systems. Thus, as demand for renewable energy increases so will demand for copper. The above attributes help explain why world refined usage has more than tripled in the last 50 years.

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  • Chile is the world's number one producer of copper. In 2012, worldwide copper mine production reached 16.7 million tonnes and Chile was by far the largest supplier producing 5.4 tonnes or roughly 32% of total worldwide production. Eight of the top twenty mines in the world are located in Chile. Therefore, their stock market has historically been highly correlated with the price of copper. Over the past year Chile (measured using the iShares MSCI Chile ETF:ECH) has had a correlation of .67 with Copper (measured using COMEX:^HG). Over the past five years the same metrics have a correlation of .89. The difference in the five year correlation relative to the one year correlation is attributed to the recent decision by the U.S. Federal Reserve to reduce their interest rate manipulation by $10 billion a month. This is evidenced by the sharp decline in ECH at the end of October as well as December (Please see charts below).

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  • Annual growth of copper has been 3.4% a year since 1900. As the world population has grown so has refined cooper usage per capita, demand will continue to increase for efficient energy, and demand will continue to increase for electric and hybrid vehicles. The average mid-size care uses fifty pounds of cooper, luxury cars on average contain around 1,500 lbs of copper wires totaling about a mile in length. Due to their efficient energy demands, hybrid and electric vehicles use more copper than luxury cars. The above factors as well as a growing global middle class point to copper usage/demand continuing to increase.

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  • As of September 2013 there was a production deficit of 162,000 metric tonnes mainly due to record-high Chinese demand.
  • Other sectors of the Chilean economy have shown strength which I attribute to the countries other characteristics such as having the highest per capita income in the region, a skilled workforce as 52% Chilean workers have technical or college education ranking them first in Latin America, a literacy rate of 96.5% of the population, and an education rate that is 94.9 per 100 inhabitants. These characteristics support strong long-term growth.
  • Chile is 3.5% below their GDP trend which is measured as the degree to which countries have closed the gap between their current GDP level and what their GDP levels would have resulted in if the pre-economic contraction growth trend had prevailed (the growth trend period is defined as the period between 2003-2008 q3). This is one of the highest in the world. As a comparison, Brazil is roughly twenty percent below their pre-economic contraction growth trend.

Weaknesses

  • Reliance on China. Recently, copper prices have been tied to the Chinese economy because China has been reliant on foreign imports to meet their demand. Therefore, Chilean market growth has recently depended on the Chinese economy.
  • The Chilean market is dependent on foreign investment and drops because of capital outflows. Thus, the Fed's balance sheet plays a role and any reduction in the Fed manipulating interest rates will have an effect on the Chilean markets.

Investment thesis

Currently, I expect that European copper demand will increase as the Eurozone slowly emerges out of recession and I expect Asian countries to follow suit shortly thereafter. I further believe that cooper prices will vary in a tight range throughout the year. More specifically I see copper slightly decreasing in the first half of the year and begin to increase in the second half and throughout 2015. Also, I view global growth as being strong in the long-term and the current demand of copper to continue its current growth trend. Based on Chile's main economic resource and other Chilean economic factors I believe an investment in Chile offers high reward and low risk over the long-term with volatility in the short-term. I expect a minimum of a 20% return using one of the investment strategies below.

Investment Strategy

For long-only investors I recommend beginning to build a position immediately (doing so on days the Chilean market drops in price). The most convenient way of doing this is through the ETF ECH. I recommend building on to this position for every 2.5% to 5% drop in the price of ECH over the next six months. The way I recommend establishing future positions is through the sale of puts. One example of this is to go short the February puts with a strike of $45. Currently, the offer price is $.85 (as of close 1/8/2013). If the put gets exercised your effective entry point would be $44.15.

The option I highly recommend is through a long-short strategy (this is the strategy I have implemented). Currently copper is down 9% over the past twelve months while ECH is down close to 30%. Based on past correlations I am expecting this gap to close. Therefore, I recommend shorting copper and going long ECH. I recommend establishing your short position using copper futures. However, for those investors that do not feel comfortable using futures I recommend the ETF JJC. I highly recommend the long/short trade because I believe investors will profit either way the global markets perform. I believe Chile is over sold relative to copper. Therefore, if global markets falter I believe copper will drop as much if not more than Chile. If global market rebound and continue to grow then Chile will far outperform cooper. I view this trade as low risk with a high reward.

Sources:

-ICSG.org 2013 world cooper factbook (here)

-ICSG.org copper market forecast 2013-2014, October 2, Chile, Report Number 13/198 (here)

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Disclosure: I am long ECH. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.