Latin America: The Highest Stakes in Town

The only semi-safe bet is Mexico

Economic collapse in Argentina. Fears of a debt default in Brazil. Unending coup rumors in Venezuela. Narco-guerrilla violence in Colombia. Latin America has problems aplenty. It's no surprise, then, that in August, investors in Latin America-dedicated mutual funds were redeeming shares at the fastest pace in 10 years.

What's an investor bent on Latin America to do? Concentrate on Mexico. It delivers the stability of a member in good standing of the North American economy while boasting the growth potential of an emerging market. That's still nothing spectacular, mind you--Mexico will be lucky to grow 1.5% this year, and its manufacturing sector has been hit hard by a drop in orders from the U.S., which takes 88% of exports. But a two-year recession is ending, and Mexico will benefit immediately when the U.S. economy revives. "Investors at this point are extremely risk-averse toward the region but increasingly are labeling Mexico as a North American rather than a Latin American play," says Joyce Chang, global head of emerging-markets research for J.P. Morgan Securities.

Earnings have taken a beating, as have stock prices, so some of Mexico's blue chips have valuations that make them attractive. First is Telefonos de Mexico, which has a price-earnings ratio of just 10.1. Then there's cement maker Cemex, which should benefit from a government low-income house-building program; and Coca-Cola FEMSA, bubbling along after three years of real wage hikes that have enabled it to raise prices without hurting sales. Some investors also like media network Grupo Televisa. Robert Bergés, senior Latin America strategist for Merrill Lynch, suggests investors ally mainly with bigger companies. "Normally, you would go for some of the second-tier names when the first-tier names have become expensive, but this isn't the case right now," he says. "It's better to stick with a large-cap strategy" because large-caps have easier access to financing and a greater ability to ride out rough patches.

The rest of Latin America presents a quandary. Forget Argentina, where the economy will shrink 10% this year. As for Brazil, investors must decide if they think it will default on its $225 billion public debt. With presidential elections in October and two leading candidates indicating that they might change the country's economic course, investors may want to wait until the results are in. But then they would miss an opportunity to snap up shares of Brazilian companies at low prices. Bergés notes that the top candidates say they will pursue fiscally responsible policies. "We believe the markets have been overreacting to the political situation and that the risk of default is largely overblown," he says.

The situation certainly looks bleak now. Brazil's sovereign debt carries a gigantic 1,800-basis-point spread over U.S. Treasuries, and domestic interest rates stand at a hefty 18%. Plus, trade-financing lines to Brazilian companies have been slashed by about half over the past few months. That should help slow economic growth to around 0.5% this year. So investors should focus on big exporters with dollar revenues and access to global financing. They include iron-ore giant Companhia Vale do Rio Doce, or CVRD; cellulose producer Aracruz; and Embraer, a commuter-aircraft maker.

Those with no stomach for equities might want to consider bonds, especially Mexican corporates. Grupo Televisa and TV Azteca bonds are up around 2% this year. Still, the outlook is mostly grim. Outside of the region, emerging-market debt is up an average of 10.2% this year, while Latin American bonds are down 8.8%. Just Mexico and oil-rich Venezuela have posted positive bond returns. Only the most adventuresome investor will want to touch Brazilian issues, which are trading at 60% of face value. "Risks are very high in certain countries for economic and political reasons, but before dismissing Latin America, remember that with high risk comes big opportunities and high yields," says Filippo Nencioni, global head of Credit Suisse First Boston's sovereign-strategy group. That's timely advice for investors with steel-lined stomachs.

By Geri Smith

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