Three Moats from South of the Border
These Latin American stocks are shielded from some of the region's volatility.
Latin America's equity markets have returned a roaring 275% since 2003, and by some measures remain undervalued. Still, the region is volatile and evolving quickly. How should an international investor best proceed?
By buying companies with fosos econ�micos, or economic moats. These firms have enduring advantages that keep competitors at bay and protect returns on invested capital. While we believe that businesses possessing moats make superior investments anywhere, they become especially attractive in less-certain markets such as Latin America.
In this article we highlight three of Mexico's best moat-protected firms. The first is a wide-moat airport operator that stands to profit handsomely from a rise in Mexican air travel. The second is a narrow-moat beverage and retailing giant that benefits from scale and strong brands. Finally, we look at the country's dominant telecom provider.
The Economic Backdrop
Although the U.S. economy is expected to decelerate or possibly shrink in the year ahead, Latin America's economies are set to expand relatively briskly. Chance explains part of the story, as the region's abundant natural resources are in high demand. But democratic and economic reforms have also fueled growth, and they should continue to bear fruit for investors.
There are exceptions, such as Venezuela and Argentina, where the future for private enterprise is dubious. But prospects are brighter among the more progressive regional players, such as Brazil, Chile, and Mexico. In these three countries--which together comprise more than half of the region's gross domestic product--reserves are strong, budgets are balanced, and inflation is low.
Despite recent advances, there are lingering risks. Latin America's history of currency devaluations, inflation, and social unrest could stage a comeback. And a sharp drop in commodity prices would ripple through local economies, hurting business and public finances. Such macro instability could lead to a wobbly near-term stock market. But for the patient investor, we think the region's long-run prospects are too solid to ignore.
Latin American Moats for Your Radar
Grupo Aeroportuario del Pac�fico (PAC)
We believe a wide economic moat surrounds Grupo Aeroportuario del Pac�fico (GAP), the sole operator of a government-owned airport monopoly in Mexico's Pacific and central regions.
Thanks to operating leverage, incremental passenger traffic yields high returns at GAP--and we expect the number of air travelers in Mexico will rise. Economic growth should drive part of the increase. But as incomes rise relative to the cost of air travel, an added thrust should come from travelers who switch from buses (traditionally a common mode of travel) to airplanes.
Although the firm has agreed to regulated airline fees, it enjoys substantial pricing power in unregulated revenues from car parking, retail leases, and other sales. As this revenue stream increases as a percentage of sales, margins should expand. New routes and the emergence of low-cost carriers offer additional avenues for top-line growth.
Despite its entrenched position, we believe GAP's future cash flows carry moderate risk. In addition to various corporate governance issues, latent regulatory risk concerns us. The government could conceivably rescind the firm's concessions or impose stricter revenue regulations. Further, Mexico's economy, more than any other in the region, is closely linked to that of the United States. A slowdown in the U.S. would almost certainly be felt in GAP's revenues. Finally, unstable seasonal weather could damage the firm's assets or curtail air travel. Still, we think GAP's prospective returns more than make up for these worries.
Fomento Econ�mico Mexicano (FMX)
Three strong subsidiaries comprise narrow-moat Femsa. The group owns a majority stake in Coca-Cola Femsa (KOF), Latin America's largest Coke bottler. In a market dominated by mom-and-pop stores, Coca-Cola Femsa wields strong bargaining power and has the profit margins to prove it. Geographic diversity (Femsa operates in nine countries), a robust brand portfolio, and Coke's marketing muscle further enhance its appeal.
A second subsidiary, Femsa Cerveza, forms half of the Mexican beer duopoly and boasts such iconic brands as Dos Equis, Sol, and Tecate. Last but not least, the Femsa Comercio subsidiary owns Oxxo, a fast-growing convenience store chain that provides a key outlet for the company's beverages. The same fragmentation that benefits Femsa's bottling operations has helped Oxxo shore up significant retail market share. The chain now has more stores than any other retailer in Mexico.
While Femsa is less exposed to macro-level risk than some of its regional peers (customers tend to consume beverages and frequent corner stores through thick and thin) several factors cool our enthusiasm. First, Coke has a history of strong-arming its bottlers. Second, high commodity prices threaten margins. Finally, retail consolidation could harm the very stores that Femsa relies on to ensure its high profitability. These threats aside, we expect Femsa's success will endure for years to come--and reward investors accordingly.
Tel�fonos de M�xico (TMX)
Telmex has a government-sanctioned stranglehold on Mexico's fixed-line and long-distance phone markets. Its margins, as a result, are among the fattest in the industry. We think the firm's business strategy will help it sustain its leading position and profitability. To mitigate a slow decline in fixed lines, Telmex is aggressively pursuing Internet and cable television services.
The company intends to monetize its foreign holdings by spinning them off, a move we expect within the next year. While Telmex will forgo some growth as a result, we'll gladly trade its foreign assets for a greater share of its wider-moat domestic operations.
In addition to the usual economic, political, and currency risks associated with emerging market firms, we caution investors that Telmex's near-monopoly position in Mexico--with 92% of the fixed-line market--may not last forever. Competitors are doggedly chipping away at its market share. And while years of public criticism have had little effect so far, heightened pressure could spur regulatory changes that weaken its grip. Still, Telmex's roots run deep, and we have confidence in its resilience.
Stay tuned for future articles discussing other stocks in the region, including our favorites from Chile and Brazil.
Adam Fleck, Mitchell Corwin, and Jacqueline Zhang also contributed to this article.
Ryan McLean does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.