Latin American mutual funds are making beautiful music this year after lagging the broad U.S. stock markets for much of the past 10 years.
Funds tracking stocks in Olympics-host-to-be Brazil, as well as in Mexico and other Latin American countries, are up 31.05% on average so far this year, going into Friday, according to Lipper Inc. That's attracting a very thorough look-see from investors who are seeking gains in the diversified portion of the portfolios.
Latin American funds are dramatically outperforming U.S. diversified stock mutual funds, which are up 4.86%. And they don't raise the volatility red flags of a category that is outperforming -- precious metals sector funds, which have more than doubled in value this year with a 120.25% gain -- but are more vulnerable to a wild roller-coaster ride going forward.
How so? Latin American stocks have a three-year standard deviation of 23.75 as of June 30. That means in about 68% of the time over the next two years, their annualized return is expected to be between -31.99% and 15.51%, based on their current three-year average annual return of -8.24%. Gold funds have a standard deviation of 41.59, so they should be nearly twice as volatile.
The main question is, can the region's funds keep up their hot Latin beat? That depends on whether the drivers that carried them this far this year still have some hot salsa left in their serving bowls.
Patricia Ribeiro, lead manager of $550 million American Century Emerging Markets Fund ( TWMIX ), which had a 13% weight in Latin American stocks as of March 31, says the odds hinge a lot on what happens in Brazil, the region's largest single market, in the next six months.
Brazil stocks have been buoyed by positive investor sentiment amid economic and political reforms pushed by the successor to President Dilma Rousseff, who was suspended for six months in a corruption scandal.
Brazil's replacement regime has about six months, Ribeiro says, to show voters it can improve their lives economically. If it does not persuade them of that, support for reforms is likely to decline. "Then we could see disappointment and a correction" in Brazil, she said.
What's Been Driving The Region
Will Pruett, manager of $549.4 million Fidelity Latin America Fund ( FLATX ) and its advisor-sold sibling ( FLFAX ), cites five reasons for Latin American funds' surge this year.
First, Latin American funds are rebounding from a dismal 2015, when they lost 29.71% on average. Also, they are benefiting from a rebound in the Brazilian real. Reflected in the performance by WisdomTree Brazilian Real Strategy ETF ( BZF ), the currency lost 25.58% last year. This year the fund is up 29.44% going into Thursday. "And Brazil basically accounts for about 50% of the MSCI Latin America index," he said.
Pruett's third reason: Oil and other commodities have rebounded this year. Brazil is a major commodities producer, and the price per barrel of light sweet crude oil is up 24% this year.
His fourth and fifth reasons are the ouster, at least temporarily, of soaked-in-scandal Brazilian President Rousseff and the market-friendly reforms being sought by her successor.
Fund Managers' Outlooks
American Century's Ribeiro says she invests company by company, not based on countries.
Still, two countries where she feels most likely to find prospects now are Brazil and Mexico. "In Peru, the (national) elections went well," she said. "There's a more business-friendly president (Pedro Pablo Kuczynski) coming in, so that's positive. Mexico continues to do well on its own and is a big beneficiary of America doing well.
"Brazil's new president is more market-friendly. One thing he is doing is privatizing some companies that were run into the ground by the previous regime, such as Petrobras ( PBR ) (the oil company in which the government owns a majority stake). We've already seen that in the price of the stock. He's doing a similar thing with Electrobras (the electric utility in which the government owns a majority stake). (President Michel Temer) said he wants it to focus on market prices so it can operate profitably, and not be used as a tool for fighting inflation (by providing subsidized electricity)."
Since June 1, shortly after Rousseff's suspension from office, Petrobras is up 40% going into Monday. Electrobras has appealed an SEC decision to delist its ADRs.
Brazil and Mexico are the region's largest markets, and their stocks generally have the most liquidity, she says. "Columbia and Peru also have good companies, but liquidity can be an issue," she added.
Raia Drogasil, up 79% this year, illustrated Ribeiro's strategy as of her latest disclosure. "It's a chain of pharmacies in Brazil," she said. "It's been in the portfolio about a year. They are doing well regardless of the macro environment."
The stock benefits from the secular trend of an aging population that is consuming more drugs. Also, the company is opening additional stores. And Raia Drogasil got a shot in the arm from recent government approval of price hikes for prescription medicines. "At the same time, they are training their personnel and looking for products that will attract people into stores," Ribeiro said. "And the company is in the southern part of Brazil, where purchasing power is higher than in the north."
ADRs for Brazil's Ultrapar Participacoes (UGP) are up 40% this year. Ribeiro said: "They have gas stations in Brazil and convenience stores in the gas stations, so even if consumption of oil and gas slows, they have sales and benefit as they grow their number of gas stations. Also, they've renovated their stores. They have positive trends."
A third Brazil holding, Odontoprev, is a dental-services provider that is up 45% this year. "(Consumers) pay every month, then whenever you need a dentist you go to one in their network and get service at a cheaper price," Ribeiro said. Many of Brazil's dentists, who can't fill their own schedules, subcontract their services to the chain.
Also in Brazil, Fidelity's Pruett said, "The education space is interesting. Several (for-profit university) stocks are reasonably priced. The benefit to consumers is better than anywhere in the world. The average graduate makes 2-1/2 times more than he did before going through the program. The focus is on engineering, nursing, business."
The boards of two holdings, Kroton Educacional and Estacio Participacoes, have agreed to a merger.
And Pruett cites customer-loyalty program stocks, Multiplus and Smiles. "They are capital-light" -- meaning they require less capital expenditures -- "generate a ton of cash, are cheap and benefit over the long term from the switch to credit card payments from cash and to electronic payments."
Among Ribeiro's non-Brazil holdings, Alsea is up 17% this year. It runs several restaurant chains in Mexico and is a food distributor. Its franchises include Domino's Pizza, Burger King, Chili's Grill and P.F. Chang's. "The Mexican economy has been on a positive trend in the last two years," Ribeiro said. "So people have gone out to eat more." Also, the company has been aggressive about acquiring additional chains and restaurants, leveraging Mexico's economic growth, she added.
ADRs of airport operator Grupo Aeroportuario (ASR), up 10% this year, have also benefited from Mexico's GDP gains.
Among Peru stocks, Fidelity's Pruett held Credicorp (BAP) as of his latest disclosure. Its ADRs are up 62% this year. "It's the largest listed company in Peru and the No. 1 bank in that market," he said. The ADRs have IBD's Composite Rating of 94. The Composite Rating, which peaks at 99, combines IBD's five performance ratings, including EPS and Relative Price Strength ratings. Stocks poised to move higher often have a high Composite Rating.
Mexico's Grupo Financiero Banorte is up 6.76% this year. "The problem in Mexico is finding reasonably valued businesses," Pruett said. "I'm finding more value in the financials, and Banorte is one of the larger banks in the market."
Going forward, Pruett is focused on individual businesses with attractive fundamentals rather than whether a broad regional trend of outperformance can continue. "I look for businesses with high market share, low competition, where market penetration is low (which leaves companies room to grow), and whose corporate governance is good," he said. "And whose valuations are quite reasonable as well."
But Pruett also thinks the region depends on Brazil, and in Brazil a political fuse is burning.
"(In) the short term, the market is driven by things like sentiment and liquidity flows, which are impossible to predict," he said. "In the medium term, which is my time horizon, it comes down to structural reform. If (President) Temer can show progress toward fiscal reform, social security reform, tax reform, subsidy reform, labor reform, tariff reform and so on, then they have a chance at improving competitiveness and driving GDP potential higher."
But Pruett is not betting on Brazil's success. "(The) clock is ticking, given local elections in October and presidential elections around the corner in 2018. I remain skeptical they'll be able to make meaningful headway. But if they do, then Brazil may be able to unlock greater growth, which could drive the market higher over the medium term."