Argentina

Argentina

I have a strong interest in emerging markets. When Turkey blew up, I looked at Turkish stocks. The Argentine stock market vomited the other day, so most recently I have been looking there (some might also remember my Despegar posts).  Argentina now holds the title of the second greatest single-day stock market meltdown in history (in dollar terms, which is cheating for the sake of a headline, but whatever). When I looked last week the impact was split basically equally between currency adjustment (24% decline in Peso vs USD) and 24% decline in the Buenos Aires MERVAL index.

RIP.  (source: Google)

What’s curious about this chart is not just the mother of all meltdowns, but the fact that the index is still up over the past 12 months. Argentine stocks have been on a massive tear in part I believe due to the influx of foreign capital into the country. Those investors got a nasty shock when they saw the (allegedly) (but probably) corrupt duo headed by former Presidente Kirchner win the primary contest, which is seen as a leading indicator for the election later this year.  Short version: Investors became bullish over the “new Argentina” which now might become the “old Argentina” again if the former President gets back in.

I found it interesting, prima facie, simply because the market went down a lot and there was a massive currency adjustment. The Peso is down over 80% against the AUD and USD over the past 5 years. There is also massive inflation, currently running at 50% annually. It is an interesting and extremely challenging investment environment.

I spent some time reviewing the 19 Argentine ADRs listed on the NYSE with a view to picking a handful of the best stocks that were a) best positioned to survive the inflation and b) most likely to generate a reasonable return over the long term.  Inflation made it in my view extremely difficult to perform a discounted cash flow valuation, for several reasons (perhaps I lack the skillset).

Firstly because costs and revenues are expanding massively, on the order of 50% a year (in line with inflation). You can adjust for inflation but you don’t know what inflation will be next year or the year after, and this could conceivably change depending on the economy strategy of the political party that wins the next election. Second, most Argentine companies have borrowed heavily in US Dollars (which is not rational, but I am not sure they had much choice) and so it is difficult to know what free cash flow you will generate if you don’t know what the currency exchange rate will be.  Third, because it is difficult to know what will happen to sales volumes and overall economic activity in the economy.  Some companies such as CRESUD (NYSE:CRESY) are doing OK at keeping their prices (beef) ahead of inflation, but they are seeing volumes reduce as the economy struggles. Fourth, there is some risk that the currency becomes valueless. Anecdotal research shows the USD is already becoming the functional currency – just look at property portals in Buenos Aires. Five, there is ye olde government risk. Assuming a stock is a perpetual instrument (which the DCF does via the terminal value) is risky in countries with political risk.  A friend shared with me the quote “You can make money in corrupt autocracies, in non-corrupt democracies, but NOT in corrupt democracies” from Firebird Management – the rationale being that in corrupt democracies everybody steals from everybody else.

So I did not do a DCF.  I approached inflation with a few basic theories, which may or may not be accurate.

1. Commodities and land (and rent) will generally hold their value over time in inflation-adjusted terms. The prime land in Buenos Aires will remain prime land in Buenos Aires. Two hundred thousand hectares of prime beef land will also (assuming prudent management), remain so. Commodities have the added advantage, when your currency is very weak, of being very exportable. Beef and oil are obvious candidates and Russia is a country that anecdotally did well out of its oil exports when the Ruble cratered in 2014.
2. US Dollar revenue (and loans) will adjust for inflation a lot better than the Peso, which will lose a lot of its value through inflation.
3. Vital assets such as pipelines, airports, utilities and similar are in a good position to pass on the cost of inflation and remain an attractive business (barring government intervention).
4. I avoided banks/financials on the simple theory that your author is too simple to understand them, also inflation erodes away the value of the bank’s loans which were made in the past at a non-inflated value, i.e. inflation benefits the borrower. This is likely overly simplistic because it overlooks what percentage of loans were adjustable rate (interest rates are now 50%), but then I couldn’t understand what defaults would look like in that environment.

I then screened companies in several ways. A company that was not profitable now (Telecom Argentina) was not suitable. Companies that had badly mismatched their borrowings with their revenues from a currency perspective (most of the ADRs, also Telecom Argentina) was likely to be filtered out.  Companies that were planning large capex while not profitable (Telecom Argentina). I avoided anything with a low return on equity  (Telecom Argentina) because this suggested real earnings were shrinking in inflation-adjusted terms.

I avoided Mercado Libre (MELI) simply because the company did not become any cheaper and it is a very consensus stock idea. A good business for sure and growing quickly but beyond that I could not make any easy decision about its value, giving it is priced at 16x sales.

MERVAL = Argentine stock market index. Chart in USD.   source: Google Finance

I was left with around 10 prospects. I avoided the oil companies like YPF because of laws that appear to require oil companies to convert their USD into Argentine pesos at the time of the sale (thus minimising a lot of the benefit of USD revenues).  I then avoided most utilities because of heavy government intervention historically, and also some unique regulation limiting pricing and requiring the utilities to purchase their fuel from the government.

Loma Negra was an interesting cement business with a large market share, consistent profitability, a strong market share (around 45% in a market with four major players) and a pretty reasonable financial position (although its 24% return on equity suggested earnings would be eroded by inflation). In addition to its low ROE, I avoided this company on the rationale that a deflating Peso and reduced ability to secure/service US funding would lead to a reduction in construction activity and reduced demand for concrete. Loma Negra reports also indicated it was struggling to access enough power to operate its plants. This insight and the increasing trend towards utilities doing deals with private businesses led to me purchasing one utility, Pampa Energia which I’ll get to in a bit.

After cutting the oil producers and the utilities I was left with three businesses that looked well positioned.

Cresud (CRESY) is probably one of the cheapest stocks in the world, but it is very hard to value and likely deserves to trade at some meaningful discount to the sum of the parts, simply due to having so many parts.  It owns several hundred thousand hectares of Argentine, Bolivian, Paraguayan and Brasilian farm land and has a decent history of upgrading this land and reselling it.  It owns Israeli businesses and shopping malls, New York property, most of an Argentine REIT, IRSA (which I was interested in but ended up going with the parent company, Cresud), a quarter of a bank, Banco Hipotecario, and a few other things here and there. Management seem modestly paid and have a decent shareholding in context of their salary.

As an aside, there is an Argentine law that limits executive salaries if the company does not pay a dividend, which at first glance appears pretty restrictive – but the more I think about it, the more I like it:

“The maximum amount of total compensation to the members of the Board of Directors, including compensation for technical or administrative permanent activities, cannot exceed 25% of the earnings of the Company. That amount should be limited to 5% when there is no distribution of dividends to shareholders, and will be increased proportionally to the distribution, in accordance with the formulas  and scales set forth under the CNV Technical Rules. When one or more Directors perform special commissions or
technical or administrative activities, and there are no earnings to distribute, or they are reduced, the shareholders’
meeting may approve compensation in excess of the above-mentioned limits pursuant to the provisions of Section 261
of the General Companies Law.”

Corporate Governance, Argentine style.  It’s an interesting reminder that some countries have to deal with thieving management a little more directly, given a handful of powerful people control a lot of wealth and the country’s key assets.

Pampa Energia (PAMP) is a utility that is subject to a variety of restrictive government regulation, but it also seems to be one of the more proactive utilities when it comes to signing deals with private business, which I think will let it perform better than other utilities.  I reasoned that retail-focused utilities will be more restricted by government pricing limits, whereas private businesses can typically better afford (and are more willing to engage in) commercial pricing for reliable service.  Loma Negra’s power shortage and the reports of other utilities suggested to me that there was a supply-demand mismatch in favour of power suppliers. Pampa also has decent-sized investments in a variety of companies including a oil/gas producer, Transportadora de Gas del Sur (more on this below), and a couple of other things that I felt gave it some more long-term opportunities than other utilities.  It had a 60% return on equity that suggests a positive after-inflation return, although it has no free cash flow due to capital expenditure.

Transportadora de Gas del Sur (TGU) is the largest pipeline in Argentine and supplies around 56% of the country. After years of capped prices it got a 50% tariff increase last year and now has the right to a biannual review. It has a 65% return on equity, but minimal free cash flow due to capex. I think it is probably one of the best assets in the country and very reasonably priced. The recent increase in tariffs suggests that there is a loosening in attitudes towards business that will let Transportadora achieve at least a positive return after inflation. It is also in a good position to supply businesses and achieve better private pricing, although obtaining the gas remains a key challenge.

In any other country I think this company would be worth several multiples of its current price and it would also achieve a much higher ROE because management would lever it up.  I do not think this is on the cards, and  nor do I think the majority market share will be able to be exploited the way it would be in, say, Australia or the USA (which is not a bad thing), but the regular tariff reviews and the strong market position I think point to a decent future for Transportadora del Sur. Over the long term I think Transportadora has the potential to be the best of the 19 Argentine ADRs (excluding Mercado Libre which I did not spend any time on). Government intervention remains a possibility.

I hold a small number of shares in Transportadora (TGU), Cresud, and Pampa, and my TGU position is largest.  I also bought a small amount of Despegar stock at $10, on the rationale that people who are not me are willing to pay $13 a share for it. I intend to sell Despegar asap while the timeframe on the other investments is uncertain. This is a disclosure and not a recommendation.

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