Finding the right stocks that offer the best return opportunities in the market is a challenging task. We believe that attractive valuations, improving profitability and balance sheet strength are clear signals of stocks with great return potential. However, achieving high information ratios for our clients’ portfolios requires not only the selection of great opportunities, but also the efficient management of risk.
Managing tracking errors and active weight is a key part of the process. At Sura Investment Management Mexico, value investing has a long-term approach that also requires the understanding of industry dynamics and an in-depth discussion of business prospects, with the help of company management to incorporate conservative and reliable assumptions in our models.
Our philosophy is focused on generating consistent superior risk adjusted performance, both against the market and our peers in medium to long-term horizons. We believe that active management generates attractive results, and in particular, in less efficient markets such as the Mexican equity market. To be able to extract consistent alphas, we have a dedicated team of portfolio managers, analysts and traders that focus on the local market, constantly in contact with companies and approaching valuations from a fundamental view.
Stock price allocation
There are plenty of opportunities in the local market, but there are also a lot of different risks. Capturing alpha requires a deep knowledge of both the companies and the market itself. Macroeconomic trends as well as individual microeconomic forces, changing regulations along with significant inflows and outflows all play their part in the setting of stock prices. Our aim is to provide our investors with the best vehicles for obtaining exposure to the Mexican markets, and our track record is a clear example of our focus.
Exchange rate behaviour is an important variable affecting business performance
Mexico has a market capitalisation of about $500bn, and remains a highly concentrated market – the 10 biggest firms represent more than 50 percent of the total market.
Our approach has been to marginally increase our performance based on valuation scrutiny and discipline, as well as to include some mid and small cap firms which offer more opportunities in mispricing as liquidity and efficiency are lower in those segments. In the last two years we have seen that the mid and small-caps index outperformed the main index. We believe this is due to the fact that the earnings growth in large caps has been low compared to the rest of the market.
In the last couple of years economic growth has gradually decreased as a consequence of lower disposable income that was affected by the fiscal reform, low productivity growth and the fact that fluctuating oil prices have also decreased the attractiveness of investments in the country (see Fig. 1). Of course, mid and small cap stocks also exposes the investor to wider risks, which is why being selective and limiting exposures is a key ingredient for being successful.
The Mexican market is quite expensive, and the IPC Index is trading at 20 times ahead of the P/E multiple based on consensus figures; which we believe have the relatively high weight of staples in the index at approximately 30 percent, and is one of the reasons for this high valuation. The implied growth of the IPC multiple based on the Gordon Growth Model stands around 8.1 percent – which is fair given that sales estimates are projected to grow at about 10 percent CAGR for the next five years.
In the last couple of years we have seen earnings revised down and the index multiple trading at the same level, the main reason bring that the performance of the IPC has been marginal. Going forward the multiple expansion seems challenging, and earnings per share (EPS) growth has not performed as expected. However, we have seen small and mid-cap companies that have over performed in the market because of multiple re-rating supported by continued fundamental improvement and better net results. Here is where the equities team at Sura strives to position its competitive advantage in the process of screening companies with high intrinsic value and sound fundamentals, always with a strong focus on risk management.
Investing in real estate
One sector that we have been looking closely at is real estate, as last year the FIBRAs (real estate investment trusts, known as REITs) index had an over performance of 16 percent against the IPC – where both local and international investors piled in this relatively new segment of the asset class and raised about $6.5bn in equity since the beginning of 2013. Currently there are nine FIBRAs in the market, and they are a growing asset class with still plenty of cash for deployment. We at Sura prefer holding FIBRAs that trade at levels near or below NAV in our estimates. Particularly, in FIBRAs we like the USD exposure given that some rents are USD denominated and the inflation protection we get as renters are mostly linked to increases in CPI. As a caution, FIBRAs have a high exposure to rising interest rates, as many investors see it as a substitute for bonds. This might become a vulnerable element for the segment going forward.
In general, our outlook for the Mexican equity market in 2015 is quite conservative, as we argue that EPS growth has been quite low in the last couple of years and although we expect a higher growth rate going forward – it will be at single-digit growth rate. Additionally, multiple re-rating seems difficult to assimilate, as no short-term catalysts are visible. In sectorial terms, we have higher conviction in firms with exposure to the US manufacturing industry (such as industrials), real estate and consumer discretionary that we expect will offer much better dynamics in EPS growth.
Weak economic growth in Mexico has also been due to lower public infrastructure spending as well as lower private construction activity, a remnant of the homebuilders collapse. Low construction activity has also impacted consumption and job loss, and despite better consumer data for food retailers with SSS increasing above inflation at the beginning of the year, we still believe valuations don’t reflect fundamentals and long- term EPS growth. So far the earnings momentum hasn’t crystallised, and the big question is how to be bullish in stocks with earnings growth at single digit rates trading above 25x forward P/Es. That’s the reason we prefer stocks with high cash generation and multiples adjusted for growth at relatively attractive levels.
One relevant issue for the equity market is the magnitude of the impact from the energy reform in potential GDP. Certainly, expectations have decreased because of the oil price collapse, but we still believe productivity gains from lower energy prices such as natural gas, gasoline and electricity will contribute in the medium-term to the improvement of gross margins of many firms. There is a lot of uncertainty in the timing of significantly higher investments in the energy sector – economists are estimating three to five years to see higher investment figures – however, we prefer to manage the expectations in a relatively moderate way.
Moving on, there are expectations of new firms coming to the market this year, with Mexican Stock Exchange officials mentioning around 10 deals between IPOs and follow-ons. New deals have been a source of alpha for Sura clients as we have found attractive opportunities in new issuances in the past. The equity that has been raised since the beginning of 2013 has amounted to nearly $22bn, which represents a significant amount of new flows given the size of the local equity market.
Exchange rate behaviour is an important variable affecting business performance. In general, companies that have a top line income in USD and COGS in MXN are always a good hedge against any sudden depreciations in the peso. Industrials, real estate and financials are generally our preferred sectors when we believe the peso will depreciate in the future, such as the current environment. On the other hand, if the peso is expected to appreciate, discretionary, staples, telecoms and materials are our favourite sectors.
Interest rates and inflation expectations also impact strongly in our investment decision process. For 2015 the 10-year inflation break-evens are at 280bps and our view is that inflation will end slightly above BANXICO’s target of 300bps, heading to 350bps. The monetary policy in Mexico will aggressively follow that of the US as the fixed income holdings from foreigners are at historical highs. This means FIBRAs could underperform if the FED liftoff takes place during 2015, which is our base case.
Even if the market looks expensive as a whole, there are still very good opportunities for extracting value in Mexican equities. Careful risk management, discipline and medium term horizon is a must, now more than ever since volatility is returning to global markets, but a focused team with a solid investment philosophy and process will make a big difference. Sura also has a presence in several markets across Latin America, reinforcing our competitive advantage in the region since we have teams of professionals based in each country. Synergies across Sura investment teams means there is a regional view that is more definite than any top-down alternative.