Argentina's Future Looks Bright

|
 |  Includes: ARGT, MELI, SSRI, TS, YPF
by: Matthew Sauer, Esq.

Summary

Argentina has a low debt-GDP ratio after defaults and inflation.

Major oil discoveries will benefit the economy.

Political changes herald an improvement in governance.

ARGT offers exposure to this turnaround story.

Argentina has not been without its challenges in the past decade. Similar to other South American countries, they have been plagued with debt defaults, defective governments and currency devaluation. These definitely are not secrets to anyone interested in diversifying their portfolio in the country. Fortunately, the prospects for Argentina are brightening. A windfall discovery of natural resources in the petroleum industry, large debt reduction and a favorable change in political leaders could be steering Argentina down a more positive path.

Investors can gain exposure to Argentina through Global X MSCI Argentina ETF (NYSEARCA:ARGT).

Cutting Debt

The main reason why Argentina has been in the economic doldrums for more than a decade is debt defaults and currency mismanagement. High inflation and defaults have worked their magic though, and Argentina has been working diligently to reduce its debt. In April, 2014 at a press briefing, a spokesman for the government indicated that the public debt-to-GDP ratio had been reduced by 76 percent. This reduction is the most of any South American country.

In mid-June, 2014, the United States Supreme Court finalized a court decision that requires Argentina to pay a 10-year-old, $1.5 billion debt. In 2001, Argentina originally defaulted on a debt which included various creditors and hedge fund operator Elliott Management Corporation. These creditors were offered restructure deals, refused and finally won their lawsuit. So far, Argentina has refused to pay the amount owed and claims that it would expose itself to an additional $120 billion in claims. A team of international bankers which include J.P. Morgan Chase & Co. and Citigroup are working on finding investors who will take over the defaulted debt. When that's resolved, it not only will clear the 10-year-old debt for good, it will also reopen international markets and financing that are now currently closed, and it could act as a short-term, positive catalyst for the country.

Even if investors are concerned that poor economic policies will continue, there's reason to be optimistic. At a recent 46 percent of GDP, its national debt is lower than that of countries such as Switzerland and Denmark. It's also a far cry from Greece's 155 percent debt-to-GDP ratio, and well below the U.S. at 107 percent. There's reason to expect Argentina will change course in the coming years, but it has a lot of room to maneuver should it return to its bad habits.

Importance of Oil

In May of 2011, a major oil field discovery occurred in the Neuquen Basin of Argentina. The country's largest oil company, YPF SA and Chevron have become involved in developing the area. The Connecticut-sized formation is located in a region known as the Vaca Muerta, and experts indicate that hundreds of billions of barrels of petroleum supplies could be removed from the region in the next 20 years. In fact, it could potentially double Argentina's oil and gas production in the next 10 years. To extract the petroleum reserves, hydraulic fracturing techniques similar to those used in Texas and North Dakota are being implemented.

Currency Concerns

Increased oil production will cut the need for energy imports and that will cut the need for foreign currency, which will be supportive of the Argentine peso. One of the victims of Argentina's economic policies has been the peso, which has devalued from 1:1 with the U.S. dollar in the late 1990s to less than 8:1 recently. The black market rate for the peso is currently around 13:1, indicative of fears that high inflation and a weak economy will continue. This is a concern for foreign investors, but there are two reasons why speculation is prudent. First, for the reasons listed in this article, the economic performance of Argentina is likely to improve in the coming years. Second, a currency devaluation is already priced in by investors because the black market rate for pesos is published daily. Third, the market is pricing in further currency weakness and any improvement in the situation will benefit assets priced in pesos.

With respect to ARGT specifically, many holdings are ADRs traded overseas and priced in dollars, limiting the exposure to the currency problem. This is a big reason why the fund is only up about 10 percent this year, compared to the more than 60 percent nominal advance in the Merval Index.

A Change in Political Structure

President Kirchner has served as Argentina's leader since her husband passed away from a heart attack in 2007, but the 60-year-old President's two terms are up in 2015. After her allies lost in a mid-term election, ending that chance that the Argentine Congress would change the constitution to allow for a third term, the Kirchner dynasty will come to an end.

Kirchner, like her husband, has governed on a populist platform that relied on personality rather than the rule of law. At times she fought against the business sector and it reached the point where the government sued economists who reported an inflation rate far higher than government's number.

One of the top candidates in the political race for president is Sergio Massa who is currently serving as mayor of Tigre. The people of Argentina are tired of politics that creates conflict, confrontation and division. While Massa has not officially put his foot in the race, he has drafted a "zero tolerance" crime program that was formulated from New York Mayor Rudy Giuliani's success. Mr. Massa has also addressed the high rate of inflation in the country, currency controls and unwanted crime levels. Business friendly and center-right, he is being touted as a potential candidate that will change the current political scene to a more positive one.

ARGT Index Change

Global X recently changed the index behind its Argentina ETF from the FTSE Argentina 20 to the MSCI All Argentina 25/50 Index, and it is a positive change that gives investors greater exposure to Argentina's economy.

The prior index counted gold miners such as Goldcorp (NYSE:GG) and Yamana Gold (NYSE:AUY) among the top ten holdings due to their presence in the country, with a combined position nearing 9 percent of assets. ARGT still retains exposure with the new index, but these two now combine for about 1.6 percent of assets.

Mining remains a large share of assets, with about 9.6 percent of assets. Holdings such as McEwen Mining (NYSE:MUX), Silver Standard Resources (NASDAQ:SSRI) and Pan American Silver (NASDAQ:PAAS) are still in the portfolio, but SSRI is now the largest miner in the fund with about 3 percent of assets. Lower mining exposure is attractive since these firms' fortunes are tied to the price of natural resources and not the Argentine economy.

Top Holdings

20.5 percent of ARGT's assets are in top holding Tenaris SA (NYSE:TS). Tenaris employs 26,825 full-time employees and is involved in the steel pipe manufacturing and distribution business. It's welded and seamless steel tubular products are used in petroleum drilling operations around the world. Argentinean demand is set to grow thanks to recent oil discoveries.

Mercadolibre (NASDAQ:MELI) makes up 12.1 percent of the ARGT portfolio and is an Argentina-based company that hosts an e-commerce platform for various countries in Latin America. Using the domain mercadolibre.com, users have the ability to conduct e-commerce transactions for goods ranging from automobiles and clothing to electronics and jewelry.

YPF S.A. (NYSE:YPF) has 8.7 percent of assets. This exploration and development company is engaged in the production of natural gas, crude oil and liquefied petroleum. It also markets, refines and transports a wide range of petroleum products. More so than Tenaris, YPF will benefit greatly from the ongoing oil discoveries in the country. George Soros doubled his stake in the company during the second quarter of 2014.

Portfolio

Between TS, YPF and a few other holdings, energy is by far the largest sector with more than 32 percent of assets. Normally, a portfolio heavily weighted towards a single sector is unattractive in a country fund, particularly one such as energy where prices are set globally. However, in the case of Argentina, domestic energy discoveries will lead to production increases and higher revenues even if oil prices are flat.

ARGT also has significant financial exposure via holdings such as Banco Macro, Grupo Financiero Galicia and BBVA Banco Frances, all top ten holdings which combine for 13.6 percent of assets.

The top ten holdings also includes media conglomerate Grupo Clarin, with 3.3 percent of assets, and Telecom Argentina, with 4.3 percent of assets. Consumer exposure comes in part through Arcos Dorados, a McDonald's franchisee with restaurants all over Latin America.

Beyond the top ten, the fund gives exposure to real estate with 2.6 percent of assets in IRSA. There is also 2.6 percent in retailer Cencosud and another 2.6 percent in agricultural giant Cresud. Power companies Empresa Distribuidora and Pampa Holding combine to provide roughly 5 percent exposure to utilities. Prosegur Comp Seguridad, a company that provides home security, helps round out the fund.

A little more sector balance to the portfolio would be nice to have in the long-run, but for now the overweight in energy is attractive.

ARGT's portfolio doesn't throw off much income at the moment; its 30-day SEC yield is 0 percent, though it has paid out dividends in the past equivalent to a 0.5 yield. This is definitely not a dividend play and is unlikely to be for the foreseeable future.

The portfolio has a P/E of 19 currently, which looks a little on the expensive side, but this is partially inflated by the high P/E of Mercadolibre , which has a P/E of nearly 40 and accounts for more than 10 percent of the portfolio. The fund is likely to stay expensive if investors agree with our thesis and buy into the market on anticipation of future growth.

Conclusion

Many of the challenges in Argentina are well known and built into the share price of ARGT. There is still a large amount of risk given that the black market is pricing in a major devaluation of the peso, and no small part of the investment case here requires political change which is hard to predict-elections aren't until October 2015. A lot can change in a year. Still, inflation and debt defaults have greatly improved Argentina's position and the heavy cost of those policies is behind us- even if the saga drags on thanks to a continually shifting legal and political environment. It looks like a final resolution to the holdout bondholders has arrived, but whether it comes later rather than sooner, the future Argentina is a low debt country flush with major oil discoveries. A major political change would be the icing on the cake, but the future is looking brighter for Argentina either way. Long-term, risk-tolerant investors should consider the fund as a small part of their international exposure.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.