Mexico: an investment opportunity
I’ve recently deployed capital to three attractive PVT investment opportunities in Mexico within the R&M International High Alpha strategy. These ideas were identified through our stock selection process after Mexico was flagged, amongst other emerging markets, by our quarterly top-down Country Cycle work as being a stock market offering an attractive investment environment. In this note I detail the investment backdrop at a country level, why I believe Mexico will benefit from a robust US economic recovery, and why our three investments were selected and particularly stand to profit from this set-up.
Within our Country Cycle data, which looks back 15 years to capture at least one full cycle, Mexico scores as one of the countries closest to its trough. At the end of Q3 2020, profitability was at its lowest point, although was still very respectable at 2% return on assets (for reference, the US is 2.3%), while valuations were in the lowest 2%. According to UBS research, Mexican equities are trading ~2 standard deviations below their historic valuation premium to other emerging markets.
This is particularly interesting because timing support for an entry point has improved. Mexico appears to offer an opportunity to piggy-back on a US fiscal response to COVID-19 that is unprecedented (probably ending up some 4x larger than the 2009 policy response) and unparalleled globally. With its open economy, low labour costs and geographic proximity to the US, Goldman Sachs estimates a +0.8% impact of US fiscal stimulus on Mexico’s GDP in 2021, double the +0.4% average across Latin America. Over the last 10 years, exports to the US have averaged 80% of Mexico’s total, and it is now the US’s second largest trading partner, with 14% share, after the EU.
This more positive outlook is a far cry from the near perfect storm that the investors in Mexico appeared to face at times over the last several years, firstly with the election of Donald ‘Build the Wall’ Trump into the US White House in November 2016 and then with the election of left-wing candidate Andres Manuel Lopez Obrador (AMLO) to the Mexican presidency in 2018. Both election campaigns featured rhetoric which spooked investors – Trump’s around re-negotiating NAFTA and ‘America First’, and AMLO stoking fears of an anti-private sector administration with elevated risk of forced nationalizations.
The bark has been worse than its bite thus far. A new trade agreement has been negotiated (USMCA) which looks relatively similar to NAFTA. Also, despite the cancellation of a new Mexico City airport a third of the way through completion, plus a 3-year oil auction moratorium, there have been more positive signals such as an infrastructure plan in which there would be high private sector participation.
A recent example of the positive were the terms of the renegotiation of the Master Development Plan – which mandates capex requirements and tariff increases – for Grupo Aeroportuario Centro Norte (OMA). This was a nice fillip for our recent investment here, which was initially made based on recovery potential for air traffic from 55-60% capacity utilization (having been down 94% in May), with a relatively high proportion of domestic traffic, and also a consumer spending recovery driving higher revenue per passenger. Airports generally have strong ‘moats’, which provide them with pricing power and attractive returns on capital, but in Mexico there is the added advantage in a recovery scenario of a ‘dual-till’ regulatory framework, which provides a set rate of return on aerospace revenues, but places no limits on the income generated from faster growing, higher margin non-aerospace revenues.
Another investment with local monopoly characteristics which benefits from a more positive economic outlook is Bolsa Mexicana de Valores (BMV), which operates the Mexican stock exchange, and is the second largest cash equities and derivatives exchange operator in Latin America. It has a diversified, vertically integrated business model with high cash flow generation, split between more stable fee income of 63% and more volatile trading revenues of 37%. We expect revenue growth to be driven by a combination of structural factors over the long term, such as growth of post-trade and market data businesses (as we’ve seen with other exchange groups globally), with a short-term support from cyclical factors such as a recovery in listing fees for equity IPOs. We were able to buy our position at a ~7% yield of what we see as sustainable free cash flow (FCF) (covering a 5% dividend yield). The 30% discount to international peers – with Brazilian peer B3 offering half the FCF yield – offers a glimpse of where it could re-rate with a tailwind.
Our final investment, Macquarie Mexico Real Estate Management (FIBRA Macquarie) is a real estate investment trust with investments across industrial (83%) and retail (17%). It has robust rental streams: revenue is mostly in US dollars, rental agreements are inflation adjusted, and they have 90%+ occupancy. FIBRA Macquarie proved its resilience during Q2, the quarter most negatively impacted by COVID-19, (with amongst the lowest rent relief in the industry (less than 3% of revenues) while maintaining a high annualized cash distribution rate to shareholders (8% yield). While the ~8% dividend yield is an important attraction, its position at the heart of the Mexican infrastructure that supports the export economy should also allow attractive levels of capital growth over the intermediate term. (As a guide, it has grown intrinsic value¹ at 11% CAGR since IPO). We believe USMCA consolidates Mexico’s competitive export status in the North American market which, combined with COVID-accelerated trends such as near-shoring, safety stock inventory (rather than pure ‘just in time’) and e-commerce penetration, should ensure a supportive environment for industrial warehouse demand.
Mexico offers an exciting new emerging market allocation within our portfolio. We are invested in three companies which give us good exposure to a domestic economic recovery, catalyzed by expansionary fiscal policy in the US, and which have attractive economics and barriers to entry. What’s more, we’ve been able to access entry points at valuations which we think reflect the past more than the future and the underlying strength of the franchises despite evidence of conditions improving.
¹Defined here as a book value per share plus dividend per share growth.