For Now, The Nafta Game Is For The Gutsy

The vote on the North American Free Trade Agreement is barely a week away. While the consequences of Congress giving free trade a thumbs down is subject for debate, few doubt NAFTA could electrify Mexican markets and handsomely reward those willing to take on the extra risk of investing in a developing country.

Already investors are betting on the side of NAFTA and putting money not only into Mexican stocks but into equity and bond mutual funds that should benefit from passage. Brokerage houses have Mexican stocks on their buy lists, and six fixed-income funds designed to play off expected increased stability in Mexico's bond markets have been launched this year alone.

NAFTA would phase out cross-border tariffs between Mexico, Canada, and the U.S. The latter two countries have had a free-trade agreement since 1988, and that pact would not be affected if Congress votes down NAFTA or if Canada pulls out of the new accord, as the newly elected Liberal Party has threatened. NAFTA really concerns trade with Mexico, and with the U.S. economy 20 times the size of Mexico's, the impact will be most dramatic south of the border.

President Clinton is still scrambling to find enough votes in the House of Representatives to see NAFTA through. So any investor contemplating playing off the Nov. 17 vote must consider several possible outcomes.

GOOD BUYS. Under the first scenario, NAFTA passes, triggering more foreign investment in Mexico and consolidating economic reforms that have been under way for the last seven years. Mexico's Bolsa de Valores, which has grown from 100 points to 2,000 in the last five years, scales ever higher. October has already brought a "Yes-NAFTA rally" as optimism that the pact will pass mounts, says Jacques Levy, deputy president of Banco Nacional de M xico, the country's largest private bank. However, because of the relative uncertainty over the vote, the full effect of the agreement passing has not yet been factored in, and Mexican stocks are still relatively cheap.

The construction industry in Mexico would be among the first to benefit as business owners in both countries launched capital projects. Cement companies Apasco and Cementos Mexicanos will prosper, says Jos Luis G mez Pimienta, president of Mexico Fund, a closed-end fund based in Mexico and listed on the New York Stock Exchange. New development will also spur the growth of Grupo DESC, which manufactures auto parts, and the phone monopoly Tel fonos de M xico, he says.

As new investment and jobs kick in and the standard of living improves in Mexico, consumer spending will flourish. Soft-drink companies, such as Coca-Cola Femsa, will benefit, as will tortilla maker Grupo Industrial Maseca and breadmaker Grupo Industrial Bimbo.

Many Mexican companies, especially small-scale manufacturers, are expected to suffer as American companies with worldwide buying clout flow across the border, says Jane Siebels-Kilnes, portfolio manager for Templeton Worldwide. Smaller U.S. companies in trucking or capital goods manufacturing could grow rapidly by taking advantage of free trade in Mexico, but "you have to go out to research the company and see if they have any plans in that area," Siebels-Kilnes says.

Large U.S. corporations that have already formed strategic alliances with Mexican counterparts will benefit from free trade, but their Mexican ventures will be such a small part of the companies' worldwide volume that their bottom line won't be dramatically affected. A more aggressive strategy would be to invest directly in Mexican partners or subsidiaries, such as Coca-Cola Femsa, Cifra (aligned with Wal-Mart Stores), Kimberly-Clark de M xico, and Sears Roebuck de M xico, says Arturo Acevedo, director of research at Vector, a Mexican financial services firm that is opening a subsidiary, Vectormex, to serve investors in the U.S. (212 407-5506).

Interest rates on Cetes, 28-day Mexican government bonds, now hovering around 13%, would fall to 10% in the month that follows the passage of NAFTA, and inflation would drop from its current 8% annual rate to 5% in 1994, predicts Banco Nacional de M xico's Levy. The reduced risk and high yields relative to U.S. rates would make Cetes great buys, especially once Mexico gets investment-grade status.

"MELTDOWN." The second scenario assumes that even if NAFTA fails, positive momentum in the Mexican economy will continue and many of the benefits of a yes vote will occur anyway, albeit over a longer period of time. The Bolsa would take a temporary hit, probably falling about 15%, which would provide a buying opportunity for the construction and consumer-based stocks. The Mexican government would protect the peso from going into a tailspin, raising interest rates to prevent the flight of foreign capital, says Wayne Lyski, executive vice-president of Alliance Capital Management, which manages the North American Government Income Trust. Most analysts are betting that Mexico could bounce back fairly easily from a "no" on NAFTA, because the country already has largely opened its economy to foreign competition.

However, there is a third scenario to be reckoned with: The positive chain of economic events in Mexico would be reversed and lead to a "full-scale Mexican meltdown" as foreign investors, who are already nervous, would withdraw, forcing the devaluation of the peso, says Richard Hoey, chief economist at Dreyfus. He puts the odds at 1 out of 3 that this would happen if Congress rejects NAFTA. The government could do little to protect the currency if the flight of foreign capital is too swift, says Levy. Then, President Carlos Salinas de Gortari would be discredited, and that might usher in a period of political instability.

The U.S. stock market would also suffer, since Clinton's failure to get NAFTA through Congress would betoken weakness. "The market doesn't like it when the President is weak, especially if he can't get economic priorities through," says Hoey. Free-trade negotiations all around Latin America could come unglued--a long-term negative to the U.S. economy, says Siebels-Kilnes.

Still interested in making a NAFTA play? There are several options open to those who dare. If you have a company in mind, you can buy American depositary receipts through your broker. Although they are traded in dollars, they are subject to currency risk if the peso is devalued. Or you can diversify a bit more by buying a closed-end fund that invests solely in Mexico. There are three available on the NYSE: Mexico Fund (212 750-4200), Emerging Mexico Fund (800 553-8080), and Mexico Equity & Income Fund (212 667-5018). Each has returned more than 42% in the past year, and Mexico Fund, the only one with a five-year track record, has averaged 40% a year since 1988.

A handful of equity funds specialize in Latin America. Scudder Latin America has returned 44%, Merrill Lynch Latin America B has yielded 29%, and G.T. Latin America Growth has brought in 27% this year, through Oct. 8. William Truscott, assistant portfolio manager of Scudder's Latin America fund, recommends that investors use dollar-cost averaging, investing the same amount every month so as to buy more shares when prices are lower and fewer on an upswing.

GETTING TOO GREEDY. On the fixed-income side, there are now eight funds available that buy corporate and government debt in Mexico, the U.S., Canada, and South America. Pilgrim's All Americas Government Income Trust, which opened to investors on Nov. 1, will put 25% of assets in high-yielding Mexican debt. Although these bond funds should be less volatile than their equity counterparts, they are still far riskier than most fixed-income funds.

Whatever method you choose, only the percentage of your portfolio that you've set aside for the riskiest strategies should be invested in Mexico. "People have a tendency to get greedy if they think there is a score waiting to be had," says Robert Glovsky, a Boston financial planner. He recommends aggressive investors put only about 5% of their portfolio into Mexico. Although Mexico holds potential rewards for those willing to jump in now, Glovsky suggests you wait until the vote to make your NAFTA play. Amey Stone

      -- Mexican stock market thrives as foreign investors take advantage of high
         growth estimates, low price-to-earnings ratios, and stable exchange rates. 
      -- Increased political and economic stability make Mexican bonds a safer
         investment and its debt is raised to investment grade.
      -- Some Mexican companies are hurt by increased competition so only careful
         stock-pickers are rewarded.
      -- U.S. markets see NAFTA passage as a positive sign and get a slight boost. 
      -- The peso begins to lose value--reduc-ing the value of foreign capital and
         discouraging investors. 
      -- Interest rates rise to attract foreign capital, acting as a drag on the
         economy, but keeping the peso stable.
      -- The Mexican market takes a short-term hit, creating a buying opportunity,
         and then recovers. 
      -- U.S. companies do not grow with the speed they would have with a major new
         trading partner.
      -- Mexican government proves unable to control the devaluation of the peso,
         investors flee, and hard-won local price stability is threatened.
      -- Confidence in President Salinas' lead-ership is eroded, perhaps leading to a
         period of political instability.
      -- U.S. markets stumble as failure to pass NAFTA is taken as a sign of
         President Clinton's weakness.
      -- The U.S. economy suffers when a "No NAFTA" vote leads to a breakdown of the
         tariff and trade negotiations with the entire Latin American region.