The Argentine Opportunity

The tide is turning

Originally published in the October 2015 issue

I am Andreas Pitchon, I run the MBA Latin America Opportunity Fund. We are now 100% focused on Argentina, and we have actually been in nine of the last 12 years 100% focused on Argentina.

Post-Kirchner politics
About the opportunity – we see two very powerful catalysts happening relatively soon. One is happening as soon as December of this year. This is the primary and trendsetting catalyst, which is the end of a current political cycle and its replacement by a more business and friendly market regime in December. Cristina Kirchner is leaving the presidency in December after 8 years in power and 12 years in a row for the Kirchner family.

Resolving the default
The second catalyst is going to be the remediation of the default. We expect that during 2016 the default will be remediated. Actually, Argentina is in a partial default since July of 2014 when Judge Griesa ruled that Argentina couldn’t pay bondholders of international law bonds unless it also pays the holdouts from the 2001 default.

These two catalysts for us will allow value. Where is the value? Argentina spreads are too high for its balance sheet. You can find spreads in Argentina of more than 1,000 basis points and even spreads in Debt that it is currently performing. Reported Net debt to GDP is below 20%. If you include most relevant off balance sheet claims, it can reach 30% of GDP.

We believe that with these two catalysts, Argentina could get, at the end of 2016, to approximately a spread of 500 basis points give or take 100 which will still place it at as one of the weakest credits in Latin America.

Recovery periods in Argentina have been very profitable historically and with low correlation to global assets since they are mostly event driven. In the previous two recovery periods that we participated in, we generated returns of 68.9% to 84.7% in periods of two to three years.

Scioli versus Macri
Where are we with catalyst number one? Catalyst number one, which is the end of Cristina’s term, is now a two-man race basically between Scioli and Macri. We just had the primary elections which in Argentina are mandatory and are like a first round election. This is pointing to having a run off in November. Why is this? Because in order to win an election, you need to either reach 45% of the polls or 40% plus 10 point difference, and this is not happening right now for any candidate. However, Scioli is not too far from a first round victory. More importantly, I think that we believe that both candidates will address the holdouts problem during 2016, which in our opinion is a very important catalyst.

Is there any difference if Scioli wins or Macri wins? There are some differences. Our base case now will be Scioli winning but Scioli winning in a second round. The differences I would say are that Macri will solve the holdouts problem faster, probably first half of 2016. Scioli will solve it more slowly, probably second half of 2016.

Since the market is so convinced that Macri will resolve it very fast, I think that if Macri happened to win, you will already have the market moving fast in a clear anticipation that this will be solved relatively fast. If Scioli were to win, I think that the market will wait more for signs from Scioli that he will solve this issue.

Main risks
Of all the risks listed here, I think that it is important to mention that most of the risks will actually mean volatility but will not mean that the positive trend will be stopped. I think there are two risks worth mentioning and one is devaluation, and this is because devaluation is a certainty, it will happen.

Currency devaluation
We believe that there will be a devaluation of around 50% order of magnitude next year. What are we doing to protect ourselves from this devaluation? Mainly we are holding dollar-denominated debt or euro-denominated debt hedged into dollars. Today around 80% of our portfolio is in hard currency. An additional 10% of the portfolio is in equity with dollar-related revenues, which leaves our exposure to the peso to less than 10% which actually is in line with our historical average peso exposure, because we believe that the peso currently is basically Monopoly money.

Policy continuity: A remote prospect
The risk that could stop the trend is policy continuity but we attach a very low probability of occurrence to policy continuity. The top economic advisers of both candidates believe that policy continuity is not an option and for additional insurance there are not enough dollars in Argentina’s central bank for policy continuity. They could last six more months, but not much more than that.

Historically, when Argentina is running out of dollars, it suddenly becomes very friendly towards investors, so we are now moving towards that direction. Recoveries tend to be very profitable in Argentina when they happen, and in the five last recovery periods we can see that median return was 182% for bonds in 3.4 years, and 368% for equities in 2.1 years.

Generally recoveries last for not less than two, and up to five years, and in the last two we were able to generate 68.9% and 84.7% returns. The other thing that we can see is equities are better than bonds for recoveries but not necessarily over long periods of time. Over long periods of time, in Argentina bonds tend to outperform equities.

We have identified eightdifferent areas of opportunities
I think that the most important point is, we can expect that the recovery, from a market point of view, will last more than the average recovery period.

Just to mention a couple, we can see that there are some performing sovereign dollar-denominated bonds. Despite the default of international bonds, some Argentine law bonds denominated in dollars are still performing and it is performing because there is no capacity to pay problem. It’s not a willingness to pay problem, there’s a legal problem that is blocking the payments of sovereign bonds under international law.

I think that the GDP warrants deserve a couple of bullets. These were given in the restructuring of 2001 to compensate investors for the haircuts that they had to take in their holdings.

Optionality of GDP warrants
They’re currently trading at around $8 or €8, and there still remains to be paid roughly $30 or €30. We believe those will be paid within the next 10 years approximately, and the next payment is going to be between $3 and $4 or euros out of the $8 value, and we think it’s going to happen in December 2018 because how it works is you need to reach a 3% growth and we don’t think it’s going to be reached until 2017, and then you are paid with one-year lag.

So there’s a lot of value in these securities, however the momentum is not there because they generally get popular when you are reaching the target of growth and then you will be paid, but right now no one expects growth either this year or next year.

Trade examples
Long province of Cordoba dollar-denominated 2017 bond
There are just three examples and three positions that we currently hold. This is the simplest. This is just a long province of Córdoba dollar-denominated bonds that matures in 2017. Córdoba is one of the most important provinces of Argentina; it has a primary and financial surplus and a low level of debt (approximately 5% of the estimated GDP).

Dollar denominated, is only $638 million, which practically takes Cordoba off the radar screen of the investors. Because of this and because of the sovereign default it yields almost 12% in dollars, it has a 12 3/8th coupon and a very short duration of 1.69.
We expect that the return from now to the end of 2016 will be around 19% assuming just a bit of spread compression and 200 bps over the Bonars17s which is the sovereign benchmark for the province of Córdoba.
An alternative strategy will be, instead of selling it when it reaches the target and the 19% profit, just holding this to maturity because this bond matures in less than 2 years, and at 12% return is another reasonable alternative for a bond that you can see that it’s not very volatile. When the financial volatility increased in August, the bond declined from 103 to 100, so $3 decline, it’s not that bad.

Long macro (bank)/short galicia (bank)
This is a long/short between two banks that we play a lot. We arrive basically at the price targets on a fundamental basis for both banks, and that indicates that their relationship in the prices should be 2.64 and currently trading at around 2.30, leaves a 13% profit to reach the target.

Also what we see is that on a historical basis over the last 4 years, it has traded consistently within an average of approximately 2.64 and between lows of 2.1 and highs of 3.20. So there’s a lot of volatility but it always tends to revert to where the stable return of equities of both banks are, and most of the volatility is generated either by quarterly results, by flow of news or just large investors getting in or out of one of their positions. Here we do trades even for just profits as small as 2% in a weekor near 10% in three months.

Long euro-denominated discount bonds (currency and duration hedged)
This is long-euro denominated discount bonds, currency and duration age. These bonds are in default. They are trading at around $90 and it includes almost €18 in unpaid coupons. So we estimate the yield is around 10.7% and it’s modified duration 6.7. We estimate this based on an exit from the default in December of next year.

We are targeting an exit spread of around 650 basis points for this bond. From this we derive an expected return north of 40%, 44% actually, that includes €23.5 of unpaid coupons by December of 2016.

I think the risk is that it moves more slowly than we are anticipating, and instead of December of 2016, it’s six more months. And because of disappointments with the timing, you have a drawdown before that, but we wouldn’t expect more than drawdowns or an extension of the timing.

Argentina’s sovereign balance sheet is healthy and supports our spread targets
Spread compression. Here we can actually see Argentina’s net debt to GDP of 17% and gross debt of 43% The difference between the gross and the net is that Argentina’s pension funds fundamentally hold the difference in that debt. So it’s debt to the Argentine pension system.

We can see that Argentina from a balance sheet perspective is clearly in line with the other Latin American countries in the table and you can see that those Latin American countries are trading in a range of spreads from a low of 145 for Mexico or a high for 351 for Brazil.

The other thing that is interesting to see is that after 2017 in which they matured $8 billion, which is less than 2% of GDP, we also don’t have any significant maturities for the next 5 years, and a spread of 500 bps implies a probability of default in 5 years of near 31% with a haircut of around 70%. We think that once Argentina remediates this default, the probabilities of defaulting again within the next 5 years are very low.

There is additional potential upside from Shale resources
There is additional upside from shale resources that we are not including in any of our projections. Argentina ranks number two and number four in the world in technically recoverable and all the resources according to the International Energy Agency.

We believe that the realization of upside depends on adequate regulatory framework that we don’t have yet and international prices. International prices for oil, not so much for gas. The domestic regulatory framework needs improvement. However, natural gas is less vulnerable to low international oil prices.

Argentina’s energy matrix and energy deficit are both concentrated on gas. Additionally, natural gas represents 83% of total non-conversional resources and a significant room to replace more expensive imports.

The first thing that needs to be clarified on the oil regulatory framework is the price. Currently in Argentina, oil is priced at $77 which is very convenient for producers, but producers will not do large-scale investments in oil with this $77 in mind, with a government that is changing and can change the framework overnight. The first thing that needs to be done is the clarification of the framework by the next government.

Investing in Argentina with MBA-Lazard is less risky than it seems
We generally get the feeling that investors believe that investing in Argentina is very, very dangerous. We want to try to convince you that investing in Argentina with us is less risky than it seems.

Performance history of the strategy
Our worst year since inception almost 12 years ago was 2008, as with most of the other hedge funds and we lost 6.9%. In August when most markets declined considerably, we were up an estimated 1.5%. Our net equity exposure has averaged only 9.6%. Our Argentine peso exposure has averaged only 8.2%. The assets of the fund are kept outside Argentina with our prime broker Credit Suisse.

We have used leverage only 15% of the time an average gross long exposure during that period was 124%. Since inception average gross long was only 72%. We are currently hedging against an increasing U.S. rate, so our modified duration for the whole portfolio is 0.3, and there is a solid institutional platform provided by MBA Lazard Argentina.

The track record extends to 12 years and our compounded annual return has been 11.3% with a volatility of 9.3 and a Sharpe ratio of 1.08. Our worst year was 2008 with a loss of 6.9%.

The above is a transcript of a presentation made at the 4th FERI Hedge Funds Investment Day, held in Bad Homburg, Germany on 10 September 2015.

Andrés Pitchon joined the firm in 1993 as the Head of Equity Research for Argentina for MBA-Salomon Brothers and was later responsible for fixed income research as well. Since 1997 and 1999 he managed MBA’s equity and fixed income mutual funds respectively, with excellent performance, keeping both funds within the top 3 in Argentina. Since 2003 Mr. Pitchon has been the senior portfolio manager of MBA’s hedge funds. Mr. Pitchon has an outstanding track record of more than eleven years. Bloomberg ranks MBA Latin America Opportunity fund top 10% over the last 5 years. Mr. Pitchon received a BA degree in IT, focused on Business Administration from the University of Belgrano, receiving also the academic merit medal for reaching the highest GPA ever in the school of technology. Mr. Pitchon also received a Masters of Business Administration from Anderson Graduate School of Business at UCLA.