Emerging Markets: Latin America

The long and short of new equity issues in Latin America

Originally published in the October 2007 issue

This year has been an extraordinary one for new equity issues in Latin America. The market for both primary and secondary deals has grown by leaps and bounds and although the flow of deals would appear to have been stemmed temporarily by the current market volatility, investment bankers are keen to resume normal service as soon as possible. Demand from issuers and, to a lesser extent, investors remains strong.

Activity to date has been focussed primarily on the Brazilian market where more than 45 IPOs have raised over US$12 billion so far this year, compared to 31 deals raising US$7.1 billion for the whole of 2006. Mexico has seen just 2 new issues and the rest of the region has also been quiet.

Recent evidence would suggest that companies in these markets are gearing up to become more active. We fully expect Brazil to maintain its dominance and we believe that the region could easily reach 60 deals this year, putting it at the top of the global league table at least in terms of the number of issues if not in terms of size.

Indeed one of the defining features of the Latin American IPO market has been that most deals have been fairly small, with only a handful of issues exceeding US$1 billion. Most new issues have been in the region of US$250 – 450 million. This means that, whilst the volume of deals has been large, the amount of money raised has not exceeded net inflows into the region. This fact, coupled with the increasing appetite of global funds to get some Latin American exposure into their portfolios, has meant that deals have been generally well covered and there have been no disastrous after-market performances.

But whilst overall fund inflows have kept pace with IPO activity, the flood of issues has caused other more fundamental problems.

Learning to run before you can walk

Firstly, as access to equity markets has been easy during the first six months of the year we have seen a number of companies coming to the market without any real justification for doing so. In other words, thinly disguised excuses have been used for owners to cash in some of their stakes. Often the only strategy seems to be to raise funds for acquisitions and yet compared to the level of IPO activity, the level of M&A activity in the region has been disappointingly low.

Secondly, because the region’s equity markets have performed exceptionally well over the last five years with a lot of newly listed high-growth stocks doing very well, valuations are no longer cheap. As a result many new companies list on the basis of current peer group multiples whereas in many cases one could argue that the peer group has had its run and valuations are looking maybe slightly stretched.

In all of this IPO frenzy one thing has been lacking: high quality at reasonable multiples. This presents certain problems for a long-only fund, especially one that tries not to get wrapped up in shorter-term market momentum such as Charlemagne’s Magna Latin American Fund. As a result, we have been very selective in our IPO participations this year. The simple fact that a large number of new companies are listing is no justification for us to move away from our approach of running concentrated portfolios.

The problems posed for long-only funds by overvalued new issues do not impact long/short equity funds to the same extent, of course. If a new issue is overpriced then in theory it can be shorted to take advantage of this perceived market inefficiency.

We add the caveat ‘in theory’ here as in practice many of the new issues have been relatively small and very few companies now bother to list ADRs in New York, an often easier and cheaper way to short stock. This creates a squeeze on the stock available to borrow and hence pushes up the cost of shorting to levels where the decision to short an equity is no longer simply driven by the fundamental valuation but also by the implied cost of holding the position.

However, this does not mean that it is not economically feasible to short stock in Latin America. As a matter of fact, the shorting of large liquid names is relatively straightforward and tends to be cost effective as well. Stocks such as Telmex for example can be borrowed for less than 50 basis points. This strategy has of course worked well over the last couple of years for market neutral funds such as the Charlemagne’s OCCO Latin America Fund, as the short side has been dominated by the ‘old legacy’ names which were in many cases overvalued relative to some of the new names appearing.

However, from the beginning of this year this equation has broken down somewhat due to the price appreciation seen in many of the companies that came to the market during 2005 and 2006 and the optimistic valuations of many of the new IPOs of 2007.

However, as markets grow and mature we fully expect that the borrowing of local stock, even in smaller names, will become easier and cheaper, reducing the reliance on big-name ADRs. Either way, it is important to point out that despite these difficulties, it is possible to run long/short Latin American equity funds without relying solely on the ability to short indices. Stock picking can be applied both on the long and the short side of portfolios and Latin American long/short funds need not simply be run as quasi long-only funds with market risk hedged out via index shorts.

The OCCO Latin America Fund aims to generate absolute returns by investing both long and short in equities across the markets of Latin America. From its launch in April 2005 through to the end of August this year it has achieved an annualised return of 13.3% with a current ex-ante standard deviation of 6.4%.

Despite some of the difficulties indicated above, the fund is focussed on taking short positions in specific equities, identifying these opportunities via a rigorous bottom-up research process. Of course we are also pragmatic enough to realise that at times it makes sense from a risk and portfolio construction perspective to hedge market risk via index shorts but this tends to be secondary to identifying stock-specific shorting opportunities.

The recent IPO of Springs Global, a linen manufacturer majority owned by an already listed Brazilian company, Coteminas, provides an example of how to benefit from the mispricing of new issues. Taking on a short position in Coteminas in the final days of the Springs Global roadshow proved a successful strategy as it emerged that the likely pricing of the IPO would leave Coteminas trading at a substantial premium to the value of its core asset: Springs Global. With clear downside risk this position has worked well for the fund and highlights the inefficiencies that continue to exist in emerging markets.

We are finding that the current market volatility works two ways. On the one hand, it has increased the potential for mispricing, especially given the plethora of recent new issues, which markets had yet to price efficiently. But on the other hand, the success or otherwise of the positions that we have taken as a result is unlikely to become clear until the market reverts to a more stock-specific focus.

The next few months may well provide a bumpy ride for all investors, not just in Latin America but across the globe, but we feel that once markets stabilise it is those fund managers, such as Charlemagne, who have remained true to their stock picking principles, going either long or short, who are likely to see the benefits.

Stefan Herz is Portfolio Adviser for Charlemagne Capital