By Joseph Hogue, CFA
I watched a video interview of Sam Zell, billionaire founder and chairman of Equity International, on Bloomberg Tuesday. Despite his willingness to express his political views and judgments, I’ve always found Mr. Zell an extremely savvy investor and businessman.
Being an emerging market analyst with a past in real estate, my ears pricked up when Mr. Zell said the market opportunities in emerging market real estate were, “enormous,” and specifically called out the fundamentals in Brazil as, “terrific.” He backs it up with some pretty impressive figures. Brazil same store sales come in at 10-12% growth compared to their American counterparts sales of 1-2%. My own research has found that population growth in Latin America averages about 1.5% while the U.S. and developed world struggle with stagnation and an aging population.
Additionally, much of the emerging world is a younger demographic. As this cohort grows into their peak earning years, and the economies of these countries support a growing middle class, commercial property will have significant upside potential. Zell singled out Colombia as, “the next star in Latin America.” I can relate to this having just returned from Medellin one week prior. Building in the city, especially in the multifamily space, is everywhere. This summer saw Colombia’s return to investment grade status by all three rating agencies, a move that has been accompanied with increased liquidity and lending from international players.
The caveat in the EM space is China. Zell mentions that his company has left China because the lack of demand for capital. This set off a few warning bells for me. When the lending environment within a country has become so overheated that capital does not offer a sufficient return to attract informed investors, then there are bound to be significant loan losses in the future.
Mr. Zell discloses that his company hasn’t built anything in the United States since July of 2007, which is pretty astonishing for a company the size of EI, but he does say that multifamily is by far the best U.S. opportunity. Vacancy rates for rental units and multifamily are falling across the country as underwater homeowners and defaulted borrowers let their properties go into foreclosure. The rental squeeze is getting so severe that regulators are examining a program to let foreclosed homes be converted into rentals, a move that Zell says would help the real estate market considerably.
Finally, Mr. Zell expresses his serious concern over the future of the dollar. He reveals that as more of the world abandons the greenback and it loses its status as the reserve currency, Americans could experience a significant reduction in their standard of living. I couldn’t help but feel a certain amount of smugness hearing this as I posted an article last month stating the exact idea and showing how investors could protect their purchasing power through emerging market currencies and assets.
As visions of outsized returns and dividend payouts danced in my head, I ran to the computer to search for REITs and real estate ADRs specializing in emerging market holdings. My disappointment was painful when I did not find a single one. Of the 11 “international” real estate funds I found, none of them offer what I would consider emerging market exposure.
The closest was the WisdomTree Global ex-US Real Estate Fund (DRW) with exposure to Singapore (8.2%), South Africa (3.9%), and China (3.3%). Given my underweight outlook for China, that leaves just 12.1% of the fund exposed to emerging market real estate companies. Granted many of the companies based in the developed markets will have emerging market properties, but I expected more options for pure play on EM companies. I’m not sure why there is a complete lack of opportunities within the emerging market real estate space. If there are any fund managers listening, I would love to talk.
Despite the lack of real estate specific stocks or funds, there are a few ADRs that will benefit from the build-out in emerging market real estate. Much of the residential housing in Latin America is constructed in concrete; this, combined with a growing demand for infrastructure spending, makes Mexico’s Cemex (CX) a viable option. The company produces and distributes a variety of cement and concrete products to other industrials as well as consumers. The company has been burned over the last year due to lower expectations of growth in its core products, but S&P affirmed the company’s rating in March with a stable outlook.
Companhia Siderurgica Nacional (SID) provides a less risky investment into the emerging markets. The Brazilian company principally produces steel products, but also produces and sells cement to a variety of manufacturers and industries. The stock sells for a trailing price-to-earnings of 8.0 and pays a dividend of 6.6%. The stock has sold off with the rest of the Brazilian market and has lost 36.6% over the last 12 months.
Another Brazilian steel producer Gerdau S.A. (GGB) offers investors several opportunities. The company’s stock has sold off over the last 12 months, losing almost exactly the same in percentage terms as SID. Gerdau is relatively more expensive though at 11.8 times earnings per share and only pays a dividend of 1.7%.
Investors could take a long position in Gerdau along with Siderurgica, for a slightly more diversified exposure. Given relative valuations and dividend yields, investors may want to consider a pair trade in the two stocks with a short exposure in Gerdau and long purchase in Siderurgica.
Given Zell’s comments on China and the possibility of a crisis associated with the country’s lending environment, I would use it as a hedge against weakness in emerging market assets. If China experiences any kind of systemic crisis, other emerging markets will certainly fall as well. Most of the markets in Latin America have strategically diversified their exports to China and away from the United States and Europe. There is a growing consumer demand within the emerging markets, especially Latin America, and this should help to shield their economies from the full effect of a Chinese economic crisis.
Bulging foreign currency reserves held by Chile, Colombia, and Brazil will help offset possible economic weakness as well. The iShares FTSE China 25 Index (FXI) holds equities of the 25 largest and most liquid companies in China. Holdings within financial services comprise more than half (50.8%) of the total fund, meaning any financial crisis will significantly effect the shares. If a crisis does not occur, then I expect other emerging markets to outperform China given relative fundamentals.
For pure plays on Latin America’s rising star, Colombia, investors are limited to a few exchange traded funds and ADRs. Currently, the Global X FTSE Colombia 20 (GXG) is the most liquid option available to investors. It reflects the performance of the 20 most liquid equities in the Colombian market. The ETF has lost about three percent over the last 12 months in the massive August selloff, but I think this is temporary and presents a buying opportunity. The Market Vectors Colombia ETF (COLX) is also available, but has much lower liquidity with only 2,000 shares traded on a daily basis. Returns have held up well in the selloff with a loss of only .7% over the last 12 months.
American Depository Receipts for Colombian companies are in extremely short supply. Only two companies are listed on the NYSE, Bancolombia (CIB) and Ecopetrol (EC), with several other shares traded over-the-counter. Bancolombia is the largest commercial bank in Colombia and one of the largest in Latin America with a market cap of $13.2 B. It pays a dividend yield of 2.2% and has returned 1.4% over the last year.
Ecopetrol is one of the four largest oil companies in Latin America with a market cap of $88.2 B and pays an astounding dividend yield of 5.0% and has returned 8.5% over the past year. Ecopetrol produces about 60 percent of the country's oil output which has grown 50 percent since 2006.
Additional disclosure: The opinions expressed by the author are his own and not necessarily those of Efficient Alpha or its consultants. Investors should perform their own due diligence before making investment decisions.