Argentina Investment Focus: Part III - Sector Policy

Sector policy has influenced valuations by affecting relative prices and income through at least three tools: Exchange Rates, Taxes and Regulated Prices.

Reforming the status quo of sector intervention creates clear winners and losers, even if it generates an overall rising tide, making it particularly challenging to modify. Unlike asset price dislocations based on the restrictions of capital detailed before, most of this sector dislocations are partially built into asset prices. However, some sectors combine both the characteristic of having limited access to capital markets and being well poised for a shift in sector policy. 

The real exchange rate of Argentina is at its lowest level in more than a decade, driven by high inflation and an intervened nominal exchange rate. As a result, exporters have been severely hurt by rising costs and falling volume. Producers for the local market that would have been hit by falling real prices of competing import products have been protected by import restrictions.

A normalization of the exchange rate at a higher rate is probably a prerequisite for the liberalization of the capital account. Given how important this is to foster foreign investment,I believe there is a good probability that this policy shift will indeed take place.

Argentina Multilateral Real Exchange Rate

Source: Elypsis Web

The sector that has suffered the most because of government tax policy has been farming where exports pay a steep 35% levy on FOB prices. Reforming the tax code to benefit farming as a whole would be a very bold move with little positive short term effects and a high financial cost for the government. Consequently, I do not believe that the reduction of export taxes across all crops will be part of the reform package for at least a few years, although some of them might get a reduction.

On the other end of the spectrum, the electronic goods industry has received significant government assistance in the form of subsidies, tariffs, restrictions on imports and an impulse to internal demand. The industry creates a lot of jobs and would be very sensitive to external competition, so radical reform could only happen on the back of a very strong economy. However, a wind-down of some of its many perks or on some of its products (i.e. computers) is likely as it would have immediate positive effects for consumers.

Pampa ADR Stock Price (US$)

The government has also kept the regulated prices of some sectors, like energy generation and distribution, below market prices. In generation, this has come coupled with a two-tier system whereas "new" energy (not clean, just new) is rewarded with a higher rate than "old" energy. The government pays old energy just the marginal cost to guarantee continuing production while promising new projects higher rates to justify the initial investment. Rates for new energy are higher than they would be in a one tier country and vice-versa. Given Argentina´s need for an increase in electrical generation investment, new energy prices will probably remain in place, but the unification of the market would be costly for the government without much short and medium term benefit, but that of the symbolical value of a "normalization".

In the distribution side, households have been subsidized by a mix of low prices by distribution companies and government subsidies. Subsidies have resulted in a higher electricity demand and will probably be diminished to both reduce that demand and save the government some cash. The low prices charged by distribution companies would also come up since there is no two tier system and investment in the sector is much needed, but will probably not be priority in the short term with rate hikes already in place.

In summary, sector policy will probably change, but those who expect an immediate change of all government policy are minimizing the short term effects of such reforms. We expect a normalization of the FX market, little changes to taxes and a reduction of subsidies but not a total "normalization" of tariffs.

Conclusion

Irecommend investments in

- Sovereign Fixed Income
- Large land plots
- Large Block Real Estate (i.e. Shopping Malls)
- "New" Energy Generation; very opportunistically old
- Exporters, though not soybean farms: food, software, mining, bpo

Argentina Investment Focus: Part II - Capital Controls

Capital controls were enforced in Argentina with full force 5 years ago restricting the transfer of funds abroad (the "cepo cambiario"). This measure has had the double effect of inhibiting foreign investors from entering the Argentine market and restricting Argentine investors and firms to investing their savings at home or accessing the illegal or contado con liqui markets.

Unlike a settlement with the holdouts, a freeing of the capital account is not an easy task since it would require the realignment of many macroeconomic variables that, if not approached in a smart, programmatic manner, could lead to a severe currency run or rampant inflation. Furthermore, some of these measures are not sector neutral and would suffer from much opposition from jeopardized actors (i.e. fx and its effect on importers and exporters). The probability that these measures will be implemented is high, but far from guaranteed.

The withdrawal or reduction of capital controls would have a significant impact in FDI and would serve as a driver for investment in private assets in a similar fashion as a settlement with the holdouts would for investment in publicly traded assets: investments would start actually yielding to foreign investors. For exactly the same reason as before, this reform would drive an increase in valuations across the board.

However, these restrictions have also created severe price dislocations because of the difficulties of the local Financial System to direct capital efficiently. Since capital has been forced to stay within the country, these dislocations have been amplified.

The Financial System in Argentina is very ineffective at articulating savers and investors.  As an example, private debt represents only 15% of GDP against 69% in Brazil and mortgages are close to nonexistent. Coupled with capital controls that restrict foreign capital and a lack of liquidity events for local groups, this has restricted investors to direct retail investments that make it very hard to finance big and long projects.

Sources: Central Bank of Colombia, Central Bank of Chile, Central Bank of Brazil, Central Bank of Argentina

Consequently, capital has flooded the markets where individual investors can atomize their investments and access liquidity relatively easy (i.e. residential real estate), but stayed away from investments which are sizeable, (i.e. infrastructure, utilities) and long-term with low current yield (i.e. significant land plots).

Empirical data is consistent with this hypotheses. Residential real estate is yielding Cap Rates of ~4%, similar to New York City with small studio apartments yielding even less, while big shopping malls are acquired at ~5pp spreads to similar assets in the US for a total return in the low teens.

The return of Argentina to global capital markets where significant pools of capital are easier to articulate would result in higher demand for big-scale, long repayment, hard to atomize assets. Furthermore, a gradual reform of the Financial System would also favor such a focus.

Argentina Investment Focus: Part I - Sovereign Risk

On December 10th Argentina will have a new president. We do not know yet with certainty who will be sitting on the “sillón de Rivadavia", but we do know it will be someone new. A lot of investors have been betting on the new policies that will come along with this change, rallying with the increasing prospects of politic and economic reform: Massa running for parliament in 2013, Macri coming close second in the first round or Scioli showing his willingness to negotiate with holdouts.

So, if one believes that Argentina will effectively undergo reforms that will make its economic regime converge to that of its neighbors, where should then investors focus their capital?

The bullish view for Argentine assets is based on the fact that a new more market-friendly government would take the steps that would lower the country´s sovereign risk spreads and eliminate current capital controls; both things would have an immediate impact by reducing discount rates that would boost multiples and valuations. However, capital controls have come coupled with an array of local sector measures and realities that have not only diminished the value of asset values, but also generated severe price dislocations that make some assets more attractive than others under the light of foreseeable reform.

Since there are very few publicly traded assets and recent relevant transactions, the search for value needs to be pursued based on the general conditions that generate attractive investment opportunities in a sector, rather than a standard valuation approach..Through a series of 3 articles I will analyse the big forces in play for the Argentine valuations' recovery story and the best strategy to invest in it:

i)Sovereign Risk
ii) Capital Controls
iii) Sector Policy

Sovereign risk has been high due to successive hostile measures towards investors: default, cheating on inflation-linked bonds, hard nosed hold-out negotiations, nationalizations. A settlement with the holdouts and a change of the economic policy team would very likely immediately reduce spreads as Argentine bonds start actually yielding to investors worldwide and the prospect of further reform starts looking more likely to investors.

There is very little short-term economic cost for reaching an agreement with the holdouts since it would allow the government to access fresh financing at lower rates and the cost of the settlement will very likely be due in kind, generating only a minor uptick in the total debt level. Someone might debate whether a settlement is economically beneficial for the country in the long term since its cost is very material, but it is very hard to argue against the positive economic short and medium term effect for the new administration.

However, it does come at a political cost since the current administration has portrayed the standoff with the holdouts as a patriotic gesture that generated a lot of empathy with the electorate and will fight any agreement that does not include a significant reduction in the total debt.

Recent comments by Daniel Scioli, the candidate that was perceived as the least likely to settle, confirmed his willingness to negotiate a deal with the holdout debtors. There is a very high probability that a deal will be promptly reached by the next president and this is already partially built into valuations.

All assets would be boosted by such an outcome, both because of its impact in the cost of capital of any Argentine asset and the indirect implications about further reform, but private assets will be boosted less without a softening of capital control restrictions. Were further reform not to happen, the biggest winner of this seldom measure would be sovereign fixed income, since it is the asset that best captures the isolated effect of the settlement.

Investments focused on a change in sovereign risk are an Argentina risk-on/ risk-off bet, and do not aim to profit from dislocations among asset classes within the country. Capital Controls, presented in our next delivery, are a bit more complicated.

Can Active Managers Outperform?

How to invest can sometimes be more important than where to invest. That is why looking at the rationale to invest in active or passive strategies  is highly relevant

The ability of managers to over-perform the market is the source of much debate in the Financial Economics discipline because of the underlying debate on the validity of the Efficient Market Hypothesis. The consensus is that the degree of over-performance a manager can achieve is related to the level of inefficiencies in the market it operates in. Illiquid assets are usually associated with higher inefficiencies, as shown by the higher dispersion of returns on Venture Capital, LBOs and Real Estate (basically Private Equity), because of the higher valuation uncertainty. 

Furthermore, in Private Equity there is a big set of  evidence showing that fund managers that outperform the market consistently do so over successive funds: it is not only the volatility of returns that drives the differences, it is the difference in skills among managers.

Therefore, good fund managers can greatly outperform the market in these asset classes, making a solid case for active investments through funds.

Publicly traded asset classes such as stocks and bonds show more concentrated returns across asset managers with lower after-fees persistence in returns. The main driver in these markets is the return of the benchmark. Consequently, good asset managers perform similarly to bad ones and they usually barely justify the fees spent on them. 

Private Equity assets are also the ones where it is harder to diversify a portfolio of direct investments passively since minimum tickets are usually sizeable, there are no direct investment diversified vehicles and the costs of analyzing and selecting deals is very high. 

Publicly traded markets provide easier ways to have a diversified exposure to a whole array of individual assets across an asset class through ETFs or directly investing in the individual assets. Consequently, investing in active funds does not provide diversification advantages over passive funds. 

I avoided talking about Hedge Funds on purpose because their case is more difficult. On average, Hedge Funds exploit the inefficiencies of liquid markets, but they amplify these differences by deviating from benchmarks, using leverage, beta neutral strategies and many other non-conventional tools. There is no passive way to do a Hedge Fund, so there is no way to avoid them and get exposure to their strategies.  Risk-adjusted returns analysis for HF is very hard to perform since they use non-linear trading strategies; but most evidence is consistent with pointing out that they do not outperform the market on a risk-adjusted basis. So, the decision here is not whether one should get active or passive exposure to HFs strategies, but whether one should invest in HF strategies at all. A debate for a different entry. However, I do believe that HFs are a more sensible way to search for alpha in public markets than regular mutual funds since they have enough discretion to do so.

Conclusion

To sum up,on average, it is better to invest with active managers in illiiquid, inefficient and volatile markets (Private Equity, Frontier Markets Equities, Frontier Markets Debt, Emerging Markets High Yield. etc) and to invest passively  in liquid, efficient and stable markets (Large Cap, US Treasuries). 

Has Buenos Aires become an IT hub?

The positive Network Effects of Clusters are a cornerstone of modern geographic and development economics. The concept is pretty intuitive: having a lot of companies in the same industry creates a pool of talent, buyers and suppliers that simplifies the establishment of new similar companies in the same place. Therefore, acquiring a critical mass of companies is crucial for the future development of the industry.

In IT, the main advantage of these clusters is the reduction of the acquisition costs of talent. Someone has already done 95% of what an IT company is doing; acquiring people with the right capabilities and experience lets you jump ahead of the competition. The most famous cluster in IT and innovation is, obviously, the Silicon Valley. It is not only for ideological reasons that the Valley has been pushing so hard for changes in the immigration policies and the JOBS Act.

It is very hard to know what is the minimum size required to call a place a hub: you know one when you see one. But the most important characteristic of an IT hub is the access to talent when building a new company in the sector.

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Buenos Aires has been an important software and IT services center for a long time. Almost 90% of all the Latin American start-ups of the 90s where originally from Argentina. The country still has one of the most literate populations in the continent.

Furthermore, it has picked up significantly duriing the 2000s, with sales growing a fivefold since 2003 and standing today at a staggering USD 4 Billion. Buenos Aires and its suburbs concentrate ~70% of the more than 1400 companies in the sector. A lot of them provide IT Services , but 52% of them are pure software development companies.

ICT Sales, Exports and Employment in Argentina

Source: OPSSI - Semi-annual report on the Software and IT Services Industry in Argentina. Seprtember 2013

Even if  significant for a country with a USD 470 Biillion GDP like Argentina, the ~50.000 employees in the sector in Buenos Aires are very small when compared to the Silicon Valley where ~300.000 people are dedicated to the industry and 150.000 people are dedicated to innovation. Moreover, most of the firms in the SV are dedicated to software development (vs 50% in Buenos Aires) and their employees have a better education and perform more sophisticated non-standarized tasks. So, no, Buenos Aires is not the Tango Valley.

However, the city does have enough resources to be a hub in some sectors. Buenos Aires is the home town of the two biggest IT companies of Latin America and they are both in Consumer Internet: Mercado Libre is quoted at a USD 6 Billlion Market Cap on NASDAQ.and Despegar was valued at ~USD 1 Billion in recent private transactions. These companies are creating a huge pool of knowledge in the sector and it is empowering new ventures like OLX, the Craiglist of Emerging Markets with presence in over 100 countries that was founded by the owners of De Remate, a competitor bought by Mercado Libre.

The city also has some sectors that are gaining significant traction like video-games with more than 70 companies and 1000 employees, where 72% create their own IP. Another relevant sector is Business Process Outsourcing, where Globant alone has USD 120 Million in revenue.

The high level of development in some sectors and the nascent status in some others makes public policy all the more important to capture the full value of the network externalities. The most obvious thing Buenos Aires needs for this industry to develop is a stable macroeconomic environment in which to operate. Even if, as we have written in previous blogs, the VC industry can circumvent most of the red tape, most of the IT industry is not VC material and is highly sensitive to the business environment. The other main driver of the industry is education since, as we have discussed earlier, talent is the most important asset. Finally, the state could help industries export their services and connect with each other.

In conclusion, the software sector in Buenos Aires is far from the biggest international IT hubs. However, it is a world-class hub in Consumer Internet and it has the potential to be a hub in the whole industry if public policy gives a helping hand.


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Thank you to Gabriel Wallach and Marcos Amadeo from the Government of the City of Buenos Aires for their assistance with the data

Venture Capital in Latin America over the next decade

Latin American Venture Capital will remain attractive for investment in the middle of a deceleration of the Emerging Markets in general and of the BRICs in particular. The appeal of its Copycat Ventures continues in place due to its still high growth and large market size; while the appeal of its Innovative Ventures grows because of a maturing ecosystem, backbreaking growth on R&D and Education Investment and active Public Policy to promote Innovation, Entrepreneurship and Venture Capital.

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As we discussed in a previous posts, Venture Capital in Latin America has mostly focused on Copycats that replicate and adapt US business models in their local markets (i.e. Mercado Libre/ Ebay, Despegar/ Expedia). Over the past ten years there has been a surge in the interest for these investments with key GPs (i.e. Redpoint, Burril, Sequoia) and LPs (i.e. Horlsey Bridge, Silicon Valley Bank, Cisco) entering the Region with a focus in Brazil.

VC Investmet Distribution in Latam

Source: Axia Ventures Proprietary Analysis

This growing interest was the consequence of Latin America´s high growth, Brazil´s new role in the world as a key market and a member of the BRICs and the successful Copycat Ventures of the 90s.

Today, the main driver of the growth of the last 10 years in the region is not there anymore: the rise in in commodity prices is slowing down as China rebalances and reduces its growth. Furthermore, the increase in asset prices via reduced risk spreads caused by institutional improvements has evaporated since spreads have compressed to almost zero.

Therefore, the growth of Latin America over the next few years will not come from the rise in commodities; it will come from productivity gains. Productivity gains in Latin America could be achieved by raising the capital and technological intensity of production, specializing through more trade or innovating.

In this context, the decision by the Pacific Alliance (Chile, Colombia, Peru, Mexico) to create a regional free-trade market for their already open economies has been appreciated by the markets that believe such strategy is a cornerstone of future growth and a sign of a willingness to eliminate red-tape that will allow for higher capital efficiency and intensity. Although we agree with this view, we believe that the region as a whole will continue to grow at a higher pace than developing nations because it is still far from the capital and technological frontier and it has stable institutions in a converging world. This is the fundamental secular reason to invest in the region since the rest of the issues will prove cyclical (i.e. politics). Most International Economic Organizations are forecasting Latin America to grow at a 6% CAGR over the next five years, 50% higher growth than the Advanced Ecomies.

Source: IMF World Economics Outlook

Furthermore, the valuations in the region have already adjusted to the slow-down of the past 2 years, paving the way for further gains by riding the growth in multiples and diminishing the downside risk. Low entry multiples have been one of the most important conditions for high PE and VC returns over the decades. Jim O'Neil, the former Goldman Sachs guru that coined the BRIC term in 2001 and predicted the emerging markets rally, says the selloff has made the Emerging Markets "very attractive".

Consequently, we believe that investing in Copycat Ventures in Latin America continues to be a sound investment due to Latam´s big and growing market and its discounted valuations and costs.

Source: Yahoo FInance

But above all, we believe there is a great story to invest in Innovative Ventures in Latin America. The Region has doubled its R&D and Education Investment over the past 6 years, on the back of growing GDP and the increasing relevance of Innovation Policies. However, there is very little capital pursuing these opportunities since there are no key innovation hubs in Latin America when looking at it on a single city or country basis. 

Source: OECD

Innovation Policies in South America

Sources 1) 14/03/2013 – FINEP- Launch of Plan Inova 2) http://www.finep.gov.br/inovaempresa/ 3) Financial Statements 1H 2013 4) Colciencias 5) MINCyT 6) “Fronteras en Biociencia" 7) Cumbre Latinoamericana de Innovación 8) Josh Lerner and Ann Leamon – Harvard Business Review

This is starting to change because R&D and Education are cumulative long-term investments that are starting to show the results of a decade of hard work and Rio de Janeiro, Medellin, Santiago de Chile and Buenos Aires are aggressively trying to position themselves as Innovation Hubs with a global competitive mindset. The Region is already producing some top-notch innovative companies like IndexTank, CVDentus, Amyris, Ciencias para la Vida, Keclon or Bioceres.

These opportunities are coming at very competitive valuations today because of the lack of capital for such investments, the recent steep decline in foreign exchange rates and the competitive pricing of technology experts and scientists. Those investors prescient enough to invest in this embryonic part of the Latin American VC ecosystem will get rewarded in kind. 

To exploit these opportunities consistently as a Venture Capitalist, a Latin American geographic and a generalist industry approach are necessary since only then will the Deal Flow have enough depth to make an Innovative Fund viable. Also, Innovative Ventures need to have Validation from Key Innovation Hubs and Business Development in the Advanced Economies. In the past, this would have been a great difficulty; but in an integrated digital world it is actually an opportunity since it creates a global company from day one.

To sum up, Latin American Copycat Ventures are still a sound investment since the Region has a big market that will continue to grow. But we also believe that there will be a growing success story in the Innovative Ventures of the Region.

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Thank you to Lisandro Bril -Managing Partner of Axia Ventures- for his collaboration on this piece

Globant. A new Latin American IPO. Another Argentinian

Yesterday, Globant filed for an F-1 with the SEC to raise USD 86 million in an IPO in the NYSE, the second Latin Tech Company to have that privilege along with Mercado Libre, another Argentinian company. Paradoxically, this happens the same week that a New York court ruled against the Argentinian Government for the restructuring of its defaulted debt.

http://www.sec.gov/Archives/edgar/data/1557860/000114420413048053/v350224_f1.htm

Globant is a symbol of Argentina´s renaissance after its 2001 crisis. Founded in 2003 as an outsourcing IT services firm, it took advantage of the abundance of talented and trained people in Argentina that were available at the cheap after the crisis and the threefold devaluation.

Since then, Globant has evolved its offering by providing more sophisticated services to its clients and refining its financial structure compensating for the loss in competitiveness of the increasing USD costs that the recovery brought with it and the complexities of the highly volatile Argentinian labor market.

Its current revenues stand at a staggering USD 120M with 82% coming from US clients like Google, Electronic Arts, Linkedin, Cisco or Coca Cola. Their revenues have grown at a 50% CAGR over the past 3 years.

The company´s bredath of services and geographies and their strategic stand in the IT sector have prompted WPP -the world´s biggest advertising company by revenues- to invest in the company and it now owns 21% of the company.

The only stain on their balance sheet is the USD 1.3 million recorded loss in 2012 which they attribute to USD 11.7 million share-based compensation charge; but it was probably also due to the high real exchange-rate fluctuations in Argentina. In 2013, they established a different compensation mechanism for exchange rates via bond purchases and they have already recorded USD 8 million earnings in the first 6 months.

The company is not alone in the world of successful technology companies of the 2000s from Argentina: Despegar is headed for an IPO, Restorando raised a 12MM Series B, Technisys is growing very fast and headed for a Series B itself, Onapsis is growing at amazing speeds in the US...

All in all, Globant´s success is a living proof that there is a lot of competitively priced talent in Argentina and that, with a management team capable of navigating the country´s financial instability, there are big opportunities to invest in its world-class technology sector. Those who decide their investment allocation based on political headlines alone are bound to miss out on a lot of opportunities.