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Market Update

Is There Opportunity in Mexico's Uncertainty?

According to many money managers and analysts, Mexican stocks are overpriced, but there are several names worth putting on a watch list.

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Mexico is trapped in a cycle of uncertainty.

Mexican markets are caught between elections: the U.S. presidential election of 2016 and Mexico's presidential election in mid-2018.

The uncertainty regarding the new U.S. administration's trade policies and its relationship with Mexico, expectations of slower economic growth, and the possibility of electing a Mexican leader with radical views will likely keep Mexican markets uneasy for the foreseeable future.

Yet oftentimes, bargains can be had during times of uncertainty. Is this one of those times?

The Trump Effect
Since Donald Trump's win in November, Mexico has offered investors a roller-coaster ride. The Mexican peso fell more than 15% between November and inauguration in January, while the Mexican stock market fell almost 5% during that same period. Before taking office, Trump said he would renegotiate or withdraw from the North American Free Trade Agreement, impose a "large border tax" on firms producing manufacturing goods outside the U.S. but that sell them on the U.S. market, and construct a wall on the border of Mexico.

"A lot of the uncertainty and weakness was there because of the unknown," said Matt Benkendorf, chief investment officer of Vontobel Asset Management, Inc. and lead portfolio manager of Virtus Emerging Markets Opportunities (HEMZX), which earns a Bronze rating from Morningstar.

So far this year, however, the peso has appreciated against the U.S. dollar almost 11% as of this writing, and the IPC Mexico index has gained 7%.

And no wonder: Since the inauguration, the new administration has softened some of its rhetoric regarding Mexico.

"We have now got more visibility to what the Trump administration means," Benkendorf said. "And the visibility takes the shape of the Commerce secretary, Wilbur Ross, taking control of this issue by visiting Mexico and using the proper language."

By March 30, the White House had communicated to Congress it would start NAFTA negotiations with Mexico and Canada, but would be seeking modest changes instead of an overhaul of the pact, according to a report in The Wall Street Journal.

Economic Ramifications
Trump's policies could mean fewer dollars flowing into Mexico through lower foreign direct investment, portfolio inflows and exports, a Jan. 17 Bank of America Merrill Lynch note said. As such, growth is expected to decelerate to around 1.8% this year from 2.3% in 2016.

Rising inflation--which touched a seven-year high of 5.3% year-on-year in the first half of March--would mean a substantial rise in the cost of living in Mexico, not only from the direct impact of higher prices, but also because it activates higher real interest rates and lower real wages, which would decelerate consumption, analysts said in the note.

With a rise in inflation, Mexico's central bank raised interest rates by 25 basis points on March 30 to 6.50%, their highest level since early 2009, and economists expect the Bank of Mexico to raise rates further in tandem with the U.S. Federal Reserve.

In addition, falling consumer and business confidence, lower external financing, higher inflation, tighter monetary policy, lower oil production, and social unrest may limit economic activity and earnings.

The Mexican Election
Adding to the uncertainty, Mexicans go to the polls in mid-2018 to elect a president, and according to surveys, the current president's party--Partido Revolucionario Institucional--is trailing the opposition.

Andres Manuel Lopez Obrador, the populist and anti-establishment candidate known locally as AMLO, is the front-runner. He has run for president twice, and experts say he has a chance at reaching the top job this time around.

National pride and anger toward the Trump administration's pledges of renegotiating NAFTA and making Mexico pay for building the border wall have propelled his popularity. Some Latin American pundits consider AMLO a "Hugo Chavez wannabe" and a threat to U.S. prosperity and security.

"The more Mexicans feel that they are being unfairly punished by the American government, the more likely they will turn to an anti-American candidate, and that is probably the far left candidate AMLO," said Peter Taylor, head of Brazilian Equities at Aberdeen Asset Management.

In addition, the current market-friendly Mexican administration of Enrique Peña Nieto enacted significant structural reforms to tax and education systems, the economy, and communication and energy sectors. But based on his dismal approval ratings of just 12%, these reforms haven’t translated into positives for most Mexicans.

Is This An Opportunity?
Mexico's economic challenges and political uncertainty are not translating into lower stock valuations.

"The missing link is valuation, and we want to see earnings more reasonable," said Chuck Knudsen, portfolio specialist at T. Rowe Price Emerging Markets Equity (IEMFX), which earns a Bronze rating from Morningstar.

"Earnings are too optimistic given the path for the economy," he adds. "We don't think the economy is going to crash, but we think it is going to slug on."

Mexico's stock market and the S&P 500 index are both trading at around 18 times earnings. But Mexico, as an emerging market, carries the potential of higher risk, notes Sammy Simnegar, portfolio manager of the Bronze-rated Fidelity Advisor Emerging Markets (FIMKX).

"Mexico is one of the most expensive stock markets among emerging markets," Simnegar said.

Given valuations today, many investors are simply holding on to their Mexican positions, waiting for more clarity from the U.S. administration on trade and immigration policies--or for a market correction that would bring down valuations.

"I don't foresee us doing anything within Mexico over the next few quarters, absent a correction that will bring down valuations to a much more attractive level," said Knudsen.

According to Morningstar's price/fair value metrics, only one Mexican company it covers look undervalued today.

Narrow-moat America Movil SAB de CV (AMX), the telecommunications service provider, is trading in a 4-star range as of this writing.

The company has been under intense scrutiny as Mexican regulators ordered the firm to spin-off its fixed line business, but Movil's "scale and solid assets throughout Latin America will enable it to reignite cash flow growth," said Morningstar's equity analyst Alex Zhao.

Movil has used its Mexican business as a base to push into other Latin American markets, creating a regional behemoth with about 240 million wireless customers, Zhao said in his latest company's report.

Though the company carries a high uncertainty rating, Zhao reiterates that Movil's scale in the Latin American telecom market is "second to none."

James Donald, portfolio manager/analyst for Silver-rated Lazard Emerging Markets Equity (LZEMX), added to his Movil position when the peso plunged, and is waiting for another point of entry to increase his position.

"America Movil doesn't have a huge direct risk from protectionism," Donald said; instead, "it has sensible managers, good capital management, and there's a good chance that it will continue to do well."

A Watch List
Though they may not be buyers today, portfolio managers we talked with offered up several fundamentally sound companies in Mexico to keep on a watch list to buy at the right price.

Rick Schmidt, a portfolio manager with Silver-rated Harding Loevner Emerging Markets (HLEMX), has an investment in Fomento Economico Mexicano SAB de CV (FMX), also known as Femsa. The company operates Oxxo (the biggest convenience store chain in Mexico), holds a 50% stake in Coca-Cola’s largest bottler by volume, and a 20% stake in Heineken.

"Femsa has identified a gap in the market," Schmidt said. "You go to the store to pay your bills, even retailers drop off their cash with Oxxo because their hours are better than banks' hours. It has created all these services in addition to selling your typical corner bodega."

Airport Group of the South of Mexico  ASUR (ASR), Airport Group of the northern and central regions of Mexico  OMA (OMAB) and GAP (PAC) have been a "great business" to investors, Schmidt adds.

As the market sold off, Taylor at Aberdeen invested in OMA, while Schmidt holds ASUR and Benkendorf owns GAP. Airport operators have been reaping the rewards of the peso weakness by attracting American and Mexicans tourists.

Wal-Mart de Mexico (WMMVY) is another noteworthy name. It competes against a nonorganized retail space.

"And if consumer spending falls off, then of all the companies, Walmex might actually get some business as people trade down," said Knudsen.

Manuela Badawy is a freelance columnist for Morningstar.com. The views expressed in this article do not necessarily reflect the views of Morningstar.com.

Manuela Badawy does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.