Mexico is the closest emerging market to the U.S. It's right next door, but it hasn't been getting much attention from American investors.
A major reason is Mexico's close linkage to the economic behemoth to its north. Mexico doesn't just catch cold when America sneezes -- it comes down with a nasty case of pneumonia.
Americans consume about 70 percent of Mexican exports, so any U.S. recession brings Mexican growth to a grinding halt. Investors concerned about another major slowdown in the U.S. are usually hesitant to look for opportunities south of the border.
The brutally violent narcotics wars in Mexico also haven't helped, dominating the headlines and scaring off not just investors but also tourists.
All of these concerns are legitimate, but they're also overblown. While the U.S. economy struggles with several headwinds, I continue to believe it will muddle through with modest growth, reducing the risk of a Mexican contraction.
Moreover, most of Mexico's gang violence is confined to the country's northern border states of Baja California, Chihuahua, Nuevo Leon and Tamaulipas, where the cartels are battling for control of lucrative trafficking routes into the U.S. Further south, the country is generally peaceful, with most Mexicans simply going about their daily lives.
A number of positive factors are at work down south. Mexico has been a major beneficiary of rising global wages. While Chinese labor costs have been rising by between 12 percent and 14 percent a year over the past five years, Mexican wage growth has quietly averaged between 3 percent and 4 percent (see chart below):
Although wage growth in Mexico is not as impressive as in other parts of the world, it's maintaining a healthy enough level to create a growing consumer class. Higher fuel prices and unfavorable exchange rates have pushed up shipping costs, prompting many manufacturers to shift production back to the Western hemisphere. As a result, unemployment in Mexico is currently at its lowest point in more than 3 years, at around 4.8 percent as of July.
These trends have been driving healthy growth in domestic consumption, helping offset export weakness in the past several quarters. In the second quarter of 2012, Mexican gross domestic product (GDP) grew by 4.1 percent, with the country's services sector contributing 4.4 percent, reflecting robust domestic demand.
The fundamentals of the Mexican economy are also extremely attractive. Credit as a percentage of GDP is only about 20 percent, compared to about 50 percent in Brazil, Latin America's largest economy. That makes Mexico less exposed to another global credit crisis that could result from a turn for the worse in Europe, as well as leaving plenty of room for future growth.
And despite a spike in July to 4.5 percent, inflation in the country has been holding steady between 2 percent and 4 percent, well within the Banco de Mexico's target band, which reduces the near-term risk of an interest rate hike.
Finally, several economic reforms, ranging from liberalizing labor markets to incentivizing private investment in energy markets, are in the legislative pipeline and are expected to become reality over the next year.
Here's a look at a couple of my favorite plays in Mexico, the "forgotten" emerging market:
One solid Mexican consumer play is Wal-Mart de Mexico (WMMVF.PK).
Shares of Wal-Mart's (WMT) Mexican subsidiary have sold off sharply in the wake of its recent bribery scandal, which involved executives paying off government officials to ease the company's expansion. As of this writing, shares were trading around $2.87, up 3.61% for the day. While the scandal is an obvious headwind for the company, Wal-Mart de Mexico is one the largest retailers in Mexico, and the country's largest private employer.
Last year, Wal-Mart de Mexico grew revenue by 13.4 percent, driving nearly peso-for-peso growth in earnings as a result of its low overhead and impressive margins. This year's earnings are forecast to grow by another 10 percent on robust revenue growth.
The company also has a pristine balance sheet with no debt, paying for more than MXN16 billion in capital expenditures -- i.e. new store construction -- out of cash flows, with MXN17 billion in free cash flow left over.
The legal woes and bad headlines surrounding the company are temporary headwinds. Wal-Mart is a tough competitor to beat, anywhere in the world.
It doesn't make sense to bet against the company's proven business model, making the stock's battered price an opportune entry point for investors.
Another excellent play on the virtuous cycle of rising consumer incomes is Grupo Televisa (TV).
A Spanish-language television powerhouse, the company is the largest broadcaster in Mexico and wholly owns or has substantial interests in both cable and satellite television providers. It also owns a vast library of Spanish-language programming content.
To place any television advertisements in Mexico, it's hard to avoid Grupo Televisa. An estimated 70 percent of television viewers tune in to its networks during prime time hours, allowing the company to command a premium and growing ad rate as more advertisers seek to tap rising Mexican incomes.
The company is doing an excellent job of monetizing its content library, recently inking a deal that provides programming access to Netflix (NFLX), which is pushing its services into Latin America.
Grupo Televisa is garnering growing content revenue, as it exports more programming to Univision, a dominant Spanish-language television station in the US.
The company's pay-television services are also enjoying substantial growth in Mexico, where cable and satellite television services have only penetrated 45 percent of the market.
Sky, Grupo Televisa's satellite television service, has seen explosive subscriber growth since it began offering low-priced subscriptions that allow access to a greater depth of content than its competitors. The service is popular with Mexican families with expanding disposable incomes, and should prove a major growth driver for the company for years to come.
While Grupo Televisa's aggressive acquisitions have dampened earnings in recent years, annual revenue growth has averaged more than 10 percent over the past five years, and earnings should soon catch up.
At $24.27 as of this writing, the stock is currently trading at just 19.9 times earnings, a discount to its historical ratio of 22 times.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.