Author: Eric Uhlfelder

15 June 2007, Institutional Investor

“Despite sterling long-term fundamentals and a stock market that’s been soaring,” says Matthew Hickman, fund manager of the closed-end Chile Fund, “many institutions have perennially underweight Chile.” A survey conducted by Morningstar of Latin American funds domiciled in the US confirms that the average weighing of funds with the significant exposure to Chile is underweight the MSCI Latin American benchmark of 7.63 percent for Chile by nearly two full percentage points.

A look at the Chile Fund’s declining premium last year echoes this sentiment. At the end of 2005, Hickman’s fund was trading at a 25 percent premium to its NAV. However, by the end of the 2006, the fund was trading a discount of 2.48 percent. This collapse transformed a 2006 NAV gain of 33.1 percent to a market value profit of just 4.2 percent. Nevertheless, market sentiment continued to move against the fund during the first four months of 2007 with the creation of a discount that’s close to seven percent.

This pessimism challenges logic. The International Monetary Fund recently commended the Chilean authorities for their “continued exemplary implementation of sound macroeconomic policies, based on strong and well-established institutions, and reinforced by strict adherence to the structural fiscal surplus rule, a highly-regarded inflation targeting framework, increasing trade integration, and a robust financial system.” This has resulted in sustained economic growth, a significant reduction in poverty, low inflation, strengthened investor confidence, and an economy that’s proving resilient to external shocks.

Hickman suspects investors have been responding to several factors. First, soaring copper prices alone have significantly contributed to the economy’s good fortunes. Second, in dollar terms, the Chilean Index has surged by more than 33 percent annually over the past five years. As a result, many investors may believe the bourse is overvalued. Relative to the MSCI Latin America with a trailing PE of 16.1, Chile is indeed more expensive with a 23.8 PE. Third, Chile is a small market worth $250.6 billion. The market’s limited free float of 37 percent reduces investment opportunities to just $77 billion.

Lmited public offerings aren’t helping matters. According to Thomson Financial, from 2003 thru June 2007, only four companies have come to market that collectively raised less than $900 million. And despite strong market conditions, investors shouldn’t expect this to change. Guilherme Paiva, Latin American equity strategist at Deutsche Bank, thinks many businesses across Chile are simply not large enough to need or command a public offering. Historically, low interest rates have made borrowing a feasible option. And culturally, many companies simply prefer retaining complete control of operations.

Lastly, a highly successful pension system that requires all workers to direct 10 percent of their salaries into retirement accounts has funneled billions into the market, helping to drive the protracted stock rally. But pending pension reform may soon divert a portion of these assets toward international destinations, potentially slowing demand for domestic shares.

According to Raimundo Valdés, head of research at Santander Investment in Santiago, pension managers are investing 18.3 percent of assets into the local market, representing nearly one third of the market’s free float valuation. With the limit on foreign investments by pension funds likely to be raised starting in the third quarter of this year from 30 to 45 percent, Valdés admits there is a risk to local valuations. “We saw a five percent drop in stocks one day in February when the market realized such change was in the works,” says Valdés. But in just a few days the market made up this loss.

Like many market observers, Valdés believes that flows into foreign securities will most likely come from a portion of the $16 billion currently invested in time deposits and from the $300 million of new monthly flows into pensions. With less than one out of every five peso already going into local stocks, he doesn’t believe pension funds will materially reallocate out of the bolsa, especially given its persistent superior performance that comes without currency risk. Any future sell off related to concerns about pension reform could be a buying opportunity.

But if already high valuations challenge the upward rerating of stocks, are there further profits to be had?

Jeffrey Urbina, portfolio of the $1.0 billion William Blair Emerging Markets Growth Fund, which has more than doubled in value since it started up in mid 2005, thinks so. “Given Chile’s highly stable political, economic, and legal structure, solid corporate revenue and earnings growth, and increasing consumerism,” explains Urbina, “I believe the country merits its higher valuations because its delivering emerging market expansion with lower risks that are typically associated with developed markets.”

Accordingly, Urbina’s 3.5 percent position in Chile is more than twice the weight of the MSCI Emerging Market index. His largest position is in the country’s top retailer. Falabella’s fashion, do-it-yourself, and credit card operations, steady EBITDA margins above 12 percent, and projected EPS growth above 20 percent has helped its shares rise 85 percent since Urbina established his 1.1 percent stake in October 2005. The company’s recently proposed acquisition of food retailer D&S is considered by most a synergistic move that should quickly be earnings accretive.

Patricia Ribeiro, manager of the $867 million American Century Emerging Markets Fund whose returns have soared by more than 27 percent annually over the past five years, comparably overweights Chile. In addition to her retail positions in La Polar, which has soared more than 131 percent over the past two years, and in spirits and beverage manufacturer Cia Cervecerias Unidas, which is up more than 47 percent during the past 14 months, Ribeiro recently established a position in the country’s flagship carrier LAN Airlines.

“This has been a very successful restructuring story,” explains Ribeiro. “More efficient operations, creative pricing schemes, supported by the country’s booming economy, have transformed this troubled carrier into an increasingly profitable global airline.” EBITDA margins, which were 8.73 percent in 2005 topped 14 percent in 2006 and are expected to approach 16 this year. Since she established her $1.91 million position in February, the ADR has climbed nearly 14 percent from $72.26 to $82.25. And currently, the airline is executing a $310 million rights issue to finance further expansion.

More evidence that there’s still value in Chile has been the recent pickup in domestic dealmaking. Last year, Thomson Financial reported 29 takeovers of Chilean companies worth $1.27 billion. This year through May alone, there have been 17 deals worth more than $4.74 billion.

Over the past three years, mutual fund assets have doubled, now exceeding more than $20 billion as investors have shifted away from low-yielding debt and savings accounts.

And in May, the government enacted a new set of market reforms, offering tax breaks to venture capital funds and newly listed companies, deferring taxes on mutual funds that reinvest capital gains, and promoting local listing of foreign companies. In all, Santander’s senior economist Pablo Correa, believes these changes will make Chilean markets “more professional, reliable, and transparent, which will facilitate funding of new investment in Chile, while increasing domestic saving and GDP growth.”

Evidence that investors may be starting to look past their doubts about Chile is evident in the Chile Fund, where over just the past month through June 14, its recent discount of 6.8 percent has soared to a 11.4 percent premium.

The Economist Intelligence Unit “expects Chile’s liberal economic policies and disciplined macroeconomic management to be maintained in 2007-08. Following GDP growth of 4% in 2006, a rebound to 5.5% in 2007 and 5% in 2008 will be led by exports, and increasing copper production, following a dip in 2006. The autonomous Banco Central de Chile (the Central Bank) will keep 12-month inflation close to its 3% target. The peso will remain steady in nominal terms against the US dollar, supported by high copper prices, helping to keep the current account in surplus.”

Stock Market Performance [MSCI Chile] thru May
YTD 1-Year 3-Year 5-Year
Local/US$ Local/US $ Local/US $ Local/US $
19.19/20.64 51.13/51.10 29.52/37.73 25.29/30.89

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