Emerging Markets: A Contrarian View On Mexican Equity

| About: iShares MSCI (EWW)


Mexico is one the largest and most important economies in the world that has been attracting investors for a long time.

For the last year, the performance of Mexican equity has been driven by political elections in the US.

Since the election, Donald Trump has "softened," which makes me believe that cancellation of the NAFTA agreement is unlikely.

The elections overheated the markets, and the fear was priced too high in Mexican equity and currency.

Investment in Mexican equity is an excellent opportunity for a contrarian investor, who can explore market inefficiency.

Mexico is the 15th largest country by GDP and the 18th largest country by exports in the world. IMF forecasts a moderate real GDP growth of 3.8%, which is above developed economies.

Source: IMF

Since 1990 foreign direct investments net inflow has increased significantly, underlying the interest of investors in the country.

Economic outlook

IMF forecasts a stable GDP growth rate and inflation, and falling unemployment for the next two years.

Source: Bloomberg Terminal

  • Mexican debt consists of 46.5% of the GDP, which is one of the lowest compared to China, Brazil, India, South Korea, the Philippines, Indonesia and South Africa.

Source: Bloomberg Terminal

Source: Bloomberg Terminal

  • For the last year, foreign direct investments from the USA have decreased from 5 bn to 2.29 bn.

Source: Bloomberg Terminal

What caused investors to withdraw their investments?

The USA is the primary trading partner for Mexico by the surplus, meaning that Mexico exports more than imports.

Source: Bloomberg Terminal

Mexico is the second-largest trading partner of the USA by the deficit, meaning that the USA imports more than exports.

Source: Bloomberg Terminal

Therefore, the economy of the USA is highly dependent on the Mexican exports and economy of the Mexico is highly reliant on USA imports.

In 1994 the USA, Canada, and Mexico signed a free trade agreement, "NAFTA," that eliminated most of the tariffs and liberated the trade between the countries. The hope of the accord was to boost economic development in Mexico and would subsequently discourage further illegal immigration to the USA, and decrease the costs and increase competitiveness for the USA and Canadian companies in the world market.

The studies of the NAFTA agreement show that it had a positive effect on the GDP growth of both Mexico and the USA: GDP of the USA grew by 50% and GDP of the Mexico by 46%.

The election of Donald Trump was a rude awaking for the investors:

Donald Trump believes that NAFTA is the "worst trade deal ever," and plans to cancel the deal and impose the tariffs. The motivation for the decision is due to the adverse impact on the USA labor market caused by the migration of manufacturing to Mexico.

Studies of the "NAFTA" agreement have shown that the deal has had a positive impact on the job market of the USA: the employment rate has increased by 24% and unemployment decreased from 7.1% to 5.1%.

The manufacturing output grew by 60% from 1993 to 2006 because of the shifted assembly lines to Mexico that significantly reduced cost.

American consumers benefit from lower prices on food and goods imported from Mexico due to the lower labor costs and will not be happy with the price increase brought by the tariffs. American corporations will have to deal with this same issue, as they will have to find new production centers with higher costs.

The cancellation of the "NAFTA" agreement will have adverse effects on both countries.The effect on Mexican economy will be significantly higher due to the lower size of the economy.

Should investors worry and withdraw their investments?

Donald Trump wants to impose 35% tariffs of the Mexican exports that will lead to an economic slowdown. With imposed tariffs, Mexico will have a hard time finding the substitution markets for the USA market; it is reasonable that investors would be concerned about these trade restrictions.

On the other hand, it's fair to assume that markets have overreacted and priced their fear too high in the equity and currency, creating an opportunity to explore market inefficiency.

A perfect opportunity for the contrarian investor.

Donald Trump was very tough on external and internal policy before the election. Nevertheless, after the election, he has "softened" and changed his views.

For example, before the election, he promised to build a 2,000-mile wall and deport around 11mm illegal immigrants. After the election, the wall is expected to be only 200 miles, and only 2-3 million criminal illegal immigrants will be deported.

The same story goes for the Affordable Care Act (ACA), which was deemed a "disaster" before the elections. After the election, Donald Trump told WSJ that he might consider leaving parts of the ACA.

This tendency shows that the Donald Trump before the election is not the same Donald Trump post-election.

A tough position on the cancellation of the "NAFTA" agreement can be quickly changed to some minor modifications in the deal.

In light of the revision of the NAFTA agreement, the government of Mexico has taken an active approach and built $177 bn of reserves (17% of the GDP), and IMF has upgraded a credit line up to $88bn (8% of GDP).

Moreover, the Central Bank of Mexico has increased the interest rate by 0.5% to 4.75%, which is the highest since 2009.

With these changes, the available reserves, IMF credit line, and increased interest rates will allow the government to support national currency from further devaluation.

What would be the opportunity for the contrarian investor?

The great opportunity comes from investment in iShares MSCI Mexico Capped ETF (TICKER: EWW).

The fund has been volatile throughout the year and has had a few massive sell-offs. After the election, the share price sharply dropped from $52.79 to $43.34 due to the unexpected Trump victory.

Source: Bloomberg Terminal

The fund was significantly outperforming S&P 500 Index (Ticker: SXP) in Mexican pesos; however, it was underperforming in US Dollars because of the increased volatility of the national currency caused by the upcoming election.

Source: Bloomberg Terminal

Even before the election, debates negatively affected the exchange rate, making the peso one of the biggest losers, which led to overheated markets and a tendency to overreact.

The election of Donald Trump has raised a panic among investors, leading to the massive sell-off of the Mexican currency and equity that has decreased performance and destroyed shareholders' wealth.

Source: Bloomberg Terminal

Taking into account changes in Trump's position after the election, it is reasonable to assume that cancellation of the NAFTA agreement is not very likely as it will negatively affect Americans.

It is fair to assume that the markets were overheated and investors overreacted by selling Mexican currency and equity, which now has created an opportunity to buy Mexican equity cheap.

I will compare iShares MSCI Mexico Capped ETF with SPDR S&P 500 ETF (NYSEARCA:SPY) to see how reasonable investment in Mexican equity would be compared to domestic.

I have taken 5yr average P/E, P/CF, and P/B ratios to minimize the volatile effect of the currency. Mexican equity is cheaper compared to the US, and investors pay less for each dollar of earnings, book value, and cash flow.

Source: Bloomberg Terminal

Source: Bloomberg Terminal

  • Emerging market companies have tended to have lower profitability, asset turnover, and higher leverage compared to the developed markets for the last year.
  • The depreciating currency has hurt the net income which translates into lower profitability.
  • Developed market countries have cost-saving effective policies that stabilize profitability
  • Profitability stabilization of Mexican equity will be critical to bringing ROE above the developed markets.
  • Asset turnover is affected by the increased sales with no change in assets.

Source: Bloomberg Terminal

  • The dividend yield is lower for iShares MSCI Mexico Capped ETF, but the payout ratio is higher than SPDR 500 ETF . The financial sector, the second largest industry concentration of the iShares MSCI Mexico Capped ETF, has almost the same dividend yield as SPDR 500 ETF.
  • The financial sector has a higher Return on Equity due to the higher profit margins and asset turnover compared to SPDR 500 ETF. Mexican financial institutions have more debt in the capital structure than equity.
  • While the percentage of the non-performing loans is higher than iShares MSCI Mexico Capped ETF, deposit coverage is lower. Mexican financial institutions are taking more risk than USA financial institutions, which explains the better performance.

What are the risks of an investment in Mexican equity?

  • Political risk

Mexico, like other emerging markets, is subject to a high level of corruption and political risk. Nevertheless, the political risk and corruption levels are some of the lowest compared to the other emerging market countries.

Source: Bloomberg Terminal

  • Currency risk

Source: Bloomberg Terminal

For the last year, the peso has significantly depreciated by 19%, which decreased the shareholder's wealth. The depreciation wasn't driven by the economic or political factors but the reaction to the political news.

The Mexican peso is forecasted to appreciate by 13%, which will boost the performance of the fund.

Source: Bloomberg Terminal

The bottom line

  • Mexico is one of the largest economies in the world and is one of the most important emerging market countries.
  • For the next year, Mexico's economy is expected to have a stable growth, which is above the average growth in the developed markets.
  • Despite the relatively low political risk and corruption compared to the other emerging markets, the performance of the iShares MSCI Mexico Capped ETF was very volatile throughout the year.
  • The volatility was driven by the markets, who overreacted to the political news and priced too much fear in the Mexican equity.
  • Mexican companies have a lower profit margin, caused by depreciating currency and asset turnover, which explains the lower ROE versus other developed market companies. Stabilizing profit margin should be the primary goal for the Mexican companies to bring ROE above developed markets.
  • The financial sector is one of the best-performing sectors with high ROE and profit margins. Still, financial sector enterprises take an increased risk through leverage and lower deposit coverage compared to the developed market companies that showed better performance.
  • Mexican equity has experienced a series of sell-offs, especially after the debates, which points out how overheated and over-reactive the markets are.
  • Investment in iShares MSCI Mexico Capped ETF is an excellent opportunity for a contrarian investor, with a high upside potential.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.

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