Latin America Equity Research 12 November 2010 LatAm Year Ahead 2011 Stay Invested Head of Latin America Research Ben Laidler AC (1-212) 622-5252 [email protected]J.P. Morgan Securities LLC Contents Strategy .........................................................5 Sectors.........................................................49 Economics and Commodities ....................113 LatAm Data ................................................135 For a complete list of contributors to this report, please see table of contents on page 3. See page 158 for analyst certification and important disclosures, including non-US analyst disclosures. J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.
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LatAm Year Ahead 2011 - Rede Globocolunas.cbn.globoradio.globo.com/platb/files/621/2010/11/JP-Morgan-Latam20111.pdfBuenaventura Peru (1) Eletropaulo Brazil 0 Source: J.P. Morgan. Note:
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Contents Strategy .........................................................5Sectors.........................................................49Economics and Commodities ....................113LatAm Data................................................135 For a complete list of contributors to this report, please see table of contents on page 3.
See page 158 for analyst certification and important disclosures, including non-US analyst disclosures. J.P. Morgan does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision.
LatAm Year Ahead 2011 — Stay Invested What to own • Brazil
• Colombia
• Argentina
• Off-Index
• Discretionary
• Financials
• Telecoms
Focus on sectors within countries rather than country recommendations.
What to avoid • Chile
• Peru
• Materials
• Utilities
• Staples
A detailed view of our country and sector recommendationswithin LatAm is available on page 14. For more detail please see country and sector pages.
10 Top Analyst Picks
(See page 16)
Top Picks Country To PT (%) Vale Brazil 49.4 PDG Realty Brazil 41.6 Cemex Mexico 35.7 Bradesco Brazil 34.9 Santander Brasil Brazil 34.7 Corporacion Geo Mexico 32.3 ICA Mexico 32.1 Grupo Mexico Mexico 31.1 Copasa Brazil 29.0 Brasil Foods SA Brazil 26.9
10 Stocks to Avoid (See page 17)
Stock to avoid Country To PT (%) Ecopetrol Colombia (36) SQM Chile (28) Grupo Financiero Inbursa Mexico (24) Telmex SA Mexico (21) Fibria Brazil (13) CPFL Energia Brazil (6) IAM Chile (4) Bancolombia Colombia (2) Buenaventura Peru (1) Eletropaulo Brazil 0 Source: J.P. Morgan. Note: To PT = Returns to analyst price target from 28 Oct 2010.
The year-ahead process The goal of this document is to present our key strategy themes for 2011 using most- and least-favored stocks from J.P. Morgan’s LatAm equity research team.
This 150+ page handbook includes strategy sections from our country strategists as well as overviews on the outlook for each major company sector and the analysts’ top picks and stocks to avoid for the year ahead. Analysts were asked to pick 1-2 large cap stocks that should lead performance in 2011 as well as a large cap stock they expected to underperform. We are positive LatAm into 2011. Macro fundamentals are robust, credit conditions very supportive, EM fund inflows expected to remain strong. Valuations are not stretched, and the earnings backdrop robust. Risks range from the fiscal and interest rates outlook in Brazil, to the security situation in Mexico, and the presidential elections in 2011 in Argentina and Peru. Capital control risks also remain real, especially in Brazil.
LatAm Strategy We are positive LatAm into 2011. Macro fundamentals are robust, credit conditions very supportive, EM fund inflows expected to remain strong. Valuations are not stretched, and the earnings backdrop robust. Risks range from the fiscal and interest rates outlook in Brazil, to the security situation in Mexico, and the presidential elections in 2011 in Argentina and Peru. Capital control risks also remain real, especially in Brazil. We are overweight Brazil relative to MSCI LatAm index, as valuations are reasonable, flows returning, and market overhangs – such as the Petrobras offering and the presidential election – are lifting. We also see outperformance from Colombia and Argentina. We are neutral Mexico, and underweight Chile. We focus on domestic stocks for which we see good growth and reasonable valuations, such as financials and homebuilders.
Fundamentals to remain robust: 2010 and 2011 GDP growth expectations have been rising, and are above long-term potential GDP growth. This has been supporting the earnings revision cycle. Inflation expectations have also been rising, and Central Banks are expected to gradually tighten policy in 2011, within the constraint of appreciating currencies but partly offset by output gaps remaining in some countries. Long-term REERs point to the undervaluation of the Mexican Peso, and overvaluation of the Brazilian Real. For more on economics team’s view, please see Latin America Outlook Presentation.
LatAm GDP outlook 2010e 2011e Long-term Forecast Current Forecast Current potential Jan-10 forecast Jan-10 forecast GDP growth
2010e 2011e Forecast in Current Forecast in Current Jan-10 forecast Jan-10 forecast
Latin America 7.2 7.3 6.8 7.3 Argentina 9.0 10.5 10.0 12.0 Brazil 4.7 5.4 4.6 5.1 Chile 2.5 3.8 3.0 3.4 Colombia 3.8 2.7 4.0 4.0 Ecuador 4.0 3.4 3.8 3.8 Mexico 5.1 4.8 4.0 4.0 Peru 2.0 2.4 2.5 2.5 Venezuela 40.0 33.0 40.0 35.0
Source: J.P. Morgan Economics.
Credit conditions remain supportive: This could support a meaningful multiple rerating and increased equity fund flows and is already altering corporate behavior. The strong outperformance of EM corporates has significantly improved relative valuations. The lower LatAm cost of equity has pushed up ‘fair value’ for stocks. Regional corporates are responding by releveraging and stepping up M&A activity, and financials are boosting capital. EM corporates are seeing strong fund inflows. This is a mirror of what equities are seeing. We believe the drivers here are sustainable into 2011, with risk-free rates likely to stay very low, EMBI spreads tight, and the EM growth premium high. See our recent note for details: LatAm Strategy – Credit rally supports equities.
Cembi Latin HY Cembi Latin IG MSCI LatAm CEMBI LatAm Broad
P/E:CEMBI Latin IG - 19.5xCEMBI Latin - 17.4xCEMBI Latin HY- 12.6xMSCI LatAm - 11.9x
Source: J.P. Morgan, MSCI, Datastream. * 12m fwd MSCI LatAm P/E and inverse of J.P. Morgan CEMBI Corporate Bond Yields.
EM fund flows continue strong: Year-to-date equity fund flows into EM have exceeded US$70 billion, above the previous record of US$64bn in 2009. These flows have been focused on ETF products and on EM and Asia funds. Flows into LatAm, as proxied by LatAm funds, have been poor. Fund flows should continue strong, as both global equity allocations increase, EM allocations within global equities are built, and LatAm flows within EM recover as Brazil ‘overhangs’ lift. This is a phenomenon across the asset class and has arguably been more powerful in corporate and FX markets so far. We generally see this as another source of upside risk to multiples. Risk here is from issuance, which has been high. Please see our weekly fund flows product for details: Herd Instinct.
GEM fund cumulative US$bn flows
22.4
40.8
(39.4)
64.469.7
(60)
(30)
0
30
60
90
120
Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
2006 2007 2008 2009 2010
Source: EPFR Global.
2010 LatAm fund flows, US$mn
(2,500)
(1,500)
(500)
500
1,500
2,500
Jan 10 Feb 10 Apr 10 May 10 Jul 10 Aug 10 Oct 10
ETF Flow sTotal Flow s
Source: EPFR Global, J.P. Morgan.
Capital control risks: Virtually every EM CB has intervened, and a number already have controls. Pressure will likely continue, as we expect more FX appreciation, with US$ weakness to persist and EM inflows to build. We see ‘real’ capital controls, such as unremunerated reserve requirements and minimum holding periods, as unlikely. An increase in transaction costs – such as Brazil’s 2% equity IOF – is a last resort, but arguably near inevitable in this flows environment. It is not enough to change our positive view on Brazil, where the potential upside beats a moderate potential transaction cost increase. For details see our report: The threat from capital controls.
Other risks: Brazil fiscal and rates outlook. In the short term we await to see the composition of Dilma Rousseff’s first cabinet and the outlines of fiscal policy going forward. This is important as an early indication of the policy direction of the new administration at a time when inflation expectations are drifting higher and the economy is growing above potential. Mexico security concerns. Investor angst here is high. We see this as an unfortunate issue that detracts from growth (1-1.5%pa) at a bad time, with the economy weak. We believe greater concerns here are likely overdone, with violence localized and largely between cartels. The risk is that this spreads to Mexico City or cartels decide to openly target the State and civilians. The electoral calendar in 2011 is significant. Peru presidential elections are in April, with three centrist candidates leading in the polls and leftist Ollanta Humala currently 4th. He is likely to rise somewhat (and this could unnerve markets) though unlikely to ultimately prevail. Argentina also goes to the polls in October. The political environment has been thrown open by the unexpected death of ex-President Kirchner. This potentially opens the way for a more market-friendly candidate, possibly from within the Peronist party.
Valuations are not stretched: We do not see LatAm valuations as demanding, with most metrics within historical ranges or at discounts to peers’. LatAm is currently trading on 11.9x 12m forward P/E, compared to 11.6x for emerging markets and 11.5x for global equities. This 12m forward P/E is at the top end of the region’s 15-year average. As highlighted before, the current regional cost of equity would argue for significant multiple expansion from these levels. When comparing EM countries we are also careful to adjust for index composition. This makes commodity-heavy indices such as Brazil more expensive and staples-heavy indices such as Mexico and Chile somewhat cheaper.
Chile 16.0 17.8 (1.8) Mexico 14.5 15.3 (0.9) Indonesia 14.8 15.3 (0.5) Korea 9.9 10.0 (0.0) South Africa 11.8 11.7 0.2 EM 11.9 11.6 0.3 Turkey 11.4 10.9 0.5 India 17.7 17.0 0.6 Brazil 12.3 11.1 1.2 China 14.3 12.0 2.3 Taiwan 15.6 12.9 2.8 Russia 11.8 6.6 5.2
Source: MSCI, IBES, J.P. Morgan. Sector-neutral P/E multiplies the country sector P/E by the MSCI Emerging Markets Index sector weight.
LatAm enjoyed a strong earnings recovery cycle in 2010. We expect this to stabilize in 2011. LatAm earnings growth (local currency) is forecast at 21% for next year versus 15% for developed markets. This is a high number, and we see risks as balanced. Commodity earnings have been easing – especially in steels and Petrobras. Domestic earnings have been moving higher as GDP expectations are raised, and earnings remain below all-time highs despite higher nominal GDP growth. Forecasts for Mexico and Brazil are very similar (~20-21%).
MSCI Brazil domestic vs commodity 12m fwd earnings integer
60.0
90.0
120.0
150.0
180.0
Jan 07 Aug 07 Mar 08 Oct 08 May 09 Dec 09 Jul 10
Brazil Commodities Brazil Domestics
Source: IBES, MSCI, J.P. Morgan.
Attractive risk/reward for 2011 justifies continued bullish positioning. We run three valuation scenarios for 2011. The MSCI LatAm potential upside is 53% and the potential downside 14%. For details see our report: Measuring the risk/reward.
1. The positive view is that lower risk-free rates are sustainable for 2011, as we forecast, and this justifies further multiple rerating. This could be significant. Our Gordon-growth ‘fair’ value target is near 15.0x earnings, over 30% above current multiples. This indicator has tracked well historically. Upside here is concentrated in Brazil. This targets 53% upside for the region and 70% for Brazil. Mexico is penalized by a potentially too aggressive 2.5% potential GDP growth. 2. The mid-case assumes current multiples are fair, at the top end of long-term historical ranges, and consensus earnings growth correct, at a reasonable premium to nominal GDP growth. This targets respectable 18% upside, with all countries closely clustered. This would be our Mexico base case. 3. The cautious view assumes both a derating and that earnings fall. A derating scenario back to long-term historical multiples (down 14%, from 12.0x to 10.5x earnings) and a 20% fall in index earnings versus current expectations, as we assume earnings growth only in line with nominal GDP growth. This shows 14% downside for the region, led by Colombia, with Chile defensive. Our baseline view is somewhere between the more bullish two scenarios, looking for even lower Treasury yields and tight EM spreads, whilst the relative Emerging growth and earnings premium remain high, continuing to attract flows and support multiples. QE2 and recent developed market data have reduced downside tail-risks.
We remain overweight Brazil, with valuations significantly derated, strongly returning flows, and multiple overhangs (election, rate cycle, Petrobras, China slowdown) reduced. Fiscal policy and equity IOF risks remain but are manageable. The focus remains on domestic stocks, especially those with growth at reasonable multiples, such as financials and homebuilders. We have good growth visibility, the earnings revision cycle remains positive, and valuations ex-staples are all cheap/fair. Top-performing staples and retailers are expensive and will likely keep performing in this environment if they can continue delivering on earnings. However, this does not mean the risk/reward is attractive. We are selective and own CBD. We see cheap, underowned, but low-growth sectors – such as utilities and telecom – as value traps but have continued to selectively add where we see pockets of growth (such as NII Holdings and TSU). In our model portfolio, we are neutral energy (positive oil and E+P but cautious Petrobras), and underweight materials – we are positive Vale but own no Steels. The sector is cheap (though earnings are falling), underowned, and benefiting in the short term from perceived QE upside, though global growth remains subpar and the sector chronically oversupplied.
Brazil macro outlook
Source: J.P. Morgan Economics.
Brazil interest rate futures
9.510.010.511.011.512.012.513.0
Feb 10 Apr 10 Jun 10 Aug 10 Oct 10
Jan-11 Jan-12
Source: Bloomberg.
We are neutral Mexico. The market has performed well in the last month on signs of a bottoming in US growth expectations (we took our global growth numbers up for the first time since April) and moderate Mexican consumer acceleration. We do not see Mexico as underweight, with the market well supported by a gradual US growth reacceleration, high equity market correlation, undervalued currency, easy monetary policy, and valuations less expensive than they ‘seem’. However, the traditional drivers of Mexican outperformance are lacking – major market sell-off, strong US data surprise, or strong local consumer recovery. We focus on domestic recovery plays – Televisa, First Cash, AMX – and special situations – Cemex and ICA.
In the smaller markets, we struggle to see a sustainable second leg to the well-known (and very positive) Chilean story. Valuations are high, and the stocks we want to own (banks/discretionary) are even pricier. We do see further fundamental upside in Colombia on the ongoing reform agenda, investment grade outlook, and capital markets development, but would play this off index (through Copa and Pacific Rubiales) given high on-index valuations. We remain exposed to Argentina. Valuations have become expensive at first glance, but the outlook for real political change – however moderate – means the market still likely has upside. Penetration rates are low and nontraditional valuation metrics (franchise value, replacement cost) attractive. We stick with GF Galicia.
12 mth fwd P/E relative to MSCI LatAm: Smaller markets at premium to LatAm
0.20.71.21.72.22.73.23.7
Jan-03 Feb-04 Mar-05 Apr-06 May -07 Jun-08 Jul-09 Aug-10
Chile Argentina Peru Colombia
Source: IBES, Datastream, MSCI.
Colombia pension fund equity exposure to rise on multifunds/demographics
Latin America Model Portfolio by Country Change Port. MSCI Dev. P/E P/E EPS ROE Analyst Ticker Price* 1 M YTD Weight (%) 10E 11E growth 10E (%) (%) (%) (%) (x) (x) 10E (%)
Brazil 245,843 1.2 4.1 70.3 67.8 2.5 12.9 10.6 16.3 13.7 Bradesco BBDC4 BZ 36.5 6.9 21.4 10.0 4.5 5.5 14.1 12.7 26.3 21.8 Saul Martinez CBD PCAR5 BZ 66.1 11.1 1.7 6.0 0.4 5.6 30.5 24.9 -7.7 6.9 Andrea Teixeira Cetip CTIP3 BZ 19.1 17.6 33.7 5.0 0.0 5.0 31.2 23.5 22.0 38.2 Frederic de Mariz Gafisa GFSA3 BZ 14.3 2.8 0.9 5.0 0.4 4.6 17.0 12.7 31.3 9.3 Adrian E Huerta NII Holdings NIHD US 42.6 0.3 26.9 5.0 0.0 5.0 25.5 13.0 -26.4 8.9 Andre Baggio OGX OGXP3 BZ 22.9 0.7 33.6 4.0 1.9 2.1 nm nm -96.4 2.1 Sergio Torres PDG Realty PDGR3 BZ 22.2 5.7 28.0 5.0 0.8 4.2 15.2 9.8 67.8 13.3 Adrian E Huerta Petrobras PN PETR4 BZ 27.0 -1.4 -26.4 10.0 13.0 -3.0 8.3 10.4 -1.8 10.3 Sergio Torres Santander Brasil SANB11 BZ 25.0 5.9 4.6 7.0 0.5 6.5 15.4 11.7 23.7 11.6 Saul Martinez TIM Participacoes TSU US 34.1 4.5 14.8 2.0 0.2 1.8 31.0 15.0 -41.9 5.2 Andre Baggio Vale PN VALE/P US 28.9 3.7 16.4 11.3 11.0 0.3 9.6 7.0 202.0 23.3 Rodolfo R. De Angele Mexico 33,431 7.7 18.5 18.0 18.2 -0.2 17.7 14.7 9.0 16.5 AMX AMX US 58.0 6.6 23.4 6.0 6.4 -0.4 15.8 13.5 -24.9 25.0 Andre Baggio Cemex CX US 9.2 10.7 -19.1 3.0 1.0 2.0 nm nm -233.3 -0.8 Adrian E Huerta First Cash FCFS US 29.5 10.4 32.9 3.0 0.0 3.0 17.2 14.7 23.7 18.7 Ben Laidler ICA ICA* MM 33.3 8.2 9.2 3.0 0.0 3.0 31.1 22.5 -8.5 3.7 Adrian E Huerta Televisa TV US 22.9 21.1 10.3 3.0 1.2 1.8 22.4 17.5 16.1 20.0 Rajneesh Jhawar Chile 5,971 3.9 38.6 3.7 7.1 -3.4 19.6 17.6 23.0 12.2 Cencosud CENCOSUD CI 3,717.2 14.0 116.1 3.7 0.8 2.9 38.9 30.3 78.6 8.0 Andrea Teixeira Colombia 3,120 6.5 58.1 6.0 3.8 2.2 25.9 17.0 26.9 na Copa CPA US 50.6 -3.8 -7.1 3.0 0.0 3.0 10.6 7.7 3.2 na Jamie Baker Pacific Rubiales PRE CN 33.4 18.0 116.4 3.0 0.0 3.0 37.2 13.8 -266.7 18.2 Sergio Torres Argentina 254,619 21.7 65.0 2.0 0.0 2.0 14.9 14.0 5.4 na GF Galicia GGAL US 15.1 51.9 162.8 2.0 0.0 2.0 24.8 17.6 24.5 14.5 Saul Martinez Peru 3,376 14.8 47.9 0.0 3.1 -3.1 19.9 15.1 27.7 EMF LATAM 79,524 3.1 11.3 100.0 100.0 0.0 14.2 11.6 15.8 13.9 Source: Bloomberg, MSCI, J.P. Morgan estimates. All estimates are for the calendar year. Updated as of 3 November 2010.
Our LatAm model portfolio is a vehicle to express our strategy views on regional equity markets, sectors, and stocks. This portfolio will normally include stocks which will be constructed relative to the MSCI EM Latin America Index and will be updated on a regular basis through our ‘LatAm Key Trades’ publication. The portfolio is primarily driven by our fundamental analyst views, and we use our analysts’ published company valuation and estimates to support inclusion, but a strategy overlay is incorporated and hence the published strategy may on occasion differ from analyst views. Analyst ratings are driven by company attractiveness relative to their sector coverage, whereas we take a regional LatAm view. The portfolio can include: 1) non-Latin America listed stocks, to the extent the region is a significant company driver; and 2) stocks not currently covered by JPM analysts, to the extent these are heavily weighted MSCI Latin America Index companies, though these companies must always be incorporated at a neutral relative weighting so as to express no strategy or fundamental view.
This portfolio has been run since November 2007. Year to date in 2010 the portfolio is up 22.0% compared to a rise for the MSCI LatAm index of 12.0%. This return is indicative only and is calculated on price returns only, excluding dividends but also excluding trading costs – which an invested portfolio would bear. Portfolio changes are implemented on the day of ‘Key Trades’ publication.
Latin America Model Portfolio by Sector Change Port. MSCI Dev. P/E P/E EPS ROE Analyst Ticker Price* 1M YTD Weight (%) 10E 11E Growth 10E (%) (%) (%) (%) (x) (x) 10E (%)
Discretionary 667.8 2.1 9.2 13.0 5.3 7.7 17.6 13.8 27.9 16.1 Gafisa GFSA3 BZ 14.3 2.8 0.9 5.0 0.4 4.6 17.0 12.7 31.3 9.3 Adrian E Huerta PDG Realty PDGR3 BZ 22.2 5.7 28.0 5.0 0.8 4.2 15.2 9.8 67.8 13.3 Adrian E Huerta Televisa TV US 22.9 21.1 10.3 3.0 1.2 1.8 22.4 17.5 16.1 20.0 Rajneesh Jhawar Staples 628.8 3.4 21.9 9.7 11.6 -1.9 24.0 19.8 21.5 12.9 CBD PCAR5 BZ 66.1 11.1 1.7 6.0 0.4 5.6 30.5 24.9 -7.7 6.9 Andrea Teixeira Cencosud CENCOSUD CI 3717.2 14.0 116.1 3.7 0.8 2.9 38.9 30.3 78.6 8.0 Andrea Teixeira Energy 1161.3 2.6 -15.5 17.0 16.6 0.4 10.9 10.2 7.1 9.7 OGX OGXP3 BZ 22.9 0.7 33.6 4.0 1.9 2.1 nm nm -96.4 2.1 Sergio Torres Pacific Rubiales PRE CN 33.4 18.0 116.4 3.0 0.0 3.0 37.2 13.8 -266.7 18.2 Sergio Torres Petrobras PN PETR4 BZ 27.0 -1.4 -26.4 10.0 13.0 -3.0 8.3 10.4 -1.8 10.3 Sergio Torres Financials 1064.7 3.3 22.0 27.0 22.3 4.7 14.7 12.3 19.6 16.2 GF Galicia GGAL US 15.1 51.9 162.8 2.0 0.0 2.0 24.8 17.6 24.5 14.5 Saul Martinez Cetip CTIP3 BZ 19.1 17.6 33.7 5.0 0.0 5.0 31.2 23.5 22.0 38.2 Frederic de Mariz Bradesco BBDC4 BZ 36.5 6.9 21.4 10.0 4.5 5.5 14.1 12.7 26.3 21.8 Saul Martinez First Cash FCFS US 29.5 10.4 32.9 3.0 0.0 3.0 17.2 14.7 23.7 18.7 Ben Laidler Santander Brasil SANB11 BZ 25.0 5.9 4.6 7.0 0.5 6.5 15.4 11.7 23.7 11.6 Saul Martinez Industrials 277.0 3.8 28.5 6.0 4.6 1.4 27.4 22.0 24.6 10.2 Copa CPA US 50.6 -3.8 -7.1 3.0 0.0 3.0 10.6 7.7 3.2 na Jamie Baker ICA ICA* MM 33.3 8.2 9.2 3.0 0.0 3.0 31.1 22.5 -8.5 3.7 Adrian E Huerta Materials 1219.1 3.0 12.3 14.3 24.4 -10.1 13.3 9.5 40.1 15.6 Cemex CX US 9.2 10.7 -19.1 3.0 1.0 2.0 nm nm -233.3 -0.8 Adrian E Huerta Vale PN VALE/P US 28.9 3.7 16.4 11.3 11.0 0.3 9.6 7.0 202.0 23.3 Rodolfo R. De Angele Telecoms 588.6 3.6 8.1 13.0 8.7 4.3 12.4 10.7 15.4 27.1 AMX AMX US 58.0 6.6 23.4 6.0 6.4 -0.4 15.8 13.5 -24.9 25.0 Andre Baggio NII Holdings NIHD US 42.6 0.3 26.9 5.0 0.0 5.0 25.5 13.0 -26.4 8.9 Andre Baggio TIM Participacoes TSU US 34.1 4.5 14.8 2.0 0.2 1.8 31.0 15.0 -41.9 5.2 Andre Baggio Utilities 383.9 2.3 9.2 0.0 5.5 -5.5 11.7 10.7 8.8 8.7 EMF LATAM 79524.0 3.1 11.3 100.0 100.0 0.0 14.2 11.6 15.8 13.9 Source: Bloomberg, MSCI, J.P. Morgan estimates. All estimates are for the calendar year. Updated as of 3 November 2010.
LatAm Model Portfolio sector allocation relative to MSCI Emerging Latin America Markets Index
-12 -10 -8 -6 -4 -2 0 2 4 6 8 10
MaterialsUtilitiesStaplesEnergy
IndustrialsTelecomsFinancials
Discretionary
Source: MSCI, J.P. Morgan estimates. Updated as of 3 November 2010.
LatAm Model Portfolio country allocation relative to MSCI Emerging Latin America Markets Index
-4.0 -3.0 -2.0 -1.0 0.0 1.0 2.0 3.0
Chile
Peru
Mex ico
Argentina
Colombia
Brazil
Source: MSCI, J.P. Morgan estimates. Updated as of 3 November 2010.
Historical changes to model portfolio Bought Sold
Nov 10 TIM Participacoes BM&F Bovespa Sep 10 Cetip, OGX, Cemex Banrisul, Banorte, Urbi Aug 10 GF Galicia, Banrisul, Cencosud Lan Airlines, OGX, Banco Macro Jul 10 Televisa, Banorte Cemex, Ternium Jun 10 Gafisa, Copa Holdings Metalurgica Gerdau, Tenaris May 10 NIHD, Cemex, First Cash Financial Vivo, Grupo Mexico, Banorte Mar 10 BM&F Bovespa, Metalurgica Gerdau, Vivo, Pacific Rubiales Cielo, Gerdau, Silver Wheaton Feb 10 None None Jan 10 ICA, CBD Cemex, Lojas Renner, Gafisa Nov 09 Santander Brazil, Cielo, Lan Airlines BM&F Bovespa, Banco do Brasil, Santander Chile Oct 09 OGX, Silver Wheaton ALL, Televisa Sep 09 Itauunibanco, Geo, ALL Banco Bradesco, Urbi, TAM Aug 09 Gerdau, Gafisa Bradespar, GVT Jun 09 BM&F Bovespa, Banco Macro Porto Seguro, Credicorp May 09 Ternium, Grupo Mexico Copa Holdings, Femsa. Apr 09 Lojas Renner, Banorte, Santander Embraer, Walmex, Entel Mar 09 Banco do Brasil, ALL, Tenaris, Geo Bradesco, SLC, Ternium, Asur Feb 09 Banco Itau, Entel, Slc Agricola, Cemex Unibanco, Urbi, Gafisa, Santander Chile Dec 08 Porto Seguro, Bradesco, Credicorp Telecom Arg., CCR, Banco do Brasil Oct 08 Asur, Walmex, Bradespar, Urbi Banorte, Lojas Renner, Homex Sep 08 GVT,PDG Realty CTC, Coeur d'Alene, Rodobens Aug 08 Homex Megacable, Urbi Jul 08 Embraer VCP Jun 08 Petrobras PN ADR, CCR, CTC, Coeur d'Alene Petrobras ON, NETC, Silver Wheaton Apr 08 Banco do Brasil, Megacable B2W Feb 08 Urbi, Rodobens, Gafisa, Telecom Argentina Cesp, Company SA, Cyrela
Emerging Market Equity Strategy The Drivers 1. The declining EM risk premium continues
2. Strong demand from EM credit continues
3. High nominal growth and nominal FX appreciation
4. DM neither a driver nor a drag
Potential Returns MSCI EM end-2011 target 1500 (+25%) • Forward PE at 1500 is 13 (based on consensus 2012
EPS)
• Current credit conditions, FX appreciation, earnings growth, and earnings estimate revisions provide upside
Other targets KOSPI 2300, NIFTY 7000
Investment themes 1. China drifts away from the Asian growth model
2. Structural OW on domestic demand
3. FDI in non-China EM increases
4. Growth premiums continue to expand
5. CEMBI Surfers still riding in 2011
6. Warning flags: Real credit growth and core CPI
7. Beware co-investing with governments
8. Liquidity without a valuation anchor
9. Higher REER bad for exporters’ margins
Risks Market Risks • Lack of valuation cushion • Bond market volatility • High correlation Policy and Political risks • Capital controls • Anti-asset inflation policies • Trade wars • Leadership change in China, Thai and Philippines
elections • Strained social contract Economic risks • Uncertain outlook for commodities • Unintended consequences of QE2 • Public sector debt stress in developed economies
Key issues for 2011 – Briefing notes 1. Scale of emerging markets
2. Capital controls and FX intervention
3. Western-China-driven growth
4. Strength of consumption in China
5. China’s infrastructure investment
6. Will China have a housing inventory problem?
Market Performance MSCI EM and MSCI World performance
Emerging Market Equity Strategy We are bullish on EM equities. Our end 2011 target for MSCI EM is 1500 (+25%). Based on consensus 2012 EPS the forward PE at 1500 is 13. Current credit conditions could support a larger re-rating (please see page 27 for potential returns). MSCI EM life high is 1338 (29 October 2007).
What about the biggest bull market of your career? Between 11 March 2003 and 29 October 2007 MSCI EM increased from 270 to 1338; +395%, or an annualized return of 38%. On 2 March 2009 EM was 475. The index is 140% higher today. To match the 2003/7 bull market MSCI EM would need to be 2351 by 20 October 2013. This requires an annualized return of 21%.
In last year’s Emerging Markets Year Ahead our end-2010 MSCI EM target was 1200. The index is within 5% of this target. But the ride was not smooth; between 15 April and 25 May the index declined by 19% to 855. Zero interest rates, QE2, currency wars, and high correlation across asset classes are likely to lead to volatility in 2011. Even with this year’s volatility, EM volatility-adjusted returns are the highest for growth assets.
Our asset allocation starts with long-term trends (EM consumer, China’s changing economic policy, sector RoEs and investment cycles, currencies, etc.) combined with short-term tactical allocation driven by market factors (relative valuations and performance, retail activity, consensus positioning). Benchmark composition often represents historical rather than future growth trends. We are bullish on the Brazilian and Chinese domestic economies yet have been underweight these markets in 2010. We have been overweight Brazilian and Chinese domestic demand but underweight the larger sectors, i.e., energy, materials and Chinese SoEs. As was the case in 2010, focus on sectors within countries rather than simple country asset allocation (see page 26).
Investors are seeking carry, growth and momentum. Both emerging fixed income and equity markets offer this. For now it is foolish to fight the trend. But remember the risks (see page 31). QE2 is an experiment. China’s ability to rebalance the driver of growth from investment to consumption is also an experiment.
Monitor the data; core inflation, property sales, actual commodity demand rather than financial demand, etc.
Source: Datastream, MSCI, IBES. Note: MSCI EM fwd PE based on trend and consensus EPS. The trend EPS is calculated by plotting a trend line through the log chart of MSCI EM realized EPS.
Higher risk-adjusted returns in EM
-1.5
-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
2.5
Jun-07 Dec-07 Jun-08 Dec-08 Jun-09 Dec-09 Jun-10
EM
World
US
Source: Bloomberg Note: EM, US and World: Three-month rolling returns adjusted for 90-day volatility.
There is limited statistical evidence of valuations mean reverting in EM (see figure on previous page). Investors should focus on factors that are currently driving a re- or derating. The rerating factors are:
1. Expanding growth premium in a low-growth world
2. Equities are cheap relative to sovereign and corporate bonds
3. Accelerating investment and consumption growth in key EMs
4. Lower relative risk profile of EM versus DM
Base Case In the risk section on page 31 we highlight the risks to our base case.
The declining EM risk premium continues Emerging economies survived the big ugly experiment of an extreme external demand shock and a credit crisis. This hit EM economies when they were a year into a tightening cycle. In passing this test and with the economies recovering ahead of developed economies, the risk premium demanded for EM should decline. Note that stock-specific risk (corporate governance, transparency, policy risk, etc.) is still higher.
Strong demand for EM credit and carry continues Investor appetite for risk has slowly increased since 9 March 2009. The bias is corporate credit for yield and emerging markets for growth. EM US dollar and local currency credit offers both and is thus attracting large flows relative to its market cap. J.P. Morgan forecast for this to continue in 2011. We maintain our CEMBI surfer theme of favoring current account deficit markets.
High nominal growth and nominal FX appreciation Data support positive nominal GDP revisions. These data include strong retail sales, car sales and loan growth. EM Central Banks are slowing FX appreciation but not reversing the trend.
DM neither a driver nor a drag Focus on the local EM dynamics rather than swings in net exports. Economic expansion in the US and Euro Area resumed in 3Q09. J.P. Morgan forecast 2011 GDP growth of 2.5% and 1.5% for the US and Euro Area respectively. This growth may be politically unacceptable as it is too slow to reduce unemployment, but for EM, slow DM growth is a benign to positive backdrop. It is benign for external demand and positive as interest rates remain low.
Investment Themes China drifts away from the Asian growth model China is a souped-up version of the Asian growth model. Investment rather than consumption drives growth. This requires a transfer of wealth from the household sector to the corporate sector through low wages, low return on savings and undervalued currency. 2010 policy and the 12th Five-Year Plan all point to a move toward consumption. This is a long-term positive. But it may mean that the growth in Chinese commodity demand is overestimated. Beneficiaries of the change are a small part of the benchmark, which may result in ongoing underperformance of MSCI China.
Structural OW on domestic demand This is where the growth is (globally). We acknowledge that these stocks do trade at a premium and the call is consensus.
Beware co-investing with governments A third of MSCI market cap is companies in which governments are the controlling shareholder. It can be profitable being a minority shareholder in these companies when the major shareholder offers favorable policies and is focused on returns. With today’s flood of capital into EMs, investor-friendly policies may not be a top priority and thus these companies could be at risk from politically expedient policies.
SoEs are 79% of MSCI China market cap. Policies designed to boost consumption by increasing the household income-to-GDP ratio will reduce the ratio of profits to GDP. SoEs in our view are particularly vulnerable to policy risk. Our structural bias is to be underweight SoEs. Russian oils stocks’ underperformance is notable, with Rosneft, Lukoil and Gazprom unchanged year to date. In contrast, Russian financials are up 25% ytd. Gazprom, with one-sixth of the world’s oil reserves, has a 2011e PE of 4. Russian energy stocks are unlikely to rerate while the market fears higher taxes.
Household income growth lagging tax and profits
343%
512%
748%
258%
0%100%200%300%400%500%600%700%800%
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
GDPGov ernmentProfitsIncome
Source: J.P. Morgan economics. Note: Income proxy is the change in urban per capita household income; Profits are the growth in aggregate industrial profits.
FDI in non-China EM increases Higher labor cost, strengthening Renminbi and tensions between Japan and China improves the attractiveness of other emerging markets for FDI. The main beneficiaries are ASEAN, Turkey and Mexico. Note in table below that a small change in China’s share of FDI could lead to a large increase in FDI in ASEAN.
FDI into China and ASEAN US$ billions
China Indonesia Malaysia Philippines Thailand 2007 138.4 6.9 8.6 2.9 11.3 2008 147.8 9.3 7.2 1.5 8.6 2009 78.2 4.9 1.4 1.9 6.0
Source: CEIC.
Warning flags: Real credit growth and core CPI Central banks responding to inflation have always ended the bull market in EM. As of now EM central banks have maintained a pro-growth bias even when headline inflation is higher than the target level. Each week we publish a detailed table on inflation in our dashboards.
The warning flags are a combination of higher real credit growth and rising core CPI. These conditions increase the probability of the central bank moving to a policy designed to slow growth in order to fight inflation. EM equities are growth assets. Lower growth and higher discount rates result in a derating.
Real credit growth and Core CPI Real Credit Growth %oya Core CPI %oya China 15 0.7 Brazil 14 5 Korea 3 2 Taiwan 4 0.7 India 9 9 South Africa 2 3 Russia 0.1 5 Mexico 3 4 Malaysia 11 1.1 Indonesia 14 5 Turkey 16 4 Thailand 4 1.1 Source: CEIC, J.P. Morgan economics, Bloomberg and central bank websites, September 2010. Note: Credit growth as of June 2010 for China, Korea, Taiwan, India, Malaysia, Indonesia, Thailand and August 2010 for Brazil. Growth premiums continue to expand Lack of developed world growth combined with low discount rates supports high growth premium. Maintain a structural bias to high growth themes; EM consumer. Compare valuations with other growth stocks rather than markets.
CEMBI surfers still riding in 2011 Demand for EM credit remains strong (see Error! Reference source not found.). The yield on the emerging market corporate bond indices (CEMBI) is 5.3%; this is lower than the average investment grade bond yield in past decade (JULI). Our bias is to own current account deficit markets when credit conditions are favorable; OW India and Turkey.
EM equities cheap relative to bonds
5
8
11
14
17
20
01 02 03 04 05 06 07 08 09
CEMBI (1/y ld) Fw d PE
Source: MSCI, Bloomberg, J.P. Morgan Indices. Note: The inverse of the CEMBI yield is used to compare PEs with EM corporate bond yields.
Liquidity without a valuation anchor The range of valuations since late 2007 is extremely wide. Correlation of risk asset is high, indicating that asset-specific fundamentals are secondary to general market trend. Higher commodity prices are partly justified by monetary conditions rather than supply or demand. Equities are inexpensive relative to bonds but if economic activity improves then bonds are expensive.
Risk assets march in step: Correlation with MSCI US
Source: Bloomberg, J.P. Morgan indices. Note: Three year correlation of monthly returns of MSCI US vs. JPMCI Energy, Precious metals and Industrial metals.
The lack of valuation anchors in equities, bonds, commodities and currencies means a wide range of possible returns and high volatility. It is critical to keep monitoring the fundamentals while acknowledging that the near term drivers of markets are dominated by momentum and casual relationships between asset classes. When implied volatility is low, consider buying protection. Remember that the 2003/7 EM bull market had five 15-20% corrections.
YTD Returns and Correlation with MSCI US Year to date
return 3 year correlation of monthly
returns with MSCI US Topix -6 0.8 Energy -4 0.6 US cash 0.2 -0.4 GSCI TR 4 0.6 Global Gov Bonds 6 -0.3 MSCI Europe 7 0.9 EM FX 8 0.8 US Fixed Income 9 0.2 MSCI AC World 9 1.0 EM Local Bonds 10 0.5 US High Grade 11 0.4 S&P500 12 1.0 MSCI EM 15 0.9 EM $ Corp. 16 0.6 EMBIG 17 0.7 Gold 27 0.1 Source: Bloomberg.
Higher REER bad for exporters’ margins Capital-flows support EM FX appreciation. Nominal appreciation combined with inflation differentials results in a real effective exchange rate appreciation. In China there have been a number of large wage increases in foreign owned export factories. This is bad for margins. Avoid export industries in Brazil and China with a large labor cost.
Focus on sectors within countries rather than country recommendations The table below provides a level summary of our views on sectors within countries. Financials is 26%, Materials is 15% and Energy is 14% of EM. All recommendations are relative to EM. The Industrials sector consists of an eclectic group of stocks. We do not rate the sector. Key country and sector recommendations, performance and fundamentals
Source: MSCI, IBES, Bloomberg, J.P. Morgan, 5 November 2010. Note: Outperformance of more than 2% vs. MSCI EM. Underperformance of more than 2% vs MSCI EM. DD=Domestic Demand, GPT=Global Price Takers, GC/C=Global Capex/Consumer, GC=Global Consumer, GCap=Global Capex.
Potential Returns and Earnings Estimates End-2011 strategy team index forecasts • MSCI EM 1500 (+25%)
Base case • Current MSCI EM forward PE 11.6
• 2012 MSCI EM EPS 112 (before currency appreciation)
• EM FX appreciation 5%
• 10% re-rating to forward PE 13
Statistical warning EM equity markets’ valuations trend rather than mean-revert. Indices also evolve with sector composition changing. The growth characteristics of stocks also change and thus their valuations. Prior to the mid-90s current account crisis, fixed exchange rates and high nominal growth supported high valuations. Investors should be suspicious of statistical justification for index targets.
Pick your methodology To illustrate the impact of different methodologies on potential returns we calculate index targets using six assumptions:
1. Current earnings to bond yield ratio using September 2011 yield forecast and end-2011e PE.
5. Five-year average earnings to bond yield ratio using September 2011 yield forecast and end-2011e PE.
6. Current forward PE multiplied by 2012e EPS based on the lower of 2012e EPS growth or potential nominal GDP.
7. Current forward PE multiplied by 2012 EPS forecast.
8. Three-year average PE multiplied by 2012 EPS forecast.
9. Gordon Growth model theoretical PE multiplied by 2012e EPS. This generates PE in excess of 30 for six markets as local bond yields in these countries are very low relative to nominal GDP growth and RoE.
Current forward PE with standard deviation ranges Index Current
Fwd PE Avg 10Y
+1 SD -1 SD Top Decile
Bottom Decile
EM 11.7 10.7 12.2 9.2 12.6 8.8 EM Asia 12.7 11.5 13.3 9.7 14.0 9.3 Latam 11.8 10.0 11.7 8.4 12.3 8.0 EMEA 9.3 9.8 11.4 8.2 11.7 8.0 China 13.0 13.1 16.3 9.8 17.3 9.9 India 17.2 14.1 17.3 10.8 18.0 9.9 Indonesia 14.9 9.6 12.9 6.2 13.7 5.0 Korea 9.9 9.1 10.9 7.2 11.6 6.5 Malaysia 15.0 14.1 15.5 12.7 15.9 12.3 Philippines 16.6 13.9 16.1 11.7 17.1 11.5 Taiwan 12.8 14.3 18.0 10.6 20.4 11.4 Thailand 12.3 10.4 11.8 9.0 12.1 8.9 Brazil 10.5 8.0 10.4 5.6 11.7 5.3 Mexico 15.1 12.1 13.8 10.4 14.1 9.8 Chile 17.4 15.6 17.6 13.5 18.2 12.8 S Africa 11.7 10.0 11.4 8.7 11.7 8.1 Russia 6.4 7.9 10.3 5.6 11.1 4.6 Turkey 11.2 9.1 11.2 7.1 11.7 6.5 Source: MSCI, IBES, Datastream, 5 November 2010. Note: Current PE > +1SD in red.
Consensus EPS estimates and revisions since the beginning of 2010 Index Actual Current Consensus EPS Consensus EPS beginning of this Year Revision in Consensus EPS (%)
Dissection of EM EPS growth The objective Disaggregate the EM EPS growth into countries, sectors and key sectors in countries.
Main observations on 2011e EPS growth • MSCI EM weighted and median EPS growth is
17%. This is 5% higher than our economists’ 2011 nominal GDP growth forecast of 12%.
• Financials and materials are the highest contributors to 2011e earnings growth.
• The contribution of IT and healthcare is the lowest (see top table, next page).
• Two sectors contribute c20% of MSCI EM 2011e EPS growth; Brazilian steel and Russian oil & gas sectors (2011e EPS growth for Vale, Sider and Gazprom is estimated by IBES to be 41%, 44% and 23% respectively).
• Note that the weighted EPS growth for Taiwan electronic components is high at 62% (primarily due
to losses or low profits at AU Optronics, Chimei Innolux, Chunghwa picture tubes, E-Ink). The median EPS growth is 24% (see second table on next page).
Dataset IBES EPS forecasts for MSCI EM constituents
Calculation The index’s calendar year EPS is calculated using the profit-weight of the constituents.
Index EPS = I x (∑ (C-EPS x FFS) / ∑ (FFS x P))
where C-EPS = Index constiuent’s EPS, FFS = free float shares for the constituents, I = index level and P = current market price.
The check Median EPS growth of the index constituents: Reviewing the median helps identify sectors in which a single stock’s impact on weighted EPS growth is large. This could be due its large weight in the index or moving from loss to profit.
Emerging markets earning growth and contribution
Country Mkt Cap Earnings weights (%) Index EPS Growth Median EPS Growth Contribution to Earning growth (%) Weight 2010E 2011E 2012E 2010E 2011E 2012E 2010E 2011E 2012E 2010E 2011E 2012E
EM Sectors’ earning growth and contribution EM Sectors Mkt Cap Earnings weights (%) Index EPS Growth Median EPS Growth Contribution to Earning growth (%)
Countries’ sub-industry contributing 70% of EM earning growth Country Sub-Industry Mkt Cap Earnings weights (%) Index EPS Growth Median EPS Growth Contribution to Earning growth
Risks to our strategy Market risks Lack of valuation cushion Our strategy is biased toward growth with good momentum but at a valuation premium. A growth premium is justified in a world where growth is in short supply. High valuations are vulnerable to a reversal in EM portfolio flows and stock-specific risk.
Bond market volatility The Fed’s objective with QE2 is to lower bond yields. The result is that bonds are expensive relative to J.P. Morgan’s growth forecasts. Higher US growth could lead to a spike in bond yields.
High correlation High correlation between risk assets may propagate volatility. A counter-trend rally in the US dollar may drive that volatility.
Policy and Political risks Capital controls Strong foreign inflows and continued FX appreciation have prompted EM central banks to implement capital control measures. These include: 1) Increase in IOF tax on foreign purchase of fixed income instruments from 2% to 6% in Brazil; 2) One-month minimum holding period restriction on SBI bonds in Indonesia; 3) 15% withholding tax on foreign bond holders in Thailand; 4) Restrictions on forward currency positions of foreign bank branches and local banks in South Korea. For equity investors, controls designed to reduce the effective carry in fixed income markets are ok. Broader capital controls which reduce the ability of equity investors to buy and sell would be negative as they reduce liquidity and increase volatility.
Anti-asset inflation policies Central banks are targeting asset prices in EM to counter asset inflation. These policies introduce economic and sector-specific risks. Note how poorly real estate stocks have performed in EM despite low interest rates.
Trade wars High US unemployment, China’s large current account surplus and polarized politics in the US increase the risk of a trade war.
Politics: Elections and change of leadership in Brazil and China Leadership change in China will occur in 2012. The transition may result in confusion on policy. Brazil’s new president needs to maintain reform momentum and develop infrastructure.
2011 election calendar Jan Feb Mar Apr
Peru Presidential & Legislative
May Jun Vietnam Presidential Turkey Parliamentary
Jul Aug Philippines Subnational - Legislative
Sep Oct Argentina Presidential Poland Parliamentary
Nov Dec Russia Parliamentary Thailand Parliamentary (Tentative)
Source: IFES.
EM CPI and earnings yield
3456789
101112
Jan-02 Jun-03 Nov -04 Apr-06 Sep-07 Feb-09 Jul-10
3
6
9
12
15
EM central banks' av erage target range ceiling
EM CPI %oy a(LHS)
MSCI EM 12m Fw d PE(RHS inv erted)
Source: J.P. Morgan economics, IBES, MSCI, November 2010. Note: CPI data is to August 2010.
Strained social contract Political and regulatory risk is high. The corporate sector has emerged from the global recession and credit crunch stronger than the households. Note that profits as a share of GDP are near cyclical highs but unemployment is 10%. Policy makers constrained by high fiscal deficits are likely to redress this imbalance through higher taxes and increased regulation. This would add to business costs and delay normal investment decisions, threatening the recovery.
As is the case in the US, Chinese corporate share of GDP increased while the household share decreased. Labor disputes and subsequent large pay increases may start to reverse this trend. This rebalancing is healthy and should move China to a more sustainable growth model. But near term the result is likely lower profit margins.
Economic risks Uncertain outlook for commodities Our commodities and energy underweight is driven by a combination of long-term economic cycles and a potential inflection point in the growth of Chinese material demand. The timing is complicated by the large influence of financial investors on commodity markets. The timing risk in a bearish view on commodity companies is high. Industrial metal prices rallied since May while global leading indicators fell. Correlation of commodities to risk assets (equities) is high today. Momentum in a world of zero interest rates is an attractive attribute. An UW commodity call is unlikely to work at this point. When it does eventually, the correction may prove to be violent as financial investors exit.
Unintended consequences of QE2 If QE2 results in a sharp increase in commodity prices it may choke off growth and ultimately be counterproductive.
Peripheral Europe sovereign stress Greek, Irish and Portuguese bond spreads to German bunds are at record highs. Sovereign stress could disrupt risk appetite as it did in 2Q10.
US state and municipal stress US states and municipalities are required to balance their budgets. The result may be rising unemployment as US local government downsizes. This would place a larger burden on the private sector to create jobs.
Strained social contract: US profit share and unemployment
810121416182022
70 75 80 85 90 95 00 05 10
0
3
6
9
12
% sa
Unemploy ment rate (inv erted)
Profit share
Source: J.P. Morgan. Note: Chart shows % share of gross value added, J.P. Morgan forecast for 2010.
Shares outstanding in commodity ETF
30000
60000
90000
120000
150000
180000
210000
Dec-07 May -08 Oct-08 Mar-09 Aug-09 Jan-10 Jun-10 Nov -10
Source: Bloomberg, DBCSO Index.
Peripheral stress in Europe
0
12
3
4
56
7
Jan 08 Jul 08 Jan 09 Jul 09 Jan 10 Jul 100
2
4
6
8
10Greece (RHS)
Ireland (LHS)
Source: Bloomberg Note: Spread of Greek and Irish 10-year bond yields to German bunds.
Brazil Strategy Key country dynamics Domestic growth and China’s demand for commodities are the main drivers for Brazil in 2011, together with a clearer definition of policies to be adopted by the newly elected government. The exchange rate is an important focus, with capital control risks on the rise.
Growth characteristics and how they are changing Credit growth at around 20% combined with the best labor market in a generation provides for a sturdy outlook for consumption in 2011. We forecast GDP of 4.5% in 2011, on top of 7.5% in 2010e. Strong growth is adding to inflation risks, and we expect a rise in interest rates in 2011. Although GDP is little influenced by commodities (exports = 11%), Brazil’s two largest companies are commodity driven. Over the next few years, investment (under 18% of GDP) will need to rise to meet the country’s need for more capacity and infrastructure. This would also allow for faster sustainable growth in the years to come.
Drivers of returns – Multiples and growth Valuation is not an impediment to Brazil’s performance. The country is trading in line with the five-year average, with commodities cheaper than domestics but with the latter likely delivering more growth in the short/medium run. Flows are key for performance and are catching up in 4Q 2010 after being lackluster most of the year. With major hurdles behind (large capitalizations, elections) and DM prospects of a muddle-through, inflows into Brazilian equities are likely to be boosted in 2011.
Recommendations We recommend exposure to domestic names and are focused on financials and homebuilders. Although we like discretionary, we feel that there are better entry points considering the strong performance of late. In financials, Bradesco is our top pick, a blue chip, large cap bank that can better withstand the rise in interest rates as about 30% of its business is insurance. In homebuilders, we like PDG: the stock is cheaper than peers’, benefits from the Agre acquisition are not fully priced, the company is fully exposed to the high-growth lower-income segment. On the commodity side, we likeVale: it is cheap, with risks mostly priced in already, while China appears to be rebounding. In the oil and gas sector, we recommend OGX as the better vehicle to get exposure to offshore as more of the company’s findings are turning into reserves.
Mexico Strategy Key country dynamics The key constraints on Mexican equities are structurally lower US GDP growth and a lackluster Mexican consumer rebound. This is offset by a cheap currency, easy monetary policy, a gradual reacceleration of US economic growth – at least into mid-2011 – and a high market correlation with US equities. Additionally, we view some concerns as currently overdone – such as the fiscal situation (oil production has stabilized) and security environment (violence localized) – whilst others are not – such as Mexico’s declining equity market relevance on lack of issuance.
Growth characteristics and how they are changing Mexican GDP growth is set to slow next year (to 3.5% from an estimated 4.5% in 2010), along with the US (2.7% GDP growth to 2.5% in 2011e). Manufacturing and IP, which led the sharp growth recovery from the -6.5% seen in 2009, should slow and domestic demand increasingly come to the fore. Consensus MSCI Mexico earnings growth could be at risk, with expectations for 18% growth versus only 12% this year. Growth is expected to be led by staples and materials.
Drivers of returns – Multiples and growth Mexico is trading at the high end of traditional valuation ranges, and we do not see room for significant multiple expansion. The valuation premiums to other markets are lower than they seem, often just reflecting Mexico’s high staples and telecom index composition. Whilst the traditional drivers of Mexican outperformance – 1) significant market weakness, 2) strong US macro surprise, 3) strong Mexico consumer recovery – look absent to us in 2011, we do expect respectable absolute performance. Local investors remain underweight the market and are seeing robust inflows. Foreign investors remain moderately overweight.
Recommendations Our strategy focus is on stocks exposed to the strengthening domestic demand environment at reasonable valuations. We also like a number of special situations exposed to recovering infrastructure segments. We would avoid very defensive staples with high valuations and low gearing to the strengthening consumer.
Chile Strategy Key country dynamics Chile will look to build on the momentum of an historic 2010, which saw the inauguration of center-right Piñera (after 20 years of the center-left Concertacion), an 8.8-magnitude earthquake (5th largest in history), World Cup success (advancing to the round of 16), the country’s 200-year anniversary and the unprecedented extraction of 33 miners trapped underground for 68 days. Confidence is running high, and the country appears to be entering a period of renewal, which could accelerate the path to developed country status (possibly by the end of the decade). However, with expectations mounting, there is room for disappointment, especially if social/political differences get in the way of progress.
Growth characteristics and how they are changing For the first time in recent years, Chile is expected to lead regional growth in the coming year on the back of an aggressive Piñera pro-growth agenda, accelerated by ongoing earthquake reconstruction efforts. This should be further helped by supportive demand dynamics out of China and expansionary fiscal policies (benchmark rate not likely to surpass 4.25% – lowest YE11e level in the region), not to mention micro-level incentives for investment by both locals and foreigners.
Drivers of returns – Multiples and growth The top-down scenario remains attractive, but valuations are lofty at nearly 18x forward P/E, representing a 50% premium to LatAm, which is just ahead of historical levels (despite recent factors that are working to close the spread – such as the move to IFRS and regional expansion). As the Chile premium suggests, performance is largely tied to supportive domestic flows (and limited foreign ownership). This support was strong in 2010 given weakness elsewhere. In the event that key markets, such as Brazil, China and the US, perform well in 2011 (especially relative to domestic fixed income), this will likely limit domestic flows, specifically from pension funds, which may be forced to trim domestic equity positions to remain within their limits.
Recommendations Although we like the Chile growth profile, we focus on names that are expanding abroad (Falabella, CCU). We also find copper play Antofagasta at an attractive valuation with significant growth potential. We avoid utility IAM, given strong relative outperformance in the utilities sector and potential Aguas Andinas share sale overhang. We also see limited upside after the speculative rise in SQM’s share price.
Top picks and stocks to avoid Mkt cap P/E (x) EPS Div. yield ROE Price Code Rating (US$MM) 10E 11E 10E 11E 11E (%) 11E (%) Top picks Falabella 4849.5 FALAB N 24,106 38.5 31.4 125.92 154.40 0.8 13.0 CCU 56.1 CCU OW 3,647 15.1 13.7 3.70 4.08 4.5 21.6 Antofagasta Minerals 1326.0 ANTO OW 22,744 16.5 11.4 80.30 116.50 0.5 116.5 Stocks to avoid IAM 747.0 IAM N 15,735 1,558 16.1 16.1 46.36 46.36 5.9 SQM 51.5 SQM N 13,873 43.6 30.4 1.18 1.69 0.0 24.6 Source: Bloomberg, J.P. Morgan estimates. Note: Share prices and valuations are as of October 28, 2010.
MSCI Chile absolute and relative to EMF Index
0
100
200
300
400
500
600
700
Dec-02 Mar-04 May -05 Aug-06 Oct-07 Jan-09 Mar-10
Absolute Relativ e to MSCI EMF Index
Source: MSCI, Datastream.
MSCI fair value range
(4293)
(4068)
(2181)
(4723)(2906)
(5772)
(6797)
(3979)
1000 2000 3000 4000 5000 6000 7000
FWD PER
PER
PBR
DY
BY/EY
BY/DY
Source: MSCI, IBES, Datastream, J.P. Morgan.
Currency outlook (CLP/USD)
400
450
500
550
600
650
700
750
800
Dec 04 Apr 06 Jul 07 Nov 08 Feb 10 Jun 11
Consensus
J.P. Morgan forecast:end Dec 10: 480end Mar 11: 505end Jun 11: 500
Colombia Strategy Key country dynamics The long-term structural rerating story continues in 2011 with the implementation of a new pension multifund system and potential advancements in tax/fiscal reform, which will likely result in investment grade. This should continue to drive investment growth in the country. We are also likely to see improvements on the trade front, including restored relations with Venezuela and numerous pending trade agreements. With key FARC leaders out of the picture, Colombia will move a step closer to peace, which could yield additional dividends. We see the key risk as reform watered down in order to maintain political consensus.
Growth characteristics and how they are changing Despite the structural improvements and macro-level progress, which is boosting investment, Colombia still faces challenges in achieving its full growth potential (JPM 2011e GDP growth at just 4.1%), primarily on the private consumption side. We believe this represents an opportunity for the Santos Administration, but major progress will take time, requiring a combination of job creation and investment diversity initiatives (via payroll tax reform and education/innovation programs). We also see access to credit as a key theme, with current caps limiting expansion in the lower-income segments (as well as for SMEs).
Drivers of returns – Multiples and growth Colombia shares a similar dynamic with Chile, as supportive domestic flows (and limited foreign ownership) help prop up valuations (current premium well ahead of historical averages). This is furthered by local accounting rules and complicated cross-holding structures, not to mention hidden assets. While growth fundamentals may not justify current valuations, we see flow support continuing in 2011 on the back of the multifund switch and Andean stock exchange integration, which should keep valuations riding high.
Recommendations We focus on selective growth opportunities at reasonable valuations (Pacific Rubiales, Millicom) and second-tier-liquidity stocks that have lagged this year (Exito) but could benefit from supportive domestic/regional flows. We avoid the large/liquid names that have led 2010 outperformance (Bancolombia, Ecopetrol), especially as flows may be redirected to second tier names and a series of new listings.
Peru Strategy Key country dynamics 1H11 will be dominated by the run-up to April presidential elections. Although we saw political overhang in 1H10, it has since started to dissipate as leftist candidate Humala is running 4th. The three currently leading candidates are all center-right, suggesting that it is unlikely we will see any meaningful changes to Peru’s market-oriented macroeconomic policy. We believe this will help cement the current economic consensus in the country. However, given Peru’s history of surprises on election day, we don’t rule out intensified noise and/or a renewed overhang leading up to the elections, especially considering that most polls don’t include rural areas, which tend to favor Humala. In addition, the emergence of Keiko Fujimori as the leading contender could reignite some historical social/political polemics.
Growth characteristics and how they are changing After a return to Asia-level GDP growth in 2010 (JPMe GDP growth of 8.2%), we expect growth to taper off to 6% in 2011, mainly due to a pullback in stimulus and tighter monetary policy. However, with tame inflation, strong commodity prices, growing credit growh and the CB on hold, there is room for upside surprises. In addition, given strong economic ties to China, progress there will be a key determinant of the extent of growth.
Drivers of returns – Multiples and growth Valuation premiums are a bit ahead of historical levels. However, they are still lower than other Andean peers’, primarily due to commodity exposure and liquid gaps (index top and bottom heavy). We believe that scarcity value in the liquid names (BAP, BVN, SCCO) is relevant and if polling data continue to suggest political continuity, it is likely to boost these names and possibly widen the premiums. We also see Peru as a beneficiary of Andean stock exchange integration, as domestic investors in Chile and Colombia look to diversify away from their home markets.
Recommendations We focus on playing continued strong domestic growth and potentially positive election results through the only liquid domestic proxy, leading bank Credicorp. We also play precious metal momentum and our generally bullish stance on silver through Silver Wheaton. We avoid Buenaventura given strong outperformance recently, but acknowledge its reserve replacement track record and scarcity value as a liquid Peruvian name.
Top picks and stocks to avoid Mkt cap P/E (x) EPS Div. yield ROE Price Code Rating (US$MM) 10E 11E 10E 11E 11E (%) 11E (%) Top picks Credicorp 124.7 BAP N 10,099 17.2 15.2 7.23 8.20 1.7% 22.1% Silver Wheaton 27.6 SLW OW 11,374 38.3 21.0 0.72 1.31 0% 18.5% Stocks to avoid Buenaventura 51.7 BVN N 14,939 19.8 14.6 2.61 3.55 0.9% 26.5% Source: Bloomberg, J.P. Morgan estimates. Note: Share prices and valuations are as of October 28, 2010.
MSCI Peru absolute and relative to EMF Index
0
200
400
600
800
1000
1200
Dec-02 Mar-04 May -05 Aug-06 Oct-07 Jan-09 Mar-10
Absolute Relativ e to MSCI EMF Index
Source: MSCI, Datastream.
MSCI fair value range
(634)
(1764)
(970)
(751)
(2635)
(3495)
(2285)
(3026)
0 500 1000 1500 2000 2500 3000 3500 4000 4500
FWD PER
PER
PBR
DY
Source: MSCI, IBES, Datastream, J.P. Morgan.
Currency outlook (PEN/USD)
2.5
2.7
2.9
3.1
3.3
3.5
Dec 04 Apr 06 Jul 07 Nov 08 Feb 10 Jun 11
J.P. Morgan
Consensus
J.P. Morgan forecast:end Dec 10: 2.78end Mar 11: 2.84end Jun 11: 2.82
Argentina Strategy Key country dynamics All eyes will be on the political situation in 2011 ahead of October presidential elections. The outlook is highly uncertain as most candidates will likely have to reinvent themselves after the death of ex-President Nestor Kirchner. We see this as a potential opportunity for Cristina Fernandez Kirchner and Peronist dissidents (PJ) to unite, while key opposition groups (PRO and Radicals) now face the challenge of adjusting their campaign from a primarily anti-Kirchner stance to a more progressive form. We take a cautious stance and see a Peronist win as the base case but acknowledge that any move toward political/economic orthodoxy and subsequent reform would be a big catalyst for the market.
Growth characteristics and how they are changing After accelerated growth in 2010 (JPMe GDP growth 8.5%), growth in 2011 will taper off (JPMe GDP growth 5.5%) as activity is curbed by rapidly rising inflation (JPMe proxy 25-30%). The use of fiscal resources should remain strong, especially in an election year and helped by what we expect to be robust agricultural commodity prices. Risks to growth (upside and downside) are largely tied to the global economy.
Drivers of returns – Multiples and growth With the near-term “spread reduction trade” priced and the longer-term “election trade” accelerated on the death of Nestor Kirchner, we believe multiples are for the most part accurately reflecting the current balance of risks. We only see an opportunity for significant further multiple expansion in the event of a more orthodox political and economic environment, backed by a reform agenda. Although there is growing optimism for a move in that direction, we believe it is still too early to tell who will win in 2011 and whether or not a reform agenda can and will be implemented. Furthermore, while the focus is on politics, at the micro level we are likely to see slower growth and inflation thinning margins.
Recommendations We focus on names with solid growth prospects in the coming year at attractive valuations that will likely benefit from the immediate political situation (Clarin and Tenaris). We avoid utilities, such as Edenor, which face an uncertain potential reform agenda. That said, the shares are likely to move on any signs of political progress.
Top picks and stocks to avoid Mkt cap P/E (x) EPS Div. yield ROE Price Code Rating (US$MM) 10E 11E 10E 11E 11E (%) 11E (%) Top picks Grupo Clarin 10.0 GCLA OW 1,437 3.4 2.5 2.92 4.00 0% 12.7% Tenaris 41.3 TS OW 26,237 20.1 16.0 2.06 2.59 0.9% 14.8% Stocks to avoid Edenor 10.3 EDN UW 494 13.3 12.2 0.77 0.84 0% 7.0% Source: Bloomberg, J.P. Morgan estimates. Note: Share prices and valuations are as of October 28, 2010.
MSCI Argentina absolute and relative to EMF Index
0100200300400500600700800900
1000
Dec-02 Mar-04 May -05 Aug-06 Oct-07 Jan-09 Mar-10
Absolute Relativ e to MSCI EMF Index
Source: MSCI, Datastream.
MSCI fair value range
(15631857)
(64068241)
(4509706)
(21956168)
(13335147)
(66024799)
(50289622)
(33410334)
400000 15400000 30400000 45400000 60400000
FWD PER
PER
PBR
DY
`
Source: MSCI, IBES, Datastream, J.P. Morgan
Currency outlook (ARS/USD)
2.8
3.0
3.2
3.4
3.6
3.8
4.0
4.2
4.4
4.6
Dec 04 Apr 06 Jul 07 Nov 08 Feb 10 Jun 11
J.P Morgan
J.P. Morgan forecast:end Dec 10: 4.05end Mar 11: 4.15end Jun 11: 4.15
Agribusiness, Pulp and Paper Key country dynamics Grain prices seem to be well supported at current levels even after a 30-60% rally since early July. Robust Chinese demand along with concerns over supply, especially in light of a La Nina year, should keep risk premiums high. As J.P.Morgan’s Soft Commodity Strategy team highlights, there’s a real possibility of corn prices hitting $7/bu in ’11, which would reverberate through the rest of the grain complex. Sugar prices continue to confound, having gone from 30c/lb to 13c/lb and back again in the course of 2010, with the only constant volatility. Any shortfall in Indian and Brazilian production estimates could take sugar prices higher still. That being said, we believe any supply squeeze would be relatively temporary and see sugar prices settling at closer to 15-18c/lb longer term. We remain structural bulls on pulp but cautious on 12M outlook. Pulp prices as of October were already 5% below their June peak, and we expect another ~17% decline through 2011 as pulp supply recovers from market- and weather-related downtime in ’09-’10 and as end demand remains lackluster. That being said, any significant improvement in developed world employment should lead to improved paper demand and poses upside risk to our outlook.
Growth characteristics and how they are changing Growth in 2011 for our covered names will be more a function of commodity prices than of capacity expansions. Longer term, we see all of our companies as having a global cost advantage and expanding production through greenfields, debottlenecking and M&A.
Drivers of returns – Multiples and growth We are not expecting multiples rerating as we do not see structural changes justifying it. Multiples should continue to reflect cyclical trends (peak multiples on trough earnings and vice versa). Near-term growth will remain dependent on commodity prices.
Recommendations We highlight the Brazilian sugar and ethanol producer Sao Martinho (SMTO3/OW) as the best play on higher near-term sugar prices. We are UW on Fibria (FIBR3/FBR) as we believe pulp sector momentum will remain negative in ’11 and valuations are not yet attractive enough to justify owning at this point of the cycle.
Overweight R$23.00 (08 Nov 10) Price Target: R$29 End Date: Dec 2011
Company description São Martinho is a top-five sugar and ethanol producer in Brazil. In the 2009/10 crop year, São Martinho crushed 13 mt of sugarcane, of which 65% was owned (40% came from third parties) and 40% was destined for sugar production (60% to ethanol). São Martinho operates 3 mills, 2 in São Paulo state and one in Goiás state. The company’s Goiás unit (Boa Vista mill) started up in the 2009 crop and will exclusively produce ethanol and electricity. São Martinho (SMTO3 BZ) shares are listed on Bovespa’s Novo Mercado.
Investment case We see Sao Martinho as the best way to gain exposure to stronger global sugar and Brazilian ethanol prices. Given the diversification of the rest of its listed domestic peers, SMTO is now the most exposed operationally to S&E. In addition, we believe the company has interesting partnerships with both Petrobras (rated Neutral by JPM LatAm oil & gas analyst Sergio Torres) and with biotech producers, the latter potentially leading to new revenue streams.
Potential for earnings upgrades Given the sharp rally in sugar and ethanol prices since midyear, there should be significant upside to consensus estimates if it is sustained. Our FY11E EBITDA of R$493m is 8% above consensus.
Prospects for re-/derating We see Sao Martinho as a well-managed company, with good capital discipline and corporate governance. On the other hand, lack of share liquidity is a concern for many investors, as is the volatility of the sector, which we do not foresee changing in the near term. Hence we are not looking for a rerating.
Price target and risks We have an OW rating on SMTO3 and a price target of R$29/sh for Dec.’11 based on a mix of: (1) DCF of R$27.5 using normalized sugar prices of 15c/lb and BRL of R$2.05 (equivalent to sugar prices of 18c/lb at spot BRL) and a WACC of 9.3% which incorporates a risk premium for lower share liquidity; (2) 5x multiple on FY12 EBITDA resulting in R$28.3; (3) replacement value analysis leading to R$27.1; and (4) recent M&A multiples of $100/tonne implying FV of R$36.1. Key risks to our rating and estimates on SMTO are: (1) evolution of sugar and ethanol prices; (2) stronger-than-expected BRL; (3) operational problems; (4) worse-than-expected economics of farnesene JV.
Underweight R$30.03 (28 Oct 10) Price Target: R$26 End Date: Dec 2011
Company description Fibria was formed by the merger of VCP and Aracruz and is the leading market pulp producer in the world, with 11% global market share. It has 5.6mt of market pulp capacity at 5 sites in Brazil along with 540,000 ha of eucalyptus plantations. The company is controlled by the Votorantim Group (29%) and by the local development bank, BNDES (30%), and has recently migrated to the Novo Mercado level of the Bovespa, the highest corporate governance standard in Brazil.
Investment case Despite our structurally optimistic view on the sector, we continue to see downside to near-term pulp prices and believe that neither sector momentum nor company valuations provide reasons for owning the stock at this point.
Potential for earnings upgrades Fibria is highly sensitive to changes in pulp prices given its operational focus (>90% of profits) and levered balance sheet (4.7x ND/EBITDA as per last reported balance sheet). Every $30/t move in the pulp price leads to a 10% change in EBITDA. Our sense is that consensus estimates are assuming flat pulp prices for ’11, suggesting downside risk to estimates if we are right on the pulp cycle outlook.
Prospects for re-/derating Cyclical stocks tend to trade at higher multiples on trough earnings and vice versa. Given our expectation of still an above average cyclical year in ’11 for prices (BEK avg of $800/t vs. normalized $750), we believe the stock should trade at or below a normalized multiple of ~8x.
Price target and risks We rate Fibria UW and have a R$26 ($16) Dec-11 price target. Our price target is based on: (1) DCF analysis using 9.6% WACC (R$24/sh); (2) 8x target multiple on ’11E EBITDA (R$24/sh) and (3) replacement value (R$30.5/sh). Key upside risks to our UW rating include: (1) higher pulp prices; (2) weaker BRL; (3) potential divestiture of paper assets.
Financials Key country dynamics We continue to see mostly favorable credit dynamics in the region. In Brazil, Peru, Chile, and Argentina, we believe that credit growth should remain healthy in 2011. We are forecasting loan growth of 17%-19% for the banks we cover in these markets. Asset quality trends should also continue improving, albeit at a more moderate pace than in 2010. In addition, we are seeing rapidly improving credit trends in Mexico and Colombia, which we expect to continue. However, continued low benchmark rates could pose risk to NIMs in Mexico.
In contrast with the positive credit trends, we have a cautious view of the Brazilian merchant acquiring business. We believe pressure on MDRs and POS rental rates should be meaningful in the coming years.
What could be the positive drivers for banks? Operating dynamics remains favorable for Brazilian banks. We see good double-digit earnings growth driven by 15%-20% loan growth, some efficiency improvements, and lower credit losses. For Banorte, loan growth will likely re-emerge and delinquency rates should continue declining, thereby leading to healthy earnings growth of 26.5% in 2011, according to our estimates. We see continued high-20% ROEs for Santander Chile and Banco de Chile in an environment of moderate inflation and good economic growth. Bancolombia should generate ROE expansion (albeit from a relatively low high-teen range) as loan growth picks up and, possibly, interest rates rise. At Credicorp, strong loan growth and cost controls should offset lower trading gains and drive 13% earnings growth in 2011.
Drivers of returns – Multiples and growth When regressing expected 2011 and 2012 ROEs against price-to-book value multiples for Latin American banks in our coverage universe, Santander Brasil, Itau Unibanco, Bradesco, and Banco do Brasil trade roughly 5%-20% below the fair price to book value predicted by the regression analysis. We expect a convergence of multiples across the region as the Brazilian banks continue posting good results and some of the “macro” overhangs related to the sector (election cycle, equity offerings) have been removed.
Recommendations Overweight: Santander Brasil (top pick), Banco Bradesco, Banco Itaú Unibanco, Grupo Financiero Galicia, Bladex. Avoid: Grupo Financiero Inbursa, Bancolombia, Redecard, and Cielo.
Source: J.P. Morgan and Bloomberg, share price data as of October 28, 2010. Risk-adjusted ROE calculated by subtracting est COE from forecast ROE in 2011 and 2012.
Share price performance in local currency – YTD: Latin American financials ex-Brazil were the main outperformers
81%
57% 56%
42% 42% 40% 38% 36%29% 27%
22%17% 13% 13% 10% 10% 7% 6% 6% 3% 3%
-21%
-5%
Mac
ro
Cred
icorp
Banc
o de
Chil
e
Sant
ande
r Chil
e
Inbu
rsa
Banc
olom
bia
Peru
Inde
x
Chile
Inde
x
Com
parta
mos
Arge
ntina
Inde
x
Porto
Seg
uro
Brad
esco
Banc
o do
Bra
sil
Bano
rte
Mex
ico In
dex
Blad
ex
Itau
Uniba
nco
KBW
ban
k In
dex
S&P
Sant
ande
r Bra
sil
Ibov
espa
Cielo
Rede
card
Source: Bloomberg. Share price data through October 28, 2010. Credicorp’s share price is adjusted for the performance of the currency (Nuevo Sol).
Top picks and stocks to avoid Mkt cap P/E (x) EPS Div. yield ROE Price Code Rating (US$MM) 10E 11E 10E 11E 11E (%) 11E (%) Top picks Santander Brasil R$24.57 SANB11 OW 54,565 15.0 10.7 R$1.62 R$2.13 5.2 14.4 Bradesco R$34.96 BBDC4 OW 76,854 13.5 12.2 R$2.59 R$2.88 2.9 21.2 Stocks to avoid Bancolombia (ADR) $66.04 CIB US UW 13,007 20.0 18.0 $3.30 $3.68 1.8 18.4% Source: Bloomberg, J.P. Morgan estimates. Note: Share prices and valuations are as of October 28, 2010.
Banco Santander Brasil SANB11.SA www.santander.com.br
Overweight R$24.57 (28 Oct 10) Price Target: R$33 End Date: Dec 2011
Company description Santander Brasil is Brazil’s 3rd-largest private bank, based on assets, loans, deposits. The bank serves individuals and corporates and has grown through acquisitions, notably of Banespa, in November 2000 and Banco Real from ABN AMRO in 2008. The bank IPO’d in October 2009. As of Sept 2010, the bank has assets of R$357bn, loans of R$153bn and equity of R$73.0 bn.
Investment case As a leading financial institution, Santander should benefit from growth in penetration. In addition, earnings growth driven by volumes, cost saves, lower credit losses, coupled with capital optimization, should drive meaningful ROE expansion. We see adjusted IFRS ROE growing to 16.4% by 2012 from 11-12% now. This should see P/BV expansion from its current 1.7x BV. Our 2011 price target of R$33 is based on a target 11E book value multiple of 2.2x.
Potential for earnings upgrades There is a lack of consensus about which accounting standards sell-side analysts base financial projections for Santander Brasil on (IFRS or Brazilian GAAP). Hence, it is difficult to assess the extent earnings upgrades are possible. Our forecasts and the company’s primary reporting standard is IFRS. We forecast IFRS earnings growth of 28.8 % in 2011 and 17.3% in 2012.
How much is already priced in? We do not believe the multiyear ROE expansion is adequately priced. In 2012, we expect the bank to generate adjusted IFRS ROE of 16.4%. Based on current ROEs vs P/BV multiples for publicly traded Latin American banks in our coverage universe, this ROE is consistent with a P/BV multiple of 2.1x.
Price target and risks YE11 R$33/share, US$18/ADR (at JPM’s 2011 FX of R$1.8). We use a residual income model & regression of risk-adjusted ROE to P/BV. Key risks: resumption of asset quality deterioration; failure to realize cost synergies from Banco Real merger; slower loan growth recovery; business disruptions due to IT integration issues; negative ruling from federal government on deductibiltiy of goodwill amortization for tax purposes; negative actions taken by Santander Spain that could impact the growth and profitability of Santander Brasil.
Underweight $68.74 (4 Nov 10) Price Target: $65 End Date: Dec 2011
Company description Bancolombia is Colombia’s largest bank (23% loan share). It also owns Banagricola, El Salvador’s largest bank (31% share). The company also provides financial products in Panama, Peru, Brazil, the US and Spain.
Investment case Bancolombia is the leader in the underpenetrated Colombian and El Salvador banking systems. Economic activity is improving and rates are unsustainably low in Colombia and likely to increase, benefiting earnings and profitability. We forecast local currency earnings growth of 19.2%, on average, from 2010 to 2012, and for ROEs to expand to 19.2% in 2012 from 17.9% in 2010. Newly elected President Santos has a market-friendly economic policy. This could lead to policy changes, such as modifications to the existing usury laws, that would increase the maximum interest rate that can be charged by banks.
Potential for earnings upgrades Faster-than-expected economic growth and an increase in NIMs due to higher rates lead to upside risk to consensus local currency numbers. US$ earnings could also benefit if the Colombian peso remains strong. Our 2011 EPADR estimate incorporates an average COP/US$ exchange rate of 2,200 versus the November 4th exchange rate of COP1,818/US$.
Prospects for re-/derating Even factoring in improving prospects, the bank is pricing ample improvement. The stocks trades 3.4x bv and 18.0x 12e local EPS (18x 12e US$ earnings). It is generating ROEs of about 18%. Our regression of ROE to P/B using a cross section of LatAm banks, shows this is consistent with a 2.8x P/B multiple.
Ultimately, we feel Bancolombia benefits from scarcity value; being the only domestic-focused stock with a liquid ADR. Hence, it may be susceptible to the emergence of alternative domestic investment opportunities. Operationally, while good local currency earnings growth is likely, Bancolombia has lost share in consumer lending and struggled with costs.
Price target and risks YE11 US$60/ADR (at JPM’s end-2011e FX of COP$2,200). We use a residual income model and regression of risk-adjusted ROE to P/B. Key risks: faster-than-expected improvement in economic conditions; a faster-than-expected rebound in NIMs; value-creating acquisitions; and continued positive sentiment toward the country’s improving macroeconomic and political dynamics.
SMid Cap Financials Key country dynamics SMid caps should continue to experience above-system growth in 2011, especially in SME lending and microlending, on the back of favorable macroeconomic trends and low leverage. We like banks with solid balance sheets, especially good access to funding, as we view this is as a structural weakness of small banks (Figure 1). 2010 was about asset quality; in 2011, investor focus will be on possible pressure on margins.
In our coverage of 6 SMid cap financials in Brazil and Mexico, we like Banrisul, Cetip and Compartamos. We base our preference for SMid caps on: 1) strong balance sheets (high BIS, high loan-loss coverage, stable funding, low debt ratio); 2) low risk of pricing/margin pressure; 3) best EPS growth; 4) M&A potential; 5) limited political/regulatory risk; 6) product diversification in 2011e adding new revenues sources; 7) attractive growth-adjusted valuations.
Growth characteristics and how they are changing In Brazil, SME lenders (roughly half of Banrisul’s portfolio is small corporate) should see loan growth above 25% versus a system average of ~20%, adding to recent strong loan growth in Brazil (Figure 2). With loan growth and stable asset quality viewed as a given, investors will focus on margin compression (on the back of changes in mix and/or increased competition). We expect Cetip to see strong earnings growth (JPMe 34% growth in EPS in 2011) on the back of higher volumes.
In Mexico, Compartamos should continue to grow, on the back of 1) the underpenetration of lending, especially for lower-income segments; 2) the benign regulatory environment (we don’t think problems in Indian microfinance will spill over to other markets); 3) contained competition.
Drivers of returns – Multiples and growth Loan growth will be the main earnings driver, while inflows (especially from foreign investors) will continue to support valuations. Efficiency gains will also drive earnings growth, and we expect efficiency to improve (at Banrisul) or remain stable (at Cetip and Compartamos).
Recommendations Overweight: Banrisul, Cetip, Compartamos. Stocks to avoid: PanAmericano.
Figure 1: Brazil/Mexico: Access to funding remains a key bottleneck for small banks, hence our focus on balance sheet strength (market share of deposits of top 5 banks)
31%39%
47%53%
64% 65% 69% 70% 76% 76% 77% 82% 86% 89%
USA
Spain Ita
ly
Arge
ntina
Colom
bia
Fran
ce UK
Portu
gal
Braz
il
Chile
Mex
ico
Swed
en
Peru
Belgi
um
Source: Central banks and J.P. Morgan.
Figure 2: Brazil: Loans-to-GDP ratio: We expect SME lending to play a key role in the next growth phase
20
25
30
35
40
45
50
1989
1991
1993
1995
1997
1999
2001
2003
2005
2007
2009
Source: Brazilian Central Bank.
* Registered/qualified as a research analyst under NYSE/NASD rules.
Overweight R$18.00 (28 Oct 10) Price Target: $20 End Date: Dec 2011
Company description Banrisul is the largest of the small caps under our coverage. It is also the only small bank with access to retail funding. The bank is controlled by the state of Rio Grande do Sul (owns 57%) and has a dominant market share in its home state (17% loan market share). The bank offers a wide variety of loans, including individual (45% of total book, mostly payroll), corporate (32% of loans), real estate (8% of loans), and agribusiness (7% of loans). Banrisul is the 11th-largest bank by assets in Brazil and has a market share of 0.8% of total loans in the Brazilian banking system (largest bank, Banco do Brasil, has 21%).
Investment case We have an Overweight rating on the stock (BRSR6) due to the bank’s strong funding structure (based on stable and cheap retail funding), good loan growth outlook (around 25% in 2010-12e), and solid coverage of nonperforming loans (ratio of loan-loss reserves to loans past due 60 days or more 226% in 2Q10).
Potential for earnings upgrades We expect loan growth to be the main driver of earnings growth, as net interest margins and loan-loss provisions should remain relatively stable in the next 12 months. Additionally, improved operating efficiency (historically a weak point at Banrisul) should continue improving, mostly on the back of lower administrative expenses.
Prospects for derating Lower-than-expected loan growth and the potential appointment of a new and heterodox management team at the bank could disappoint investors.
Price target and risks Our Dec-11 price target of R$20 is based on a residual income methodology and a regression of ROE and P/BV multiples for banks. We assume a cost of equity of 13.1% and long-term earnings growth of 5%. Risks to our price target and OW rating include 1) political interference at the bank; 2) lower-than-expected loan growth; 3) limited gains in efficiency.
Latin America SMid Cap Financials Frederic de Mariz AC *
Underweight R$7.73 (28 Oct 10) Price Target: $10 End Date: Dec 2011
Company description PanAmericano offers consumer loans to the lower-income segments of the population, making it an ideal play on rising income levels in Brazil. Roughly two-thirds of the bank’s loan portfolio are vehicle lending, with payroll and credit cards making up the rest of the portfolio. The bank has a network of 199 points of sale, 2.1 million clients and 12.1 million issued credit cards. The bank currently has a market share of 0.4% of loans in the Brazilian banking system (the leader, Banco do Brasil, has a market share of 21%).
Investment case We have an out-of-consensus Underweight rating on the stock (BPNM4), due to 1) accounting issues and weak internal controls; 2) uncertainties around the new management team; 3) weaker funding structure than that of other banks in our coverage universe (roughly half of the funding comes from loan cessions, loan securitization and time deposits with a special guarantee), and 4) lower loan growth outlook in auto loans than in other loan segments.
Potential for earnings upgrades The bank will continue to suffer from high loan loss provisioning levels (D-H ratio at 10.9% as of 2Q10). Also, tougher competition in the auto lending segment could put pressure on margins.
Prospects for rerating We have a cautious view on the benefits that CEF could bring to PanAmericano. CEF announced the purchase of 37% of PanAmericano in Dec-09. The stock could rerate if the new management team of PanAmericano were to articulate how the agreement with CEF could 1) improve the funding structure of PanAmericano and/or 2) bring revenue synergies.
Price target and risks Our Dec-11 price target of R$10 is based on a residual income model and a regression analysis of ROE and P/BV. We consider a cost of equity of 13.1% and a long term earnings growth of 6%. Risks to our UW rating relate to a redefinition of the strategy of the bank by the new management team, an improvement in funding structure and significant revenue synergies with CEF.
Latin America SMid Cap Financials Frederic de Mariz AC *
Source: Bloomberg. * Registered/qualified as a research analyst under NYSE/NASD rules.
Company Data Price (R$) 7.73Date Of Price 28 Oct 1052-week Range (R$) 12.36 - 6.55Mkt Cap (R$ mn) 1,888.78Fiscal Year End DecShares O/S (mn) 244Price Target (R$) 10.00Price Target End Date 31 Dec 11
Food, Beverages & Tobacco Key sector dynamics LatAm beverage markets are mainly oligopolies with rational pricing and stable volume growth. Companies have seen aggregate sales CAGR of 12% last decade. They have little or no debt, robust margins and high ROICs. On the other side, LatAm food can be divided in two: packaged food companies with branded products, and meat/commodities beef companies with volatile margins (raw material and Fx). For tobacco, it is all about brands and pricing power while containing higher taxes and usage restrictions.
Growth characteristics and how they are changing Economics, demographics and specific company strategies should keep driving organic LatAm staples growth, especially in beverages. For the food sector we expect a confluence of both organic and inorganic growth as we expect consolidation in the food space to continue. In our view, tobacco sector growth will be driven mostly via pricing and innovation and despite stable to declining volumes.
Drivers of returns – Multiples and growth Emerging market staples are trading above developed markets’. This is a first. Plus, the LatAm staples group is already trading at a record premium of 70% over the rest of the LatAm MSCI. We don’t see this gap spreading further, but it should remain stable. A key valuation driver should be use of cash, specifically how much is returned to shareholders. These beverage and tobacco companies pose upside risks to increased dividends. Meat (beef) companies face a different challenges related to how to maintain or expand their low profitability and their delevering process.
Recommendations Despite some relatively rich valuations we still see as an opportunity FMX (OW) for EPS growth, CCU (OW) for its relative value and Modelo (OW) for event-driven growth. Among food companies, we prefer processed food powerhouse and poultry exporter Brasil Foods (OW). This company has a solid growth outlook and material upside risk to merger synergies. On our sole tobacco company, Souza Cruz, we currently remain Neutral on valuation. In one sentence, our sector has high-quality names that are not cheap but pose selected opportunities with the right risk/reward balance.
Top picks and stocks to avoid Mkt cap P/E (x) EPS Div. yield ROE Price Code Rating (US$MM) 10E 11E 10E 11E 11E (%) 11E (%) Top picks FEMSA 26.4 CSMG3 OW 1,783 6.4 6.0 4.13 4.39 8.3 12.0 Brasil Foods 23.5 GETI4 OW 5,246 10.7 9.8 2.19 2.38 10.7 181.4 Stocks to avoid Minerva 40.4 CPFE3 UW 11,368 13.7 13.9 2.94 2.90 5.4 25.3 Source: Bloomberg, J.P. Morgan estimates. Note: Share prices and valuations are as of October 28, 2010.
Food and beverages absolute and relative to MSCI LatAm
Brasil Foods BRFS3.SA www.perdix-international.com
Overweight R$24.42 (28 Oct 10) Price Target: R$31 End Date: Dec 2011
World’s largest exporter of chicken Brasil Foods (BRFS3) is the merged entity of Perdigao and Sadia, the two leading poultry companies in Brazil. With $15bn in annual revenues, Brasil Foods is the fourth-largest protein co. in the world. It sells mainly poultry. Most BRFS sales are in the domestic Brazilian market, yet it is the global leader in chicken exports. Domestically, BRFS3 is the undisputed leader in processed foods, which have better margins than commodity proteins. The co. also sells pork, beef cuts, milk and other dairy products. Its operations are fully integrated, and it owns the largest number of consumer brands in Brazil. Undisputed leader in the growing Brazilian market Poultry has been the fastest-growing protein globally for well over a decade. Strong demand continues in Brazil and abroad. The premium in price of beef vs. chicken is well above the historical average. We expect beef prices to remain high; given this and recent increases in corn and soy prices, we estimate we are entering a year when prices for global poultry should increase. In this sense, Brasil Foods is well positioned to benefit from this situation. Potential for earnings upgrades – More synergies, less taxes For a LatAm meat company, Brasil Foods’ ’10e net debt to EBITDA of 1.9x is one of the lowest. Plus, once Brazil’s regulatory authority, CADE, approves the integration with Sadia, we believe the company is likely to positively surprise the market with synergies materially higher than its current guidance of R$500mn/year. Net net: with higher-than-expected FCF generation, we see upside risk to our ’11e EPS estimate of R$1.44 for BRFS3. Stock should at least maintain its valuation multiple Although at 8.5x ’11e EV/EBITDA and 17.0x ’11e P/E the stock does not look cheap, we believe these multiples have yet to capture the full value of the company given a) post integration BRFS will have unparalleled scale and pricing power in Brazil, b) that BRFS3 should be a key beneficiary of accelerated global growth in poultry market and, lastly, c) its potential to deliver higher-than-guidance synergies from the merger and yet-to-be-accounted tax benefits. Dec ’11 PT offers 27% potential upside – with some risks Using perpetuity growth of 3% and a WACC of 9.5%, our DCF model indicates a Dec ’11 PT of R$31 for BRFS3, implying 27% upside & a 2% div yield. Key risks are a) a weaker-than-expected rebound in poultry market; b) failure to deliver expected synergies; and c) Fx & grain price volatility.
Latin America Food, Beverage and Tobacco Alan Alanis AC
Overweight $54.92 (28 Oct 10) Price Target: $59 End Date: Dec 2011
A consumer conglomerate FEMSA (FMX) is a holding company with three major investments: (a) 100% ownership of Oxxo, a chain of +8k convenience stores in Mexico that is among the fastest-growing and most profitable retailers in the region. (b) 54% ownership and full management control of Coca-Cola FEMSA (KOF), the largest Coke bottler in Latin America. KOF sells Coke products in nine Latin American countries – including Mexico and Brazil – for the equivalent of what would be more than 1 out of 10 Coke products in the world. (c) 20% ownership of Heineken, a leading global beer company. At a very attractive discount to the sum of its parts FMX’s valuation gets a deep discount for its corporate structure. We believe this is unmerited and unsustainable. Both Heineken and KOF are listed, so taking their current prices, we see Oxxo with an implied EV/EBITDA multiple of only 7x. This is half the current valuation of Walmex, Mexico’s leading retailer. Yet Oxxo has faster growth, better margins and more scale versus its competitors. Furthermore, Oxxo keeps opening stores at a pace of almost 3 per day. Working capital of the business is a beauty – all they sell is cash, all they buy is on credit. Payback for store investments is ~ 3 years. From a net cash position, FMX balance sheet is getting even stronger We expect dividends coming from Heineken to increase, as well as those coming from KOF. On top of that, Oxxo should continue to grow and expand its margins regardless of the economic scenario. Catalysts include higher dividends and continued growth FMX (ex-KOF) is already sitting on +$500mn of net cash. So absent any large acquisition, shareholders of FMX have material upside risk on dividends (currently 2% for ’11e). Also, we see room for multiple expansion if KOF resumes double-digit growth next year. Price target and risks Our PT for FMX is based on the PT of Heineken (rated N by JPM European beverages analyst Mike Gibbs), our Dec 11 PT of $79 for KOF, and a 14x ’11e EBITDA for Oxxo (similar to Walmex’s historical average). We apply a 10% holdco discount to obtain a Dec ’11 PT of $59. Key risks are macro, particularly around Fx. Also, volatility of Heineken and KOF stock prices.
Latin America Food, Beverage and Tobacco Alan Alanis AC
Neutral R$6.14 (28 Oct 10) Price Target: R$8.10 End Date: Dec 2011
A sophisticated Brazilian exporter of beef Minerva (BEEF3) is the 3rd-largest beef producer in Brazil, with a slaughtering capacity of ~9k head/day in 10e. It’s a pure beef player that gets 70% of its revenues from exports. Minerva’s main products are fresh and processed beef, but the company is also Brazil’s largest live cattle exporter. Meat packers are seeing profit margin compression International beef prices are increasing, but not at the same pace as rising cattle prices. In fact, Brazilian cattle prices are now more expensive than in the US and Australia, the other two big players in the international beef market. Also, we don’t see much space for beef producers to increase prices domestically to protect margins as the beef price premium over chicken is above the historical average. Substitution toward poultry may accelerate. Hence we have a bearish view on the overall beef sector. This industry outlook leads us to believe that BEEF3 should be a stock to avoid in ’11, despite its professional and sophisticated management team. Volatility of earnings may continue Minerva’s involvement in complex financial instruments such as derivative hedges clouds earning estimates. Thus, consensus EPS estimates vary by orders of magnitude. At +4x net debt to EBITDA, Minerva is among the most levered companies in LatAm staples. We see limited potential for earnings upgrades, as these are likely to remain volatile for this producer of meat as a commodity (low-margin business). It may take many consistent (good) quarters for rerating up At 6x ’11e EV/EBITDA and 9x ’11e P/E Minerva looks inexpensive (thus our Neutral rating); but it is likely to remain that way, in our view. There is downside risk to its margins due to continued high cattle prices. Its lack of operating leverage gives limited scope for rerating. Dec. ’11 PT offers nice upside, but with high risks – Remain N Using perpetuity growth of 3% and a WACC of 10.7%, our DCF model indicates a Dec 11 PT of R$8.1 for BEEF3, implying ~30% upside. This apparent high return poses high risks, thus our relative skepticism. Furthermore, outstanding warrants (BEEF11) likely to be exercised would be dilutive. Add to macro and Fx risks, other risks inherent to the meat packing industry, such as changes in trade restrictions and further sector consolidation.
Latin America Food, Beverage and Tobacco Alan Alanis AC
Neutral Company Data Price (R$) 6.14Date Of Price 28 Oct 1052-week Range (R$) 7.92 - 5.31Mkt Cap (R$ mn) 649.23Fiscal Year End DecShares O/S (mn) 106Price Target (R$) 8.10Price Target End Date 31 Dec 11
Homebuilders Key country dynamics We continue to prefer the Brazilian Homebuilders vs the Mexican names as we expect Brazil’s macroeconomic scenario to continue supporting the sector on the back of positive government participation and a robust growth outlook. Further, we believe the expected tightening in the Selic that could begin in 2011 represents only a marginal adjustment to government monetary policy and is already priced in. Despite cost pressures in Brazil, companies have been able to maintain margins given a positive outlook on housing prices. On the other hand, in Mexico companies are in a transition phase, moving more toward the AEL segment and also entering the informal sector (self employed and informal jobs) where there is high pent-up demand but not much mortgage availability yet. Moreover, the focus is now on free cash flow generation, which is still at question given its WC demands. Revenue growth should remain in the low double digits in the near term.
Growth characteristics and how they are changing Despite the positive outlook for all income segments in Brazil, given attractive mortgage conditions and pent-up demand, the companies have been increasing their exposure to the lower-income segment to benefit from the government’s housing program and its shorter cycle. In Mexico, the sector is still recovering from the credit crisis, which reduced mortgage availability, especially from Fovissste and banks (which are focused on the middle-income and residential segments). As a result, companies remain focused on the AEL segment and are in fact increasing their exposure further due to its resilient characteristics.
Drivers of returns – Multiples and growth We are not expecting multiple expansion in Brazil or in Mexico as in both countries companies are trading in line with their 12-month averages (around 10.0-11.0x), so earnings growth will drive the upside, in our view. However, we believe investors could pay a higher multiple in Mexico if the economic outlook improves and in Brazil if companies start to generate cash. Regarding growth, we assume a conservative view for all the companies.
Recommendations PDG is the top pick among the BZ HB as its earnings have upside potential on the back of the Agre acquisition. Geo is our top pick among the MX HB given its strong growth and potential improvement in margins. We recommend that investors avoid Cyrela given current uncertainties about future results.
Adrian Huerta AC *
(52 81) 8152-8720 [email protected] J.P. Morgan Casa de Bolsa, S.A de C.V., J.P. Morgan Grupo Financiero.P. Morgan Securities LLC
Bloomberg JPMA HUERTA <GO>
Selic should not have a negative impact on Brazilian homebuilders
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50
100
150
200
250
300
May
-06
Aug-
06No
v-06
Feb-
07M
ay-0
7Au
g-07
Oct-0
7Fe
b-08
Apr-0
8Ju
l-08
Oct-0
8Ja
n-09
Apr-0
9Ju
n-09
Sep-
09De
c-09
Mar
-10
Jun-
10Au
g-10
Nov-
10Ja
n-11
Mar
-11
May
-11
Jul-1
1Se
p-11
Nov-
11
7.0
9.0
11.0
13.0
15.0
17.0BZ HB index Selic
Source: J.P. Morgan estimates and Bloomberg.
Working capital for MX continues to deteriorate Adj. Cash Conversion Cycle - In Days
Top picks and stocks to avoid Mkt cap P/E (x) EPS Div. yield ROE Price Code Rating (US$MM) 10E 11E 10E 11E 11E (%) 11E (%) Top picks PDG R$21.18 PDGR3 BZ OW 6,874 14.5 9.4 1.46 2.26 - 19.2% Geo Ps39.31 GEOB MM OW 1,747 12.2 9.7 3.23 4.08 - 22.0% Stocks to avoid Cyrela R$22.80 CYRE3 BZ UW 5,659 12.2 9.9 1.88 2.31 - 20.1% Source: Bloomberg, J.P. Morgan estimates. Note: Share prices and valuations are as of October 28, 2010.
Overweight Ps39.31 (28 Oct 10) Price Target: Ps52 End Date: Dec 2011
Company description Geo is the largest homebuilder in Mexico, selling more than 56k units per year and focused mainly on lower-income housing, with revenues of more than Ps18 bn in 2009. The company has operations in 17 states and 56 cities.
Investment case Geo is our top pick among the MX HB given its strong top-line growth of ~15% and its potential to improve operating margins. Also, the company has made significant progress on its debt profile and maintains the lowest net investment in land, which has helped it to post the highest ROEs among its peers at more than 20%.
Potential for earnings upgrades In the 1H10, the company grew more than expected, with revenues +14% yoy vs 8-11% guidance. Further, Geo released a 5-year target growth plan recently, and it expects to build 100K homes by 2015 (12.5% CAGR) and to expand gross margins by 3pp and SG&A by 1pp; however, in our estimates we are only incorporating a 1pp increase in gross margins to be conservative.
Prospects for re-/derating Despite the company’s robust growth plans, it trades at a discount to peers on P/E basis, given a lower net margin. This should change as Geo executes its growth plans, improves margins and starts to generate positive FCF.
Price target and risks We ate Geo Overweight with a Dec-11 price target of Ps52, which is the average of our DCF-based valuation and our GGM-based valuation. The COE of 10.6% is based on a beta of 1.2, country risk of 1.6%, and a risk-free rate of 3.0%, resulting in a WACC of 10.9%. We see lower-than-expected growth in revenues as the main downside risk. The company needs to generate significant FCF in 2H10 in order to be neutral to slightly positive in FCF for the year. Negative FCF for the year likely will be taken negatively by investors.
Mexico Homebuilders Adrian E Huerta AC *
(52 81) 8152-8720 [email protected] J.P. Morgan Casa de Bolsa, S.A de C.V., J.P. Morgan Grupo Financiero
Bloomberg JPMA HUERTA <GO>
32
35
38
41
Ps
Oct-09 Jan-10 Apr-10 Jul-10 Oct-10
Price Performance
Source: Bloomberg.
Performance 1M 3M 12M
Absolute (%) 8 15 9 Relative (%) 2 8 -11
Source: Bloomberg. * Registered/qualified as a research analyst under NYSE/NASD rules.
Company Data Price (Ps) 39.31Date Of Price 28 Oct 1052-week Range (Ps) 44.60 -
30.75Mkt Cap (Ps mn) 21,084.15Fiscal Year End DecShares O/S (mn) 536Price Target (Ps) 52.00Price Target End Date
Overweight R$21.18 (28 Oct 10) Price Target: R$30 End Date: Dec 2011
Company description PDG became the largest market cap (around USD6.9bn) company among the BZ HB after acquiring AGRE early in the year, thereby gaining exposure to the mid- and high-income segments and now having exposure to all income segments. The company is geographically diversified, has one of the best management teams among its peers, with a strong focus on cash flows and with management interest aligned with minority shareholders.
Investment case We believe that the recent acquisition of AGRE will provide room for stronger top-line growth versus peers’ and will allow the company to deliver one of the highest operating margins in the industry. PDG also offers opportunities to improve AGRE’s lower ROEs through better operating efficiencies and lower financial expenses.
Potential for earnings upgrades We believe that the company offers one of the highest potential upsides to earnings given the lack of track record for the combined company as PDG has only reported one quarter consolidating AGRE. We believe investors are still conservative on growth and margin assumptions for PDG.
Prospects for re-/derating Currently PDG is trading at 9.4 P/E 11E, in line with Cyrela and Rossi and at a discount to MRV; however, we believe that if margins improve and growth accelerates, it could trade at least in line with MRV’s multiples.
Price target and risks We rate PDG Overweight with a Dec-11 price target of R$30, which is the average of our DCF-based valuation and GGM-based valuation. The COE of 11.6% used is based on a beta of 1.3x, country risk of 2.1%, and a risk-free rate of 3.0%, resulting in a WACC of 10.5%. The main risks to our positive view are lower-than-expected synergies from the AGRE acquisition impacting our forecasts on growth and margins resulting in lower-than-expected results. Given its significant exposure to lower income, through Goldfarb, PDG can also be impacted by changes in MCMV policy and CEF execution capabilities.
Brazil Homebuilders Adrian E Huerta AC *
(52 81) 8152-8720 [email protected] J.P. Morgan Casa de Bolsa, S.A de C.V., J.P. Morgan Grupo Financiero
Bloomberg JPMA HUERTA <GO>
12
16
20
24
R$
Oct-09 Jan-10 Apr-10 Jul-10 Oct-10
Price Performance
Source: Bloomberg.
Performance 1M 3M 12M
Absolute (%) 2 15 51 Relative (%) 10 34
Source: Bloomberg. * Registered/qualified as a research analyst under NYSE/NASD rules.
Company Data Price (R$) 21.18Date Of Price 28 Oct 1052-week Range (R$) 22.73 -
12.32Mkt Cap (R$ mn) 11,675.24Fiscal Year End DecShares O/S (mn) 551Price Target (R$) 30.00Price Target End Date
Underweight R$22.80 (28 Oct 10) Price Target: R$29 End Date: Dec 2011
Company description Cyrela is the second-largest homebuilder in Brazil in market cap and is considered a premium player in the sector given its long track record. The company is a diversified player, acting on the lower-income segment via its “Living” brand, which launched more than 16k units in 2009, representing 40% of its total launches. Cyrela is present in 66 cities and 16 states, having one of best geographic diversifications, with a land bank of R$34.9bn in PSV.
Investment case It is our stock to avoid given the lack of good results in 1H10 as the company launched only 24% of full-year guidance vs 40-50% from peers, and also due to weakening margins in recent quarters on the back of higher-than-expected costs.
Potential for earnings upgrades We see limited room for positive earnings surprise in the short term, and given its increasing focus on the lower-income segment, margins are not likely to improve from the levels seen in recent quarters. It is important to flag that in the last 3 quarters Cyrela reported higher-than-expected project costs.
Prospects for re-/derating Despite its weak results in 1H10 Cyrela is trading in line with peers at 9.9x P/E 11E and 2.3x P/BV. We believe these valuations already reflect a potential recovery in 2H10 and 2011 results.
Price target and risks We rate Cyrela Underweight with a Dec-11 price target of R$29, which is the average of our DCF-based valuation and GGM-based valuation. The COE of 11.6% used is based on a beta of 1.30, country risk of 2.1%, and a risk-free rate of 3.0%, resulting in a WACC of 10.3%. The main upside risks to our price target and rating include better-than-expected margins as we are assuming a conservative approach on the name given the weak results in 2Q. We are also not incorporating company launch and presale guidance for 2012, which, if it follows plan, could result in higher-than-expected growth in the coming years.
Brazil Homebuilders Adrian E HuertaAC
(52 81) 8152-8720 [email protected] J.P. Morgan Casa de Bolsa, S.A de C.V., J.P. Morgan Grupo Financiero
Bloomberg JPMA HUERTA <GO>
16
20
24
R$
Oct-09 Jan-10 Apr-10 Jul-10 Oct-10
Price Performance
Source: Bloomberg.
Performance 1M 3M 12M
Absolute (%) -8 -2 7 Relative (%) -9 -7 -10
Source: Bloomberg. * Registered/qualified as a research analyst under NYSE/NASD rules.
Company Data Price (R$) 22.80Date Of Price 28 Oct 1052-week Range (R$) 26.15 -
16.58Mkt Cap (R$ mn) 9,642.37Fiscal Year End DecShares O/S (mn) 423Price Target (R$) 29.00Price Target End Date
Metals & Mining Key sector dynamics The key themes for the metals and mining sector in 2011 should be (1) the outlook for China’s commodity demand, (2) the pace of global economic growth, (3) industry fundamentals, and (4) government regulations. China remains the center stage of global commodity demand and should be strong in 2011 (partially offsetting weakness in the developed world) – it should announce its 12th 5-year plan in 1Q11, which our China economist believes will re-emphasize its commitment to urbanization and infrastructure development. The outlook for different subsectors appears to be mixed, and we believe iron ore and copper will be outperformers in 2011 as their supply remains tight relative to steel, which should continue to be in gross overcapacity. Finally, government regulations should be a source of noise, especially for the miners, but further clarity should ease concerns.
Growth characteristics and how they are changing Given J.P. Morgan expects the global economy to grow at 3.0% in 2011, the sector should continue to build on the growth shown in 2010. However, we highlight two key points: (1) Emerging economies should grow at a faster rate compared to the developed ones (5.8% vs. 1.9%), led by China (9.0%); and (2) The growth should be relatively moderate compared to 2010e.
Drivers of returns – Multiples and growth We believe the main drivers of returns will be both sector/stock rerating/derating as well as changing earnings expectations for the different subsectors. We highlight steel as a sector in whixh we see risks of downward revision of earnings, and a potential derating as the industry could stabilize at a lower normal given slower recovery in demand as well as weaker margins. Iron ore and copper, on the other hand, should benefit from both upward revision of estimates and a potential rerating, mainly as the overhang of government influence eases as more clarity emerges on regulations.
Recommendations Within miners, we recommend Vale (OW) and Grupo Mexico (OW) as the best vehicles to gain exposure to iron ore and copper, respectively, our favored commodities. We remain cautious on the steel sector, especially Brazilian flat steels, and see Usiminas (UW) as the most exposed to (1) the deteriorating pricing environment, and (2) higher raw material costs that we do not expect to subside meaningfully until 2014.
Top picks and stocks to avoid Mkt cap P/E (x) EPS Div. yield ROE Price Code Rating (US$MM) 10E 11E 10E 11E 11E (%) 11E (%) Top picks Vale $31.80 VALE OW 163,216 10.2 7.4 2.92 4.13 3.0 23.3 Grupo Mexico Ps40.44 GMEXICOB OW 25,453 17.5 10.9 0.19 0.30 5.1 24.6 Stocks to avoid Usiminas R$20.96 USIM5 UW 12,386 21.2 12.1 1.02 1.88 2.95.4 xx.xx Source: Bloomberg, J.P. Morgan estimates. Note: Share prices and valuations are as of October 28, 2010. Vale price refers to ONs. Price for PNs was $28.29.
Metals & Mining absolute and relative to MSCI LatAm
Overweight Ps40.44 (28 Oct 10) Price Target: Ps53 End Date: Dec 2011
Company description Grupo Mexico is one of the largest copper producers in globally, and has copper operation in Mexico, Peru and the US through its subsidiaries SCCO (80%) and Asarco (100%). The company has a $5.6B expansion plan in place that should increase its copper capacity by ~600kt to over 1.5Mtpy. It also has railroad operations in Mexico and controls a leading market share through its two subsidiaries Ferromex (56%) and Ferrosur (75%).
Investment case We remain bullish on copper prices and see GMex as a unique copper growth story with large capex expansions in regions with relatively stable business environments. In addition, we view Asarco as a hidden asset in GMex’s portfolio, especially with copper above $8,000/t. Finally, GMex trades at a 31% discount to its NAV, which is unwarranted, in our view, and we believe it should trade at a ~15% discount that incorporates any concerns related to the “holding” nature of the company. Trading at 5.4x ’11e EBITDA, it remains cheap vs. SCCO at 8.9x and peers at 5.7x.
Potential for earnings upgrades We remain 4% above consensus on ’11e EBITDA and believe consensus should move up as we see more upgrades on copper price assumptions.
Prospects for re-/derating We see multiple potential catalysts for rerating of GMex shares over the next 12 months – a SCCO-Asarco merger and the IPO of the railroad business, which should bring transparency to GMex valuation. On the other hand, potentially any significant increase in hedging of copper production may cause a derating as investors may not get the desired exposure to copper prices.
Price target and risks We base our price target and OW rating on GMex on an SOTP analysis – Dec’11 PT of Ps53.0 ($4.32/sh at JPMe FX rate for end-11 of Ps12.25/USD), assuming a holding company discount of 15%. The main downside risks are (1) weaker copper and moly prices; (2) appreciation of USD vs. MXN or PEN; (3) slower global growth, especially China; (4) recurrence of mining strikes; and (5) revocation of railroad concessions, weaker domestic economy, etc.
Mexico Metals & Mining Rodolfo R. De Angele, CFA AC
Overweight PN $28.29 (28 Oct 10) Price Target (PN): $41.50 End Date: Dec 2011
Company description The world’s 2nd-largest miner, largest iron ore producer, and 2nd-largest nickel producer also produces manganese, alloys, thermal & coking coal, bauxite, alumina, aluminum, copper, cobalt, fertilizers. Most operations are in Brazil, with presence in Canada (Inco), other LatAm, Africa, Indonesia, China.
Investment case We remain bullish iron ore and China commodity demand. Given Vale’s cost-leadership, reserve quality and expected growth, we believe it is best leveraged to benefit from this tightness. The current share price fails to capture the potential, in our view. Our model suggests the current share price implies $53/t (FOB Brazil) for fines; low vs a current and YTD average of ~$120/t. At 4.9x ’11e EBITDA, Vale is cheap vs. respective historical and peer averages of 6.8x and 5.6x, and more than discounts higher capex and royalties/taxation concern.
Potential for earnings upgrades Iron ore market remains very tight, and given the steep cost curve, marginal increase in demand can lift prices sharply and, in our view, presents the biggest potential for earnings upgrades. Similarly, higher prices for other commodities could add similar upside risks, and vice versa.
Prospects for re-/derating Vale could rerate if concerns related to a slowdown in the global economy (double dip) mitigate and/or investor optimism on China demand improves further (announcement of China’s 12th 5-year plan could reinforce this). In addition, detailed disclosure of Vale’s capex plan as well as clarity on new regulations for the industry should help by removing potential overhangs. If these concerns continue or become more widespread, the stock may derate.
Price target and risks We base our Overweight and price target for Vale PNs on a combination of DCF and an EV/EBITDA multiple of 7.5x, and use a WACC of 9.2% and 3% perpetuity growth. We then add a “voting share” premium of 14% (historical average) to arrive at our fair value for Vale ONs. Risks are a weaker-than-expected global economy, especially China; harsher-than-expected government regulation; capex delay and/or cost run-ups; and higher operating costs.
Overweight Com pany Data Price ($) 28.29Date Of Price 28 Oct 1052-week Range ($) 29.67 -
19.89Mkt Cap ($ mn) 151,784.75Fiscal Year End DecShares O/S (mn) 5,365Price Target ($) 41.50Price Target End Date
31 Dec 11
Com. Vale do Rio Doce (CVRD) (VALEp;VALE/P US) 2009A 2010E 2011E 2012EEPS - Recurring FY ($) 1.00 3.02 4.13 4.62Revenues FY ($ mn) 23,311 41,995 54,963 61,085EBITDA FY ($ mn) 9,629 24,188 34,785 38,832EV/EBITDA FY 17.7 7.0 4.8 4.1P/E (USD) FY 28.8 9.5 7.0 6.2Source: Company data, Bloomberg, J.P. Morgan estimates. (1) P/E multiples calculated assuming 100% PNs. P/E multiples, considering ONs as well, are 10.3x, 7.4x and 6.6x for '10, '11 and '12, respectively. (2) Shares O/S in the 'Company Data' table represents the total number of shares outstanding for Vale, i.e. ONs and PNs.
Underweight R$20.96 (28 Oct 10) Price Target: R$26 End Date: Dec 2011
Company description Usiminas is the largest flat-steel producer in Brazil, with ~9.5Mtpy of crude steel capacity. It has two plants – its original plant in Ipatinga and the plant of former Cosipa in the state of São Paulo. The company produces a broad range of steel products and is the main domestic supplier for the automotive and auto parts industries in Brazil. Aside from this, USI also owns iron ore mines and has interests in logistics and capital goods assets.
Investment case We expect the outlook for Usiminas to continue to be challenging in the medium term, driven by deteriorating fundamentals for the Brazilian flat-steel industry. Imports into Brazil, in our view, are here to stay as Brazil lacks rolling capacity to supply the flat-steel demand in the domestic market, keeping prices as well as domestic premiums under pressure. In addition, the company should continue to suffer higher raw material costs, which we believe are unlikely to subside meaningfully until 2014. We see potential in USI’s mining unit, but there are challenges related to finding a viable solution for the port.
Potential for earnings downgrades We believe there are downside risks to the consensus expectations for domestic steel prices, as premiums should remain under pressure, driven by continued strong inflow of imports and a strong Real. In addition, we expect raw material prices to remain tight, keeping margins under check. Finally, a potential delay in the recovery of heavy plates should cause further downside to earnings.
Prospects for re-/derating Global steel supply discipline (resulting in higher prices) and any weakening in raw material costs should help rerate Usiminas. In addition, a solution to the port issues and/or a potential IPO of the mining unit could rerate the stock.
Price target and risks We rate Usiminas UW based on our Dec 11 price target of R$26/share UPDATE, which is derived from a combination of DCF (80%) and multiples (20%). We use a WACC of 10.9%, perpetuity growth of 3% and target EV/EBITDA of 5.0x (historical average). The main upside risks are related to depreciation in BRL, higher international steel prices and potential increases in steel import duties.
Oil, Gas & Petrochemicals It’s all about creating economic value. The value chain of oil production has many moving parts, but at the end of the day what matters here as in any other business is adding value to the base of capital employed. Production growth, backlog growth and asset growth matter little if the returns on new investments don’t cover the cost of capital, in our view.
Bullish oil curve favors all; one must be selective An improved outlook for oil prices has emerged in tandem with global currency issues benefiting the earnings outlook of the sector as a whole. As always, we favor portfolios that can beat the performance of the underlying commodity. Services & equipment are now a large portion of our coverage, and there we focus on exposure to capex trends and superior earnings power relative to peers.
Integrated oils: Petrobras and Ecopetrol are both national oil companies (NOCs) with the mandate to supply the domestic fuels market. This imposes significant pressure on their E&P segments to keep replenishing reserves. Historically PBR has done a great job, but we are worried about its ability to add value on the recent asset purchase for $43 billion. In the meantime Ecopetrol is expanding production of low-cost barrels and finding new ways to boost its exploration success.
E&P: The appeal of independent E&P names keeps growing; emphasis remains on exploration. The market will operate in 2011 with 2 new players in Brazilian E&P, HRT and Karoon. The heavyweight remains OGX, which was our top pick in 2010. In Colombia, juniors are spreading, with adult names being scarce.
Services & equipment: The cycle stage still appears to favor exploration over development, and the key is gaining exposure to capex trends. Tenaris is enhancing positioning with minimal investments but more importantly it stands to benefit from cost reductions. Lupatech is investing in value-neutral ventures in order to gain access to new sources of revenue.
Petrochemicals: The change in scope of PBR’s Comperj project changed drastically the outlook for Braskem in the Brazilian market.
Recommendations Our top picks for 2011 are Tenaris (TS US), the world’s most profitable OCTG producer, and Pacific Rubiales (PRE CN), the largest and most dynamic independent E&P producer in Colombia.
Top picks and stock to avoid Mkt cap P/E (x) EPS Div. yield ROE Price Code Rating (US$MM) 10E 11E 10E 11E 11E (%) 11E (%) Top picks Pacific Rubiales 31.69 PRE CN OW 36.4 13.2 0.90 2.43 - 15.2 Tenaris 41.33 TS US OW 11.4 7.9 2.11 2.68 - 13.3 Avoid Lupatech 21.55 LUPA3 BZ N 604 16.8 13.3 0.11 1.28 - 1.0 Source: Bloomberg, J.P. Morgan estimates. Note: Share prices and valuations are as of October 28, 2010.
Pacific Rubiales Energy PRET.TO www.pacificrubiales.com
Overweight C$31.69 (28 Oct 10) Price Target: C$36 End Date: Dec 2011
Pacific Rubiales is the largest independent E&P company in Colombia and the second-largest operator after NOC Ecopetrol. PRE has been a successful growth and value play since 2009. In our view, PRE’s low risk development story is already priced in, but we believe that the risk/reward is still attractive. PRE is our favorite stock to play the potential of heavy oil in Colombia.
Low-risk exploration in attractive prospects should drive value in 2011. PRE has 2P reserves of 269 mn boe but has identified ~628 mn bbl of prospective oil resources in Colombia and Peru. PRE’s track record in exploration is over 80% success in Colombia, and it has recently acquired exploration licenses in onshore Guatemala that are believed to be exposed to a continuation of the onshore basins in Mexico.
Our price target is not fully loaded. We are conservative in our NAV assumptions because we are only assuming half of the prospective resource estimated by PRE. Our estimates have upside from further drilling success that could confirm the company’s prospective figures, from the gas export project that could start in 2013 and from further analysis of the prospects in Guatemala and block CPO-12 in Colombia.
The company still trading at compelling multiples. PRE is trading at 3.7x EV/EBITDA for 2011e. Our Dec’11 target price of C$36/share implies an EV/EBITDA exit multiple of 3.9x 2012e. With the company having doubled production in 2010 to 67 kboed (net after royalties), we expect production to grow 67% in 2011 and 22% in 2012, excluding exploration potential.
Main risks: 1) unsuccessful exploratory drilling; 2) uncertainty over capital expenditures; 3) disappointing results at Rubiales field tests for secondary recovery; and 4) a decline in oil prices.
Colombia Exploration & Production Sergio Torres AC
Overweight $41.33 (28 Oct 10) Price Target: $52 End Date: Dec 2011
TS is one of the best early-cycle plays. We believe oil prices will lead a reactivation of exploration and development drilling globally. Tenaris is the most profitable manufacturers of steel tubular goods for the oil and gas industry. The company has a leading footprint in the niche of premium (oil country tubular goods (OCTG). We believe that Tenaris (TS) is likely to keep its dominance position on global OCTG market and gain market share in other key growing markets such as the US, Saudi Arabia, Iraq and, yes, Brazil.
We project an annualized earnings expansion of 12.9% between 2009 and 2012, mostly driven by cost reduction and volume growth. Reduction in structural costs is a major differentiating factor because the industry is suffering from sluggish pricing and cost pressures. Equipment producers with global footprints, such as TS, offer investors a broadly diversified play on oil, gas, onshore and offshore projects, with ROCEs that are bouncing from the cycle trough.
Benefits from expansion to be visible as early as 2011. TS is adding capacity in its Mexico plant in late 2010. Ramp-up of capacity would allow TS to export low-diameter OCTG out of Mexico to the US shale gas market, among other destinations. New facilities could also allow TS to reallocate output from higher-cost sites, such as Europe.
We don’t see risk of overcapacity in seamless OCTG. For now we believe the NA market appears in check. With the countervailing duties on China there is a shortfall of about 1.5 mn tons of seamless pipe in the US alone. Planned expansions are targeting such shortfall.
We have a YE11 target of $52/ADR, derived from a combination of SOTP model and target multiples. On an EV/EBITDA basis, TS is trading at 7.9x, similar to peer Vallourec. We believe TS deserves a premium because it generates ~22% higher EBITDA per ton than VK (rated OW by JPM European machinery analyst Alessandro Abate).
Retail & Healthcare Key country dynamics Solid growth in both the retail and healthcare sectors in Brazil has been led by strong consumer demand driven by: (1) Income mobility to middle-income segment. (2) Strong job creation, which is driving unemployment rates to record lows. (3) Inflation under control. These factors are leading to record-high consumer confidence.
As a result we believe the country is the best positioned in terms of growth within Latin America for retailers and healthcare names, while we are still cautious with retail in Mexico. While there is some evidence of economic recovery, correlation with the US economy is still high.
Growth characteristics and how they are changing In Brazil, both sectors are growing fast, on the back of the solid growth of the Brazilian economy. We expect solid growth to continue but to slightly decelerate in 2011 given tougher comparisons.
Drivers of returns – Multiples and growth Main drivers of growth for the retail sector are (1) consumer confidence, (2) unemployment rate and wage mass increase, (3) inflation, and (4) credit supply.
For the healthcare sector, the main drivers are: (1) wage mass increase; (2) formal job creation; and (3) increased penetration of private healthcare spending within the population, which is currently very low.
Nevertheless, we don’t expect further reratings for the sectors given recent outperformance. Any potential appreciation is likelier to come from earnings surprises.
Recommendations OW: Hypermarcas (HYPE3) is a core holding in Brazil consumer, given its focus on high-growth lower-income segments such as pharma and HPC. Its accelerated M&A allows for more synergies in 2011-2013e. It trades at a relatively cheap P/E 11e of 20.7x, a 25% discount to Brazilian peers that we view as unwarranted given high EPS CAGR 10-13e of 20%. OW: DASA (DASA3): We expect revenue growth to pick up in 2011 as the company has resumed M&A. DASA will likely start capturing revenue synergies as a result of its integration with MD1. UW: SORIANA (SORIANAB): Lack of catalysts in the short/mid term and rich valuation, trading at 12-M forward P/E of 18.5x, a 20% premium to historical, and 12-M fwd EV/EBITDA of 9.7x, 23% above historical, which in our view does not reflect the risks.
Top picks and stocks to avoid Mkt cap P/E (x) EPS Div. yield ROE Price Code Rating (MM) 10E 11E 10E 11E 11E (%) 11E (%) Top picks Hypermarcas R27.99 HYPE3 BZ OW R$14,941 28.3 20.7 0.99 1.35 DASA R$21.07 DASA3 BZ OW R$6,555 30.9 17.8 0.68 1.18 300.7 31.9 Stocks to avoid Soriana Ps37.40 SORIANAB MM UW Ps67,320 21.6 18.2 1.73 2.06 0.4 10.2 Source: Bloomberg, J.P. Morgan estimates. Note: DASA3 and SORIANAB share prices and valuations are as of November 9, 2010; HYPE3 valuations share prices and valuations are as of October 28, 2010.
Diagnosticos da America (DASA) DASA3.SA www.dasa.com.br
Overweight R$21.07 (9 Nov 10) Price Target: $26 End Date: Dec 2011
Company description Dasa is the largest diagnostic laboratory in Brazil. Its business model is divided into three segments: (1) private clinical and image analysis, (2) public services provider and (3) lab-to-lab operations. Its growth is based on a mix of organic growth and acquisitions. Currently, Dasa is established in 12 states and holds 21 different brands (after acquisition of MD1 and Cerpe).
Investment case Our positive view on the company is due to its leading position in the most important markets in Brazil (SP and RJ after the acquisition of MD1) and its exposure to less affluent demographic sectors.
Potential for earnings upgrades Dasa announced in the beginning of October the acquisition of MD1, the fourth-largest laboratory in Brazil. The integration process has the potential to create both revenue and cost synergies. DASA should also still benefit from margin expansion as new management is focused on increasing profitability.
Prospects for re-/derating Although the stock has been performing strongly lately (more than +40% YTD), we think there is more upside to come. After its weak period of top-line expansion, we expect revenue growth to pick up in 2011 since the company will likely capture revenue synergies as a result of operating leverage from growth and the integration of recent acquisitions MD1 and Cerpe. Dasa trades at a 15% premium to Fleury on a P/E 11e basis, which we believe is warranted given (1) its position in less affluent segments, (2) higher diversification of payers and (3) higher stock liquidity.
Price target and risks Our R$26 price target (end date Dec-11) is based on a 9-year discounted free cash flow to firm (no acquisitions) at a 10.3% nominal reais discount rate and 5.0% perpetuity growth. Main risks to our thesis are (1) if management does not deliver its guidance of 27.5% EBITDA margin, (2) pricing pressure and/or increased competition for acquisitions, and (3) economic slowdown.
Brazil Retail & Healthcare Andrea Teixeira, CFA AC
Overweight R$27.99 (28 Oct 10) Price Target: $30 End Date: Dec 2011
Company description Hypermarcas, one of the leading consumer products company in Brazil, is established in 3 segments: pharmaceutical, household/personal care and food.
Investment case Hypermarcas is a combination of fast-growing consumer exposure in Brazil with a defensive profile as its portfolio is mostly composed of staple goods. Still, the HPC and pharma industries are very fragmented, meaning that there is enough room for additional M&A. Still, even if acquisitions stop, we estimate an improvement in EBITDA margin of at least 200bps.
Potential for earnings upgrades The company is targeting 15% same brand sales (SBS) growth for the next few years, which we view as conservative. We believe that the market might incorporate higher estimates as the company delivers stronger results. Also, Hypermarcas has the potential to unlock value by delivering more than official guidance of R$2.5bn in acquisitions for 2010-2011 (it has already delivered R$1.3bn). Recent debenture issue of R$1bn may indicate a continued interest in shopping.
Prospects for re-/derating Our Dec 11 price target is R$30, derived from a 50/50 mix of organic model (R$29 per share) and acquisitions-plus-growth DCF (R$32/share) and considering company official M&A guidance. Also, we ran a sensitivity analysis incorporating an additional R$1bn in M&A, which added R$1 to our PT. Hypermarcas currently trades at P/E 11e of 21x, a 16% discount to Brazil peers, which we view as unwarranted given high EPS CAGR 10-13e of 20%.
Price target and risks Our price target is based on a 9-year DCF analysis at 11.3% WACC and perpetuity growth of 6%. We blend the organic and the organic-plus-acquisitions scenarios 50/50 in our price target valuation. Main risks to our thesis are (1) increasing competition for acquisitions, (2) potential overhang from private equity fund which owns 17.3% of the company and (3) Hypermarcas is reliant on founder “Junior” to prospect for and negotiate deals.
Brazil Retail & Healthcare Andrea Teixeira, CFA AC
Underweight Ps37.40 (9 Nov 10) Price Target: Ps38 End Date: Dec 2011
Company description Organizacion Soriana is a food retailer operating 500 stores (as of 3Q10) across Mexico. The store formats are mostly hypermarkets, clubs and convenience stores.
Investment case Our negative view on Soriana is due to a lack of catalysts in the short/middle term. Soriana has been experiencing weak sales growth despite easy comparisons. Last year, the company was hard hit by the economic downturn. We still see competition and cautious consumer purchase of discretionary categories in Mexico as dragging Soriana’s growth. Also, the stock is trading at rich valuations, at P/E 11e of 22.1x and EV/EBITDA 11e of 10.8x.
Potential for earnings upgrades We see limited room for positive earnings surprises as the improvement in SSS performance expected for the 4Q10 and 2011 seems already priced into consensus. We expect Soriana to continue to face headwinds from heavy competition as (1) Walmex is aggressively lowering prices and has greater bargaining power with suppliers; (2) Fourth-largest competitor Chedraui is now well capitalized and is gaining share (SSS at 3Q10 stood at 4.4% vs. 2.9% for Soriana and 2.8% for Walmex).
Prospects for re-/derating We believe further recovery is priced in, as Soriana is trading at significant premiums to its historical averages. At a 12-month forward P/E, the stock trades at 23.3x, a 44% premium, and 12-month fwd EV/EBITDA of 11.1x, 47% above historical, which in our view do not reflect the risks.
Price target and risks Our Ps38 December 2011 price target is based on a 50/50 blend of a 9-year DCF at 7.4% nominal WACC, 4% growth and 16.8x P/E 12E (30% discount to peers). Upside risks to our cautious view include: (1) faster-than-anticipated recovery in the economy; and (2) better-than-anticipated execution, i.e., no market share losses.
Mexico Retail & Healthcare Andrea Teixeira, CFA AC
Telecom, Media & Technology Key country dynamics We believe investors should only have a selective exposure to the sector, either through high- growth/underpenetrated market stories or through stocks offering a mix of growth and cash flow (like TSU/AMX). Generally, telecom stocks tend to be defensive, while media stocks are more cyclically exposed, as are tech stocks. We believe the telecom sector could offer attractive cash flow and dividend yields, compensating for slower growth. Media stocks fared better in earnings than developed peers as most of the media expenditure is still staple variety rather than discretionary. Tech stocks offer highest growth among TMT sector, as LatAm is still underpenetrated, with high demand.
Growth characteristics and how they are changing Among telecom companies, growth is mainly driven by the increasing contribution from data revenues: companies are investing a large amount in data networks, and there will be a 3G license auction in Brasil (NIHD likely to be the only bidder) as there was in Mexico. Looking at media companies, we could see them grow, on increasing pay-TV penetration and also from the offer of combined services. Tech companies could benefit from good economic momentum, given higher demand.
Drivers of returns – Multiples and growth TMT investors benefit from attractive cash flow yields as well as good dividend distribution, as the sector usually provides low growth for reasonable cash generation, and thus is considered defensive. We believe exposure should be taken in stocks with cheap FCF yield relative to EBITDA growth.
Recommendations OW: TIM Participações (TSU): only pure mobile player in Brazil, with the highest growth among Brazilian telcos; lower exposure to MTR changes; valuation of 9.3% FCF yield and 2.9 x EV/EBITDA 2011E.
UW: Telmex (TMX): weak trends, demonstrated by double-digit EBITDA decline over the last six quarters; rich valuation relative to higher-growth LatAm peers; tough outlook, given rising competition in Mexico.
Top pick and stock to avoid Mkt cap P/E (x) EPS Div. yield ROE Price (US$) Code Rating (US$MM) 10E 11E 10E 11E 11E (%) 11E (%) Top pick TIM Participacoes 31.85 TSU OW 7,900 29.4 14.3 0.19 0.4 1.7% 10% Stock to avoid Telmex 15.02 TMX UW 13,586 12.2 13.0 0.8 0.7 5% 37% Source: Bloomberg, J.P. Morgan estimates. Note: Share prices and valuations are as of October 28, 2010.
Overweight $32.21 (28 Oct 10) Price Target: $40 End Date: Dec 2011
Company description TIM Participações S.A. (NYSE: TSU) provides telecommunication services all across Brazil. Most of its revenues come from mobile, and it also has long distance and data transmission services. TSU is controlled by the Telecom Italia group.
Investment case TSU is our top pick: (i) turnaround to go on, demonstrated by better FCF; (ii) higher growth among Brazilian telcos; (iii) increasing presence as data service provider; (iv) lower MTR exposure, even when compared to VIV/TSP combined; (v) cheap valuation of 9.8% FCF yield 2011e and 2.8x EV/EBITDA (still cheap on ON+PNs, at 8.1%/3.4x).
Potential for earnings upgrades We believe TSU could upgrade earnings if: (1) it maintains a high number of subscriber additions without substantial dilution in ARPU, (2) it is able to increase levels of data as % of service revenues toward the ones reported by Vivo and Claro, as well as improve its offer of data services; (3) it reduces advertisement expenses.
Prospects for re-/derating The market could derate TSU, if: 1) results from the free on-net minutes strategy disappoint in ARPU; 2) competition increases with the entry of new players (5th license); and 3) capex rises as result of more voice or data traffic, depressing FCF.
Price target and risks We rate TSU OW and our Dec 11 price target is $40 based on the average of our DCF and multiples valuation. Our DCF valuation is based on 9.4% WACC, 1.5% LT growth and yields, a $43.3 fair value. Our multiples-based valuation derives from a 10% target FCF yield, resulting in a fair value of $36.7. The downside risks are mentioned above.
Brazil Telecom, Media & Technology Andre Baggio AC
Underweight $15.15 (28 Oct 10) Price Target: $12 End Date: Dec 2011
Company description Telmex provides fixed-line telecommunications services in Mexico. The company’s service coverage comprises the operation of the nation’s most complete local and long distance networks. Additionally, Telmex offers services such as connectivity, internet access, co-location, web hosting and interconnection services to other telecommunications operators.
Investment case The key reasons for our UW rating are: (1) Continuing weak core trends at TMX as demonstrated by double-digit EBITDA decline over the last six quarters; (2) Likelihood of adverse regulation hurting trends further; (3) Less alignment with Carlos Slim, given recent AMX-CGT-TII transaction, which lowered his effective stake in TMX significantly; (4) Rising competition in Mexico, especially from cable operators.
Potential for earnings upgrades We believe TMX could upgrade earnings if it is able to control costs, which have increased in line with inflation although revenues have been declining. Moreover, TMX could get a pay-TV license, which would help trends.
Prospects for re-/derating The market could rerate TMX, if trends improved or if there is an expectation of a tender offer for minorities from its controlling shareholder AMX at a premium to market price. No such offer has been announced.
Price target and risks Our PT of US$12 is based on a combination of DCF ($14.1 value), growth model ($10.1) and multiples ($11.5). Our DCF methodology and uses a WACC of 10.4%, LT growth of -1% and LT margin of 39%. We rate TMX UW in light of weak trends, rich valuation relative to higher-growth LatAm peers, and a tough outlook. Upside risks to our rating are the same as the ones mentioned in the above paragraph (better trends, a tender from AMX).
Mexico Telecom, Media & Technology Andre Baggio AC
Utilities Key sector dynamics In Brazil, the main sector drivers for 2011 should be: (1) inflation. If inflation expectations increase in 2011, most companies in the sector provide a hedge due to indexed tariffs; (2) energy prices. With long-term electricity supply-vs.-demand balance still comfortable, free market prices seem capped for the near term, limiting upside to generators. Outcome of new capacity auctions will give the market more visibility on balance and price trend; (3) regulation. The pending issue of concession renewals might be tackled in 2011; additionally, while water companies are expected to benefit from new regulation, uncertainty should be high for power discos as they start their 3rd cycle of tariff resets. Overall, we remain lukewarm on the sector outlook for 2011 and recommend investors to selectively focus on individual cases of potential regulatory upside and stocks that provide inflation hedges. In Chile, expectation of tight reserve margin in 2011 means thinner margins for generators (especially heavily hydro-based) and overall growth outlook remains uncertain for major players.
Growth characteristics and how they are changing Despite the high demand growth and increased need for new capacity, auction for greenfield projects should remain competitive, thereby limiting the upside for generators. Discos should also benefit less from demand growth in the future due to recent changes in tariff regulation.
Drivers of returns – Multiples and growth Valuation discount of Brazilian to global utilities is sustained by high local interest rates, and we do not expect this to change in 2011. Major potential for re-deratings will come from regulatory changes. Although cost cutting and M&A are potential drivers for power discos, we are skeptical on execution during 2011.
Recommendations Our top picks among Latin American utilities are: Brazilian water utility Copasa (CSMG3) due to expected rerating coming from a new tariff framework, and Brazilian power utility AES Tiete (GETI4) due to earnings stability, high dividend yield and inflation hedge on revenues. We recommend that investors avoid Brazilian power utility Eletropaulo (ELPL6), due to the risk related to the tariff reset process in July 2011 and potential nonrecurring R$1bn liability, and vertical Brazilian utility CPFL Energia (CPFE3), due to relatively expensive valuation.
Top picks and stocks to avoid Mkt cap P/E (x) EPS Div. yield ROE Price Code Rating (US$MM) 10E 11E 10E 11E 11E (%) 11E (%) Top picks Copasa 26.4 CSMG3 OW 1,783 6.4 6.0 4.13 4.39 8.3 12.0 AES Tiete 23.5 GETI4 OW 5,246 10.7 9.8 2.19 2.38 10.7 181.4 Stocks to avoid Eletropaulo 29.9 ELPL6 UW 2,936 4.8 8.5 6.29 3.54 12.3 18.0 CPFL Energia 40.4 CPFE3 UW 11,368 13.7 13.9 2.94 2.90 5.4 25.3 Source: Bloomberg, J.P. Morgan estimates. Note: Share prices and valuations are as of October 28, 2010.
Overweight R$26.35 (28 Oct 10) Price Target: R$34 End Date: Dec 2011
Company description Controlled by the state government of Minas Gerais in Brazil, COPASA (CSMG3) is a water utility providing water distribution for 603 municipalities (population of 13.8mn) and sewage collection for 156 municipalities (population of 7.8mn) in the state.
Investment case CSMG3 trades at a valuation discount to peer SABESP, global water utilities and Brazilian electric utilities, mainly due to the lack of a regulatory framework in which the company’s capex is properly remunerated by market-based return rates. Nevertheless, a regulatory agency was created in the state and is expected to develop a new and market-friendly tariff framework during 2011, to be implemented by Mar 2012. Additionally, COPASA benefits from high cost efficiency relative to peers, high corporate governance, high volume growth prospects and a high dividend yield (2010e at 7.8%).
Potential for earnings upgrades For 2011, positive surprises on earnings could come from: (1) sales volume growth above our 9.5% estimate; and (2) tariff adjustment above inflation in March. For the long term, since there is still uncertainty regarding the final design of the new tariff framework, we chose to be more conservative and assume a mild tariff reset of +2.3% in March 2012 (i.e., below inflation). Earnings upside could come from a better outcome.
Prospects for re-/derating While globally water utilities trade at a valuation premium to electric utilities, in Brazil CSMG3 currently trades at a significant discount to electricity peers. We expect valuation convergence under a new tariff framework.
Price target and risks We have a DCF-based 2011YE price target of R$34, with 9.1% real cost of equity and 0% perpetuity growth. The main risks are: (1) worse-than-expected tariff reset; (2) sales volume growth for 2011 below our expectation; (3) below-inflation tariff adjustment in Mar 2011; (4) lower-than-50% earnings payout; and (5) high increases in operating costs.
Underweight R$29.90 (28 Oct 10) Price Target: R$30 End Date: Dec 2011
Company description Controlled by the US utility AES and BNDES (Brazilian Development Bank), Eletropaulo (ELPL6 BZ) is a pure power distribution company that owns the concession for the metropolitan area of Sao Paulo city and serves 6.0 million customers (9% market share in Brazil).
Investment case We believe that the stock’s performance in 2011 should be capped by the following potential negative drivers: (1) increased likelihood of a cash disbursement of ~ R$1.1bn in the judicial dispute with Brazilian utility Eletrobras; and (2) uncertainty regarding the outcome of the July 2011 tariff reset. Moreover, we expect sustainable dividend yields to decrease post 2011 to levels below of those of more predictable utilities in Brazil, which is a major negative since a high dividend yield has been for years one of the highlights of ELPL6’s investment case.
Potential for earnings upgrades Since the potential cash disbursement of R$1.1bn in the judicial dispute with Eletrobras is not yet included in our estimates, this represents the single highest downside risk for 2011 earnings. The second major source of downside (or upside) is the outcome of the July 2011 tariff reset. We assumed a 1.6% tariff increase allowed by the regulator.
Prospects for re-/derating ELPL6 currently trades at similar valuation levels to other power utilities in Brazil. Although we do not expect this to change in the near future, we do expect a relevant reduction in profitability after the July 2011 tariff reset.
Price target and risks We have a DCF-based 2011YE price target of R$30, with 10.0% real cost of equity and 0% perpetuity growth. The main risks: (1) a better-than-expected outcome from the July 2011 tariff reset; (2) lower-than-expected expense with pension liability; (3) a favorable resolution to the ~R$1.1bn debt dispute with Eletrobras; (4) steep reduction in controllable costs; and (5) a sooner-than-expected restart of the sale process of a controlling stake by BNDES.
• Global GDP growth slowdown may have already bottomed.
• Data flow has been generally positive, with our global PMIs signaling a slight pickup in growth this quarter.
• Global GDP growth in 2011 revised up a touch, the first upward revision since April.
• Inflation pressures muted well past 2011 in the major developed economies; return to target unlikely.
• Fed and BoJ open quantitative easing spigot, BoE likely to follow by early next year.
Laying the seeds for 1H11 acceleration
We are becoming more confident that the seeds are being sowed for a lift to above-trend growth starting in 1H11. The latest developments in the US, Europe and Asia all suggest that earlier drags are fading. And while midyear shocks will reverberate through production plans as firms slow the pace of inventory accumulation, evidence suggests this adjustment is moving forward constructively. Largely in response to the stronger-than-expected Chinese data out last month, we have marked up our global GDP outlook for 2011(%oya) to a modestly above-trend pace of 3% from 2.9% as of the last GMOS. Although the change is small, it is the first upward revision since late April and the momentum in positive data surprises has turned positive in the last four weeks after a midyear run of negative outturns. Consequently, along with our tiny upward revision to the growth outlook, the risk bias has shifted to the upside.
The deceleration in global economic activity looks to have continued in the current quarter. After jumping 3.9% annualized in 2Q10, global GDP growth downshifted to a 2.7%pace last quarter and is projected to step further down to a2.3% pace this quarter. Some deceleration should not have been a surprise as the record surge in global manufacturing in the first year of the recovery came off the boil. However, the downshift was amplified by an unexpected slowing in consumer and business spending, coupled with deterioration in sentiment and risk appetites. Given the global nature of the step down in manufacturing output growth, the deceleration has been broad-based, with growth slowing across the developed and emerging markets.
Paul Meggyesi (44-20) 7859-6714 [email protected] J.P. Morgan Securities Ltd.
The forces behind the midyear slowdown—a policy-induced downshift in China, a sovereign debt crisis in Europe and a slide in consumer confidence and spending in the US—were broad-based and together posed a legitimate risk to an expansion still in its early stages. Also of concern was that these drags would be magnified by a sharper retrenchment in business spending. Another worry was of a negative feedback loop where slower growth fed weakness through a deterioration in financial conditions. In the event, firms appear to be bending modestly in the face of slower growth but continue to increase capital spending and hiring. Moreover, financial conditions remain a positive for growth, helped in part by the easing signals sent by central banks.
China provides the most concrete signs that drags are abating. The latest figures confirm that the most intense phase of the midyear inventory correction has passed and that growth bottomed in 2Q. A steady rebound is now under way, with domestic demand rising at a robust pace despite softness in the export sector. We expect economic activity in China to accelerate further in the coming quarters, fueled by ongoing strengthening in domestic demand. With monetary conditions still very easy and government infrastructure projects for next year to begin ramping up, the risk of overheating is now increasing. We have thus raised our estimate for China’s real GDP growth in coming quarters.
Recent developments suggest the risks to our Euro area growth forecast are to the upside, with a shallower and shorter soft patch than the one currently in our projections. While the downward pressure on growth in the periphery remains intense, the extent of the spillover to the area wide economy looks to be more moderate than we have been anticipating. Indeed, German business surveys continue to impress.
In the US, developments are less clear-cut, with consumer confidence still depressed and the impact of an imminent fiscal tightening uncertain. However, goods consumption rebounded smartly in the three months ending in September and the latest reading on October auto sales points to a further acceleration into the current quarter. In addition, an upturn in investment and hours worked remains intact. A key issue relates to the impact of the Fed’s recently announced quantitative easing package. While we are not building in significant growth benefits from these actions in our forecast, the Fed’s success in promoting more stimulative financial conditions helps limit downside risks as the economy continues to move forward at a modest pace. Perhaps the most important effect of the Fed’s actions will be its impact on confidence and asset prices.
Inflation probability distribution for 2011 (developed)
% , p ro b a b ility (b a s e d o n 1 9 2 p o s s ib le o u tc o m e s )
H e a d lin e in fla tio n (% 4 Q / 4 Q )
M e a n = 1 . 1 %J . P . M o rg a n fc s t = 1 . 0 %P ro b (< ta rg e t) = 6 4 %
Source: J.P. Morgan.
The most recent readings from our J.P. Morgan global PMIs are adding some upside risk to the projected further slowing in growth in the current quarter. Based on the data in hand, the J.P. Morgan all-industry PMI (out tomorrow) appears to have jumped from 52.6 to just under 55, a large move that would be the first increase since peaking back in April and erase all of the decline since July. If the current level of the index holds through the end of the year, global GDP could expand at an annualized pace of 2.9%, over 1/2%-point stronger than our current forecast. More importantly, it is signalling that the midyear slowdown may have already bottomed as of the third quarter.
Deflation odds low, inflation odds also low
Although economic activity appears set to accelerate into 2011, we are still only looking for trend-like growth in 1H11 and a move to above trend by 2H11. Consequently, the elevated levels of economic slack—primarily in the US, Euro area, Japan and UK—will remain in place well past 2011 and so too will the downward pressure on inflation. Despite a year of above-trend growth in the first year of the recovery and a jump in commodity prices from their recession lows, core inflation rates in the developed markets (DM) have slid to the lowest level in over 50 years. In this regard, the historical record is clear: the level of economic slack matters more than its change. Since 1970, negative output gaps in every OECD country have been associated with declines in core inflation even in periods of above-trend growth. Phillips-curve-based model estimates suggest headline inflation will fall further next year in the developed markets, reaching just 0.1%oya by the end of 2011. By contrast, the J.P. Morgan forecast looks for headline inflation to remain near 1%oya.
The J.P. Morgan forecast rests on two key factors that should stabilize inflation next year. The first is that inflation expectations remain anchored near central bank targets. Improved monetary policy over the past two decades supports the view that expectations will remain anchored. With that said, the greater risk is that expectations will move down in line with the recent decline in core inflation. The second factor underlying the J.P. Morgan forecast is the considerable evidence that the transmission of slack to inflation is diminished at lower levels of inflation. Institutional as well as behavioral impediments create significant downward nominal rigidities in the price-setting process, thereby putting a floor under inflation.
In a recent report, we estimate that DM inflation will average 1.1%oya in 2011 across a wide range of possible behavioral and economic scenarios (“Stuck in a low inflation rut,” Global Issues, October 27, 2010). This result is in line with the J.P. Morgan forecast. Deflation for the DM as a whole is unlikely, with a probability of just 2%, but is somewhat more likely in the US. Although deflation risks appear low, our analysis shows that it will be difficult for central banks to raise inflation to a level with which they are comfortable. We estimate a two-thirds probability that inflation in the developed markets remains below central bank targets by the end of next year.
Although the risk of a deflationary spiral appears low, this will be of limited comfort to central banks, who face a formidable challenge in returning inflation to a level with which they are comfortable. Large negative output gaps continue to exert a powerful downward pull on inflation. As an illustration, we estimate that GDP growth would need to reach about 5.5% in the US, 3.3% in the Euro area and 5.8% in Japan in 2011 to return inflation to target in the coming year. Moreover, these calculations assume stable inflation expectations, anchored at central bank targets. If inflation expectations move down in coming quarters, in line with past experience, growth will need to be even stronger.
It is against this backdrop that the Fed has reopened the quantitative easing spigot today, roughly in line with market expectations. While the recent FOMC statement indicated inflation is only somewhat low, recognizing that the unemployment rate will remain elevated for some time suggests an admission of failure on both legs of its dual mandate. The BoJ has also already acted with the announcement of a wide-ranging new asset-purchase program.
The initial installment was modest in size, although officials have said they will expand it if necessary. We also look for the Bank of England to renew its bond-buying program by early next year, although, with inflation proving stickier at an elevated level, this is a much closer call. In sharp contrast to each of these central banks, the ECB has indicated it sees the potential costs of quantitative easing as outweighing any potential benefits. That said, none of these central banks is expected to begin raising rates until mid-2012 at the earliest.
Note: This piece is excerpted from the issue of Global Markets Outlook and Strategy dated November 3, 2010.
Note: For some emerging economies, 2010-2011 quarterly forecasts are not available and/or seasonally adjusted GDP data are estimated by J.P. Morgan. Bold denotes changes from last edition of Global Markets Outlook and Strategy published November 3, 2010, with arrows showing the direction of changes. Underline indicates beginning of J.P. Morgan forecasts. Source: J.P. Morgan estimates.
Capital Controls and FX Intervention State of current FX regime, capital controls and possible future Intervention measures in Emerging Markets FX regime Recent measures Possible future measures
China Closed Capital Account. Bond Investment only possible through QFI, but discouraged by authorities
None None
India Strict Limits on size of foreign bond investment. Limit of $5bn on government bonds and $15 bn on corporates
In September, SEBI announced the increases in the FII Limits to $10bn for
government bonds and $20bn for corporates
Potential for currency intervention, but we expect no action against bonds.
Indonesia Interest and an income tax at 20%, but majority of investors use tax treaties to reduce these taxes between 0-10%
1-month minimum holding period for foreigners investing in SBIs
Further restrictions on SBIs; Tax increases are unlikely as it needs
parliamentary approval Korea Withholding tax was made exempt on MSB and KTB since May
2009 In June, caps on foreign banks FX forward positions were announced leading to less
MSB holdings.
Possibly reimposing WHT on MSBs and KTBs. Further lowering of cap on foreign
banks FX fwd positions. Malaysia No taxes None None Philippines Income tax of 20% on interest income and capital gains. None None Singapore Open capital account. No taxes. None None Sri Lanka Strict Limits on size of foreign investment in T-bonds and T-bills at
10% of total outstanding. Investment in corporate bonds is not permitted.
None Easing of capital controls.
Taiwan Time deposits are not allowed for foreigners. FINI account required for foreign investment, frequest inspections of custodian banks
Verbally discourage fixed income investment by FINI accounts, propose mandatory use of USD for foreigners
equity margin accounts.
None
Thailand Foreigners exempt from WH tax for government bonds 15% WHT was reintroduced to equalize with current tax regime for domestic
holders.
Potential introduction of across the board tax on all fixed income inflows with
potential restrictions on minimum holding period.
Argentina Non Convertible and capital outflow controls remain in place with a minimum holding period of 1year and US$2mm outflow per month
None None
Brazil Non Convertible. Tax of 6% on foreign fixed income investment and 2% on equity investment. Increase margin for derivative transactions
Increase IOF Tax on fixed income investment to 4% on Oct 4th and to 6% on
Oct 18
Risks remain high for further interventions.
Chile Non Convertible. No capital controls None Near-term risks are limited although an increase in FX intervention is possible if
CLP rallies further Colombia Non Convertible. 33% tax on income and capital gains and 6% WHT
on coupon payments for bonds with maturities up to 5 years and 4% for longer bonds.
USD purchases of $20mm day Risks remain high for further interventions both in spot FX and potentially increases
in Reserve Mexico Free floating and deliverable. No FX controls. Banxico sells $600mm
of USDMXN puts per month. None None
Peru Non Convertible. Reserve Requirements on foreign deposits (120%), 30% tax on interest paid to non-residents. Limits on pension
fund short USD positions
Reinstated 4% fee on Bank CDs Unlikely to initiate new tax measures but purchases of USD have been high this
year at $8bn YTD. Czech Free floating and convertible None None Hungary Free floating and convertible. It is important to note the heavy
indebtedness of the private sector in foreign currency debt. None None
Israel Free floating and convertible. Interventions in the fx market have been substantial and we estimate have been running at a $700mm
per month pace.
None None
Poland Free floating and convertible. None None Russia Managed float vs a basket of EUR and USD (45%/55%). Current
band of the basket is between 32.90 and 36.90 Recently widened the band Moving toward more currency flexibility
South Africa Freely convertible. SARB does intervene on occasion. No capital controls
None Risk of more aggressive intervention
Turkey Freely floating and convertible. CBRT engages in daily FX auctions of $40mm USD and sets a weekly guidance of an extra amount.
Lowered the interest rate on foreign currency deposit rates to 0.25% from
2.50%. Increased weekly auction amounts to $500mm most recently.
Risk of aggressive and unorthodox intervention is low, but policy of building
reserves remains in place.
Source: J.P. Morgan, “Get over It: EM FX Appreciation and Interventions Are Here to Stay,” Sclater -Booth et al, 21 Oct 10.
Brazil Economics Inflation risks on the rise Despite the slowdown observed in the central quarters of the year, the economic activity scenario remains very robust, especially due to the domestic demand drivers. The labor market is extremely tight, with the unemployment rate at a historical low and real wage gains accelerating at a worrisome pace. On top of that, credit conditions continued to improve despite the 200bp monetary tightening implemented between April and September. Against this backdrop of strong domestic demand expansion, we believe Brazil’s growth rate will reaccelerate by the end of this year and will begin 2011 on a strong footing. The resumption of growth in an environment of already tight utilization rates will put even more pressure on headline and core inflation, which are already running above the BCB target of 4.5%.
Will Rousseff rebalance Brazil’s policy mix? The economic policy mix in the last year of the Lula Administration has been clearly unbalanced, with the expansionary fiscal policy putting upward pressure on interest rates, and the high yields of local rates market attracting short-term capital inflows. The problem is that the government has responded to the resulting fx appreciation pressures with the imposition of new taxation on foreign capital inflows instead of promoting a fiscal adjustment aimed at reducing aggregate demand. We expect that the next administration will promote some fiscal correction, but the resumption of a monetary tightening is inevitable, in our view. Our forecast is that the Selic rate will be increased by 175bp next year, to 12.50%. Assuming some policy action will be taken by the next administration, we anticipate growth will moderate to 4.5% next year (from 7.5% in 2010), which will help to reduce inflation from 5.6% this year to a still-above-target 5.1% in 2011.
All eyes on cabinet formation The market expects a market-friendly cabinet, with ex-Finance Minister Palocci likely setting the agenda from the Chief of Staff’s chair. BCB Governor Meirelles is seen as an invaluable asset and should be retained, either remaining at the BCB or being appointed to a more political position. If Meirelles leaves the BCB, an appointment from within is likely. For the finance portfolio, Guido Mantega and Luciano Coutinho are the leading contenders, in our view.
Fabio Akira AC (55-11) 3048-3634 [email protected] Banco J.P. Morgan S.A.
76
78
80
82
84
86
88 6
8
10
12
14
% of full capacity, saHigh utilization of labor and capital resources
Mexico Economics External demand might curb growth, but auto
sector and credit could boost domestic demand
Unfortunately, gubernatorial elections will likely create a political impasse for structural reforms
Sluggish growth and well-behaved inflation will keep Banxico on hold all year long
Favor long MXN over front-end receivers in TIIE swaps
Fundamentals and politics in 2011 Structural change in the auto sector and credit growth could overcompensate sluggish US growth The externally driven manufacturing production has led Mexico’s economic recovery throughout the year. Nevertheless, growing concerns about longer-term sluggish growth in the US is posing risks ahead. In this context, we believe Mexico’s GDP will grow 3.5% in 2011 (consensus: 3.5%). We could even see lower growth rates in Mexico. Nevertheless, it is our take that the structural change that the auto sector has experienced in the Mexican economy and credit growth in Mexico will help to overcompensate US growth’s sluggishness. On the one hand, several automakers across the world have reallocated part of their production to Mexico to benefit from a weaker peso, skilled Mexican labor, still-high transport costs, and the country’s strategic geographic location.
On the other hand, commercial banks’ credit might post significantly high growth rates in 2011. The Mexican banking system is composed of 41 well-capitalized commercial banks. The average capitalization index stands at 17.7, with a range of 12.3 to early 240. Unfortunately, total commercial bank credit to the private sector represents less than 15% of GDP. After the credit boom in Mexico in 2004-2006, nonperforming loans increased significantly, making banks rethink their credit-giving policies. Nevertheless, commercial banks have now “cleaned up” their credit balances and employment conditions have improved significantly in the past 12 months. As a result, we believe that it is highly likely that all these factors will probably lead to an ascending trend in the country’s domestic credit cycle.
Banco J.P. Morgan S.A., Institución de Banca Múltiple J.P.Morgan Grupo Financiero
Gubernatorial elections will likely create a political impasse for structural reforms There is no doubt that Mexico needs several structural reforms, particularly meaningful fiscal and labor-market reforms as well as new guidelines to empower antitrust officials to dilute monopolies and foster competitiveness. We strongly believe that the lack of these structural reforms is restraining domestic demand and Mexico’s potential GDP. Furthermore, the prevailing legal uncertainty with regard to enforcing contracts is short-circuiting the credit intermediation function of commercial banks. Unfortunately, the seemingly large GDP growth rates that the country has observed in 2010 appear to be providing a “false sense of security” to government officials, particularly legislators, who have now downplayed the need for reforms in Mexico. Furthermore, with gubernatorial elections in six states next year, particularly in the highly populated State of Mexico, it is going to be difficult to secure congressional approval for the key reforms that the country needs.
Not all long-term plans are negative. We believe infrastructure projects, including construction of roads, water treatment plants, and massive transportation systems, will play an important role in the next two years. This is mainly because several projects that had been in a feasibility study phase over the past two years are now ready to start construction. Furthermore, several projects suffered important delays because of the global financial crisis. However, state-owned development bank BANOBRAS has modified its lending framework to provide guarantees in addition to funding and is now working with the National Infrastructure Fund to also provide direct, nonrefundable funds to projects with a high social return.
Banxico to keep rates on hold throughout the year The growth backdrop we have sketched above, in addition to well-anchored medium-term inflation expectations and moderate wage increases, clearly support our “low-for-long” monetary policy call, in which we anticipate that the first hike will not take place until 2Q12 (consensus: 1Q12).
Market strategy We favor long MXN over receivers in the front end of the TIIE swap curve.
China Economics Growth momentum in China’s economy improved moderately in 3Q10, with real GDP rising 8.1%q/q saar by our calculation, exceeding our forecast of 7.5% and following a 7.2%q/q saar expansion in 2Q. The latest macro figures confirm our view that growth bottomed in 2Q and has been on a steady rebound since, with domestic demand rising at a solid pace despite softness in the export sector and with the most intense phase of inventory correction gradually fading. We expect growth in China to pick up steadily in coming quarters, with further solid expansion in domestic demand in particular. Local governments are anticipated to gear up for the start of new projects going into 2011. This, along with the central government’s efforts to meet the 5.8-million-unit housing target, solid private consumption and investment demand, the gradual fading of the inventory drag, and largely accommodative monetary conditions, could increase the risk of overheating by early next year. We have moderately increased our estimate for China’s real GDP growth in coming quarters. Our forecast for 2010 full-year GDP growth has been fine-tuned to 10.0%oya (previously: 9.8%), while our estimate for 2011 GDP growth is now 9.0%oya (previously: 8.6%). We have also revised the forecast for 2010 average CPI inflation rate to 2.9%oya (previous forecast: 2.8%). The forecast for 2011 average CPI inflation now stands at 3.2%oya, taking into account the impact of potential further resource and energy price liberalization. Indeed, we believe the PBoC’s 25bp rate hike effective on October 20th is intended to signal that the central bank is keen to contain inflation expectations. As such, we expect headline CPI inflation to peak in coming months, with the inflation rate gradually stabilizing at around 3.2% by early next year. Our US team is looking for the Fed to maintain its fed funds target rate through to 2Q12, and to begin QE2 in early November. So these factors imply the PBoC would be somewhat constrained should it want to undertake further rate hikes. We now expect the PBoC to be on hold in coming months as it monitors the impact of tightening measures on the property sector. We expect the next rate hike to come in 2Q11, and we look for a total of two rate hikes next year. For the property sector, we believe the authorities will continue to focus on sector-specific measures, targeting both the demand and the supply sides, in an effort to contain further rises in property prices.
Meanwhile, CNY/USD appreciation has accelerated in recent weeks, and the trend could continue post the US midterm elections and G-20 summit in November. The probability of more significant near-term CNY/USD appreciation could yet be capped by Chinese policymakers’ fears over ongoing uncertain external demand and its impact on exports, and if the spot rate begins to show more two-way volatility when political pressure starts to ease later this year. Our forecast is for the CNY/USD rate to be unchanged at 6.6 at year-end, with the bilateral rate expected to appreciate steadily toward 6.3 by end-2011. On the fiscal front, we expect the focus to shift from infrastructure investment toward consumption and achieving more balanced growth. In addition to structural reforms and the gradual buildup of social security, urbanization and infrastructure spending will likely remain a key focus in the 12th five-year plan. Therefore, solid public investment and steadily strengthening private consumption should ensure that the economy expands at a solid 8% pace over the next five years, despite soft global demand. This, together with the government’s commitment to increase the supply of housing, suggests that commodity demand from China will remain solid in coming years. However, the government’s firm resolve to conserve energy and slower the pace of private investment growth, given the softer global demand and abundant capacity in many manufacturing sectors, suggests that the booming pace of China’s commodity demand growth during the past decade is unlikely to be repeated.
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% per annum China: benchmark lending and deposit rates
China Infrastructure Target railway capex for 2010 and 2011 As per the Ministry of Railway’s (MOR) plan announced in July 2009, the total railway spending target for 2010 and 2011 is Rmb825 billion and Rmb900 billion respectively. The target capex on civil works, which accounts for c.85% of the total railway capex, is Rmb700 billion for 2010 and Rmb750 billion for 2011. This implies that spending on civil works is estimated to increase by 17% in 2010 and 7% in 2011. This is significantly lower than the average growth rate of 64% in the last four years.
Strong railway spend so far Railway capex is up 27% yoy in 9M2010. The MOR’s railway spending amounted to Rmb491 billion in the first nine months, achieving 60% of the full-year target of Rmb825 billion, ahead of last year’s ratio of 55% over the same nine-month period. Within this, a total of Rmb430 billion was spent on civil works, forming 88% of the railway spending and achieving 61% of the full-year target, ahead of last year’s 57%. For the final quarter of the year, the pace of increase is expected to soften markedly to a meager 3% yoy, assuming the MOR’s target is kept unchanged. It is likely that the current target may be exceeded if the current momentum is maintained.
Target railway length Based on the latest version of the MOR’s medium- to long-term railway development plan (announced in 2008), China plans to achieve a total ending length of 120,000km by 2020. During late 2008 and early 2009, in response to the financial crisis outside China, the MOR fast-tracked a number of projects on back of the government’s aggressive fiscal stimulus. With this year’s ending length at approximately 90,000km, our regional infrastructure team expects China to achieve a total railway length of 110,000km by 2012. The MOR’s existing medium-term target of 120,000km of railway network by 2020 can be achieved as early as 2015.
Expectations from the 12th Five-Year Plan While the 12th Five-Year plan has not yet been officially announced, our regional infrastructure team believes that there is a high likelihood of upward revisions to railway infrastructure spending and increases in the MOR’s medium-term railway operating length target. The government has emphasized on several occasions that improving transportation links, particularly the railway network, is vital to rebalancing economic growth across regions.
China infrastructure spending outlook Spending (Rmb B) 2005 2006 2007 2008 2009 2010E 2011E 2012E Capex on total railway spending 120 208 255 414 701 825 900 880 Capex on civil works 89 155 177 337 600 700 750 700 Capex on locomotives and others 31 52 78 77 101 125 150 180 % capex on civil works 74 75 69 81 86 85 83 80 % capex on locomotives and others 26 25 31 19 14 15 17 20 Y/Y growth (capex on civil works) 75 14 90 78 17 7 (7) Y/Y growth (capex on locomotives) 68 49 (1) 31 23 20 20 Ending railway length (km) 75,438 76,919 77,904 79,625 86,500 90,000 93,500 108,000 MOR’s railway spending during the year 89 155 177 337 600 700 750 700 Highway/Tollroads (Rmb B) 649 688 967 1160 1276 na Source: MOR, J.P. Morgan estimates.
Western China Western China includes six provinces (Gansu, Guizhou, Qinghai, Shaanxi, Sichuan, and Yunnan), five autonomous regions (Guangxi, Inner Mongolia, Ningxia, Tibet, and Xinjiang), and one municipality (Chongqing). The major cities (with a population over 5 million) are Chengdu, Chongqing, Xi'an, Kunming, Wulumuqi.
Land area and population Western China accounts for 71% of mainland China’s area. Its population as of 2009 was 370 million, or 27.5% of China’s total population.
GDP growth From 2000 to 2008, Western China’s GDP growth consistently lagged that of the non-western regions (see table top right). As a result, Western China’s share of China’s real GDP experienced a steady decline during the period (see figure top right). In 2007, Western China accounted for 15.9% of China’s real GDP growth, lower than its share in 2000 (16.3%). However, in 2009 the trend reversed, with Western China’s GDP growing at 12.4%, higher than the non-western region’s at 11.5%. The two main reasons for this were: a) With its greater reliance on China’s exports, the impact of the global recession in 2008 was more severe on Eastern China; and b) Western China benefited from China’s massive infrastructure spending in 2009, as significant resources were allocated to the western region, which has poor infrastructure facilities.
Per-capita GDP There is significant scope for economic development in Western China compared to the more developed coastal regions. 2009 average per capita GDP in the 12 western provinces was Rmb17,595. This is less than half of the per capita GDP of Rmb42,469 in the coastal provinces. The average per capita urban income for the 12 western provinces was Rmb13,896. This is only 70% of the average in coastal provinces (Rmb19,766).
Real GDP growth – Western China lagged until 2008
89
101112131415
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Western region
Non-w estern region
Source: CEIC, J. P. Morgan Economics.
Western China’s real GDP as % of national real GDP
15.8
16.0
16.2
16.4
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
Source: CEIC, J. P. Morgan Economics.
GDP per capita – Western vs. coastal provinces (Rmb/yr)
Policy initiatives and projects announced in 2010 In 2000, Beijing adopted the ‘Go West’ policy to develop its relatively isolated and underdeveloped Western China region. The main components of the policy included infrastructure development, attracting foreign investment, improving ecological protection, promoting education, and retaining high-skilled labor from moving to richer provinces. From 2000 to 2009, China launched 120 projects with a total cost of Rmb2.2 trillion (source: Reuters).
In 2010, the following projects and preferential policies were announced to further improve the development of the western region:
1. The National Development Reform and Commission (NDRC) announced on 6 July that China will embark on 23 new projects in the west region this year totaling Rmb682 billion (US$100 billion). These projects range from railway, airports, power grids, power stations, wind powers to coal mines.
2. China’s State Council announced on 7 July that the new resource tax, which was levied in Xinjiang as of 1 June 2010, and is charged at 5% of the revenue of coal, oil and gas companies, should be extended to all 12 provinces in Western China. The resource tax reform will help the local governments in Western China to collect taxation revenue to develop the local economy and gradually bridge the gap between developed coastal regions and the less developed western regions.
3. The state council confirmed that the encouraged industries in Western China will be entitled to 15% preferential income tax rate for another 10 years. In comparison, the income tax rate of Chinese enterprises in other regions will be unified to 25%. This measure should help boost Western China’s medium-term growth by attracting more factories/companies and creating more job opportunities.
Source: finance.sina, Bloomberg news. Note: Except Shanghai and Beijing, all districts in the table have multiple tiers of minimum wages. The minimum wages and increase % shown for those districts are of the highest tier.
% of households grouped by annual income as of 2008 Annual income % of households <RMB10000 1.5 RMB10000-20000 9.9 RMB20000-30000 17.7 RMB30000-40000 18.3 RMB40000-50000 15.0 RMB50000-60000 10.8 RMB60000-70000 7.8 RMB70000-80000 5.3 RMB80000-90000 3.7 RMB90000-100000 2.6 >RMB100000 7.5 Source: CEIC.
China FAI: Do not extrapolate Can housing starts continue to grow in 2011 or will there be an inventory correction? Residential construction (advanced 12 months) versus sales (millions of square meters GFA per month)
Estimated total monthly residential construction starts Monthly residential sales
Source: CEIC, J.P. Morgan calculations. Notes: Monthly total construction data is available in China. The ratio from 2005 to 2010 of residential construction to total construction is 80%. This ratio is used to estimate the residential starts from the monthly total construction starts. The monthly total constructions starts and monthly residential sales data are seasonally adjusted.
Per capita consumption of cement (tonnes) vs. adjusted per capita nominal GDP
0.0
0.2
0.4
0.6
0.8
1.0
1.2
1.4
0 6000 12000 18000 24000 30000 36000 42000 48000
Russia (1991-2009E)
Brazil (1985-2009E)
India (1985-2009E)
China (1985-2010E)
US (1930-2008)
UK (1985-2009E)
Germany (1985-2009E)
Japan (1985-2009E)
Taiwan (1985-2009)
South Korea (1985-2009E)
Mexico (1985-2009E)
GDP per capita (USD)
Cement consumption per capita (tonnes)
US 2008
Russia 2009E
Brazil 2009E
Mexico 2009E
S. Korea 2009E
Taiwan 2009
UK 2009E
Germany 2009E
Japan 2009E
India 2009E
China 2010 E
China 2009
1993: per capita cement consumption peaked in Taiwan
1997: per capita cement consumption peaked in Korea
Source: US Geological Survey and J.P. Morgan estimates. Note: The GDP per capita is restated for today's dollars by adjusting the deflator series.
Note: Increases in affordable housing construction starts 167M sq m of GFA in 2011 – just six weeks of private construction starts (J.P. Morgan estimates, see China affordable housing, Kwong et al, 27 October 2010).
↑ indicates revision resulting in stronger local FX , ↓ indicates revision resulting in weaker local FX* Negative indicates JPM more bullish on USD than consensus,** Consensus Economics Publication: Foreign Exchange Consensus Forecasts September 2010
Source: J.P.Morgan
JPM forecast gain/loss vs Dec-11* Actual change in local FX vs USD
2010 2011 2012 2010 2011 2012 2010 2011 2012Total Market 100.0 9.0 20.4 16.3 Total Market 100.0 23.0 11.2 7.1 Total Market 100.0 17.1 4.8 6.7Consumer Discretionary 9.7 39.9 14.0 9.4 Consumer Discretionary 4.6 65.0 18.7 19.6 Consumer Discretionary 0.0 NA NA NAConsumer Staples 25.4 -4.9 20.4 4.5 Consumer Staples 15.2 84.1 12.7 8.3 Consumer Staples 0.0 NA NA NAEnergy 0.0 NA NA NA Energy 0.0 NA NA NA Energy 10.0 NM -41.8 9.6Financials 6.0 39.4 27.2 15.7 Financials 9.7 26.7 9.4 23.1 Financials 44.5 7.0 3.6 11.8Health Care 0.0 NA NA NA Health Care 0.0 NA NA NA Health Care 0.0 NA NA NAIndustrials 4.7 23.8 -3.7 NA Industrials 20.5 51.3 27.5 NA Industrials 0.0 NA NA NAInformation Technology 0.0 NA NA NA Information Technology 0.0 NA NA NA Information Technology 0.0 NA NA NAMaterials 16.2 -10.2 50.4 25.8 Materials 23.1 177.0 4.1 14.6 Materials NA NA NA NATelecommunication Services 38.0 13.4 15.3 8.1 Telecommunication Services 2.7 -2.3 15.4 7.4 Telecommunication Services 39.4 21.4 27.7 3.3Utilities 0.0 NA NA NA Utilities 24.1 -19.6 8.0 27.8 Utilities 0.0 NA NA NA
2010 2011 2012 2010 2011 2012 2010 2011 2012Total Market 100.0 27.7 31.1 22.5 Total Market 100.0 26.9 47.1 -34.8 Petrobras 19.0 -0.9 -4.1 0.9Consumer Discretionary 0.0 NA NA NA Consumer Discretionary 0.0 NA NA NA Vale 16.4 97.4 47.8 12.4Consumer Staples 0.0 NA NA NA Consumer Staples 5.9 20.1 38.8 24.6 Itauunibanco 9.4 32.1 20.1 15.4Energy 0.0 NA NA NA Energy 29.0 26.3 42.3 NA Bradesco 6.6 13.9 16.4 12.3Financials 30.8 21.4 18.2 NA Financials 39.5 36.7 67.0 NA Ambev 3.4 13.9 12.5 6.5Health Care 0.0 NA NA NA Health Care 0.0 NA NA NA Itausa 3.0 29.9 16.6 42.9Industrials 0.0 NA NA NA Industrials 0.0 NA NA NA OGX 2.9 89.7 75.7 172.3Information Technology 0.0 NA NA NA Information Technology 0.0 NA NA NA BM&F Bovespa 2.7 37.9 19.2 19.5Materials 69.2 31.5 38.2 24.3 Materials 16.3 -0.2 45.7 NA CSN 2.1 -33.0 62.2 5.8Telecommunication Services 0.0 NA NA NA Telecommunication Services 0.0 NA NA NA Banco do Brasil 1.9 19.9 12.9 18.4Utilities 0.0 NA NA NA Utilities 9.2 21.1 16.7 10.6 BRF Foods 1.6 5.3 66.7 32.9
Source: I/B/E/S, Bloomberg, MSCI, J.P. Morgan Updated as October, 2010Note: Average earnings growth calculated based on earnings aggregate of MSCI contituents from IBES.
Profit Growth Outlook: Changes in 2010 and 2011 EPS Forecasts
Source: I/B/E/S Updated as of October 2010Notes: The dashboard aims to show changes in earnings expectations. All year ends are for December. EPS figures are normalized, starting at 100 on base date Feb 2009 for ease of comparison. These numbers are directly from IBES aggregate and may differ from those in the growth expectations pages where adjustments are made for exceptional items.
Profit Growth Outlook: Changes in 2010 and 2011 EPS Forecasts
Source: I/B/E/S Updated as of October 2010Notes: The dashboard aims to show changes in earnings expectations. All year ends are for December. EPS figures are normalized, starting at 100 on base date Feb 2009 for ease of comparison. These numbers are directly from IBES aggregate and may differ from those in the growth expectations pages where adjustments are made for exceptional items.
Source: I/B/E/S, MSCI, J.P. Morgan* Market forecast numbers are derived from bottom-up calculations of each individual MSCI constituents using I/B/E/S estimates Updated as of October 28For all other markets, forecast numbers are derived from bottom-up calculations of each individual MSCI constituents using JPM estimates for covered stocks and I/B/E/S estimates for the rest.USA, Europe and Japan PE are I/B/E/S aggregate estimates. Japan Valuation estimates are for the financial year ending March
Consumer Discretionary 13.9 12.8 12.8 12.8 14.4 12.0 14.4 13.3 15.4 31.0 NA NA NAConsumer Staples 14.5 12.7 14.2 18.4 18.4 17.3 20.4 19.9 20.1 24.0 24.6 NA 34.5Energy 10.4 10.3 8.7 8.2 5.6 12.0 10.3 10.0 NA NA 10.8 NA 20.7Financials 10.9 9.3 9.2 12.3 10.8 12.4 12.6 12.4 15.2 14.1 12.5 15.3 11.3Health Care 11.4 10.5 10.8 18.8 14.1 22.0 NA NA NA NA NA NA NAIndustrials 13.4 12.1 13.2 13.4 10.7 14.4 22.9 24.3 20.9 22.3 NA NA NAInformation Technology 12.8 12.2 13.6 11.2 9.9 12.3 10.4 10.4 NA NA NA NA NAMaterials 11.8 13.6 10.5 11.2 12.2 12.3 10.1 8.6 16.8 19.5 NA 16.6 51.5Telecommunication Services 12.0 13.2 10.4 11.6 10.9 12.3 11.0 8.0 12.0 11.7 9.1 NA NAUtilities 12.3 12.8 10.7 11.8 10.8 13.7 10.9 9.4 NA 13.1 NA NA 37.3Market Aggregate 11.6 13.2 9.0 11.6 9.1 12.4 11.9 10.9 15.1 17.7 13.0 16.6 18.3Sector Neutral* 12.0 11.5 10.9 11.6 10.9 12.9 12.9 12.3 14.4 15.9 12.6 13.5 21.2
Value: P/BV Matrix for Countries and Sectors
Trailing P/B
Glob
al
USA
Euro
pe
Emer
ging
Ma
rket
s
EMF
EMEA
EMF
Asia
EMF
LATA
M
Braz
il
Mexic
o
Chile
Arge
ntin
a
Peru
Colo
mbi
a
Consumer Discretionary 2.1 2.8 2.0 2.7 3.2 2.5 3.0 2.8 3.2 4.9 NA NA NAConsumer Staples 3.0 3.5 3.1 3.5 4.0 3.7 3.1 3.0 3.5 3.0 1.9 NA NAEnergy 1.7 1.9 1.6 1.4 1.0 2.4 1.4 1.4 NA NA 0.7 NA 5.1Financials 1.2 1.1 1.0 2.1 2.0 2.1 2.6 2.5 2.6 4.2 2.7 3.8 2.1Health Care 2.6 2.5 3.1 4.3 3.2 5.2 NA NA NA NA NA NA NAIndustrials 2.1 2.7 2.4 2.1 2.1 2.0 2.8 3.3 1.8 3.2 NA NA NAInformation Technology 2.9 3.7 2.5 2.3 1.1 2.3 18.8 18.8 NA NA NA NA NAMaterials 2.1 2.8 1.9 2.2 2.7 2.0 2.2 2.3 1.3 2.6 NA 7.1 1.4Telecommunication Services 1.9 2.0 1.6 2.5 2.8 2.1 3.3 1.3 5.3 2.8 1.5 NA NAUtilities 1.4 1.5 1.4 1.3 1.1 1.5 1.2 0.9 NA 2.1 NA NA 2.7Market Aggregate 1.7 2.0 1.6 2.0 1.6 2.1 1.9 1.7 2.8 2.2 1.7 5.6 2.3
Source: IBES, MSCI, J.P. Morgan. Note: PEs are derived from bottom-up calculations of each individual MSCI constituents using JPM estimates for covered stocks and IBES estimates for the rest.*Sector neutral PE are calcuated by using sector weights of MSCI EM and sector PE of respective markets (MSCI EM sector PE used where country sector does not exist)
Source: I/B/E/S Updated as of October 2010Notes: The dashboard aims to show historical consensus trailing P/BV with +/-1 SD bands since Dec 1995 . For EMEA Trailing P/BV since Feb 1999.
Source: MSCI, J.P. Morgan.*We use a re-organized Gordon growth model to derive a ‘fair value’ P/E = (ROE-g)/ROEx(COE-g). 1) COE made up of the US 10-year treasury yield as the risk-free rate, the respective country EMBIG spreads, and a fixed equity market risk premium of 5% (30-year average)2) We take the potential GDP growth as the growth rate; 3)the 12m-forward I/B/E/S consensus ROE
Value: Forward PE for Sector
Source: I/B/E/S Updated as of October 2010Notes: The dashboard aims to show historical consensus forward PE with +/-1 SD bands since Dec 1995 . No Heathcare sector
Consumer Discretionary Energy Financials
Materials
Consumer Staples
Industrials Telecom Utilities
5
10
15
20
25
30
95 97 98 99 00 01 02 03 04 05 06 07 08 10
-1SD
+1SD
8
11
14
17
20
95 97 98 99 00 01 02 03 04 05 06 07 08 10
+1SD
-1SD
0
5
10
15
20
95 97 98 99 00 01 02 03 04 05 06 07 08 10
+1SD
-1SD
3
6
9
12
15
18
95 97 98 99 00 01 02 03 04 05 06 07 08 10
+1SD
-1SD
3
6
9
12
15
18
21
98 99 00 01 02 03 05 06 07 08 09 10
+1SD
-1SD
2
4
6
8
10
12
14
16
95 97 98 99 00 01 02 03 04 05 06 07 08 10
+1SD
-1SD
6
9
12
15
18
21
24
95 97 98 99 00 01 02 03 04 05 06 07 08 10
+1SD
-1SD0
8
16
24
32
95 97 98 99 00 01 02 03 04 05 06 07 08 10
+1SD
-1SD
MSCI LatAm MSCI Mexico MSCI ChileMSCI Brazil
5
7
9
11
13
15
17
Jan 03 Feb 04 Mar 05 Apr 06 May 07 Jun 08 Jul 09 Aug 10
12 Mth Fwd PE Gordon Growth P/E
3
6
9
12
15
Jan 03 Feb 04 Mar 05 Apr 06 May 07 Jun 08 Jul 09 Aug 10
12 Mth Fwd PE Gordon Growth P/E
7
9
11
13
15
17
Jan 03 Feb 04 Mar 05 Apr 06 May 07 Jun 08 Jul 09 Aug 10
12 Mth Fwd PE Gordon Growth P/E
6
8
10
12
14
16
18
20
22
Jan 03 Feb 04 Mar 05 Apr 06 May 07 Jun 08 Jul 09 Aug 10
Hungary 1.0 2.8 0.9 2.6 0.0 -0.3 0.4 -0.2 0.0 2.0 2.0 2.0 4.9 3.6Egypt na na na na na na na na na na na na na na
Czech Republic 2.0 3.2 2.0 2.0 0.0 0.0 0.3 -0.2 3.8 2.5 2.3 2.5 na naMorocco na na na na na na na na na na na na na naJordan na na na na na na na na na na na na na na
Source: J.P. Morgan estimates, Bloomberg Updated as of October 28Note: Consensus estimates for Jordan, Egypt and Israel sourced from WES and Morocco from EIU
Consensus JPM (% Y/Y)Consensus GDP SAAR
(1.5)
(0.8)
0.0
0.8
1.5
Indon
esia
S Ko
rea
Malay
sia
Colom
bia
Philip
pines
Thail
and
South
Afric
a
Turke
y
Chile
Braz
il
Mexic
o
China Peru
Taiw
an
Hung
ary
Polan
d
Russ
ia
Arge
ntina
Czec
hRe
publi
c
2010E GDP Growth: JPM Minus Consensus Change in Consensus Forecasts for 2010E GDP over last 3 months (%)
Source: EPFR Global, MSCI, J.P. Morgan calculations. The survey covers 45 fund managers. The calculation of OW is greater than 2% overweight versus the MSCI benchmark. UW is less than -2% of benchmark weighting. Fund weightings are as of 30 September 2010 and MSCI weightings as of 1 October 2010. Numbers in brackets are the previous month values. Potentially China stocks have been misclassified as Hong Kong, hence the combined weight for Hong Kong and China. Hong Kong investment may be providing non-China exposure Source: Bloomberg, J.P. Morgan, I:Net, MKK, Lipper FMI, MSCI, Datastream. *EPFR Global data. ***Data from Lipper
FMI. BRIC Funds separated from EM Funds from 11 May 07. 12 month average column shows ratio of current flows to past 12 months rolling average. ****Total EM Equity includes Global EM, LatAm, EMEA, Asia ex Japan and BRIC funds.
EM Managers’ Positioning Relative to MSCI EM: Major EM Markets Regional and US Mutual Fund Flows
Cumulative EM Fund Flows (US$ BN), by Year 2010 LatAm Funds Cumulative Total and ETF Flows (US$ MN)
(3,000)(2,500)(2,000)(1,500)(1,000)
(500)0
5001,0001,500
Jan 10 Feb 10 Mar 10 Apr 10 May 10 Jun 10 Jul 10 Aug 10 Sep 10 Oct 10
Economic Forecasts: Credit Risk External (2010E) Fiscal Position Sovereign Ratings (Long Term Foreign Debt)
Foreign CurrentReserves Account 2010F** 2010F** 2010F** 2011F** 2009 2010F** Moody's S & P(US$bil) %GDP (US$bil) %GDP % GDP % GDP % GDP % GDP Rating Action Date Rating Action Date
Morocco* 13.6 -0.9 na na na na na na Ba1 O/L changed to stable Jun-18-03 BB+ Upgrade, O/L stable Mar-23-10Jordan* 5.3 -14.4 na na na na na na Ba2 O/L changed to stable Jan-08-07 BB Affirmed, O/L stable Mar-12-10
Source: Bloomberg, J.P. Morgan Source: Bloomberg, J.P. Morgan Source: Bloomberg, J.P. Morgan Source: Bloomberg, J.P. MorganSource: CEIC, J.P. Morgan estimates, Moody's, Standard & Poor's, Bloomberg * Data from World Economic Outlook for October 2009, ** F denotes forecast.
Updated as of October 28
Public Sector DebtFiscal DeficitExternal Debt
EMBI Global Spreads and Yields EMBI Asia Spreads and Yields EMBI Latin America Spreads and YieldsEMBI Europe Spreads and Yields
Perspective: Demographic and Key Economic Statistics
Age Gross 2010E Growth Dependency Ratio* Enrollment Ratio US$ Per capita Total Per capita Total Per capitamillion %YoY Young Old Secondary** billion (US$) (%) (%) (%) (%)
USA 310 1.0 na na 98 14,646 47,213 4.1 3.1 3.0 2.0
Source: CEIC, Datastream, Bloomberg, US Consensus Bureau, World Bank, IMF, UNESCO, J.P. Morgan estimates Updated as of October 28* Age dependency ratio defined as dependents to working-age population.** Gross Enrollment Ratio is defined as pupils enrolled in a secondary level, regardless of age expressed as a percentage of the population in the relevant official age group *** 10-year CAGR for period 1999-2009, in local currency. # CAGR for period 1999-2009 ## Population data based on IMF estimate as on July 2007Data for Gross enrollment data for 2004 except for Malaysia, Brazil and Argentina which is for 2003
Perspective: MSCI Emerging Market Index Composition by Countries and SectorsNumber of Companies: 754 Total Market Capitalization (in billion US$): 7407
Other companies recommended in this report (and priced as of October 28, 2010): Bladex (BLX/US$15.29/OW) Cielo (CIEL3.SA/R$14.60/Neutral) Coca-Cola FEMSA (KOF/US$78.40/Neutral) Compania Cervecerias Unidas (CCU/US$56.05/Overweight) Fleury (FLRY3.SA/R$21.85/Neutral) Grupo Modelo (GMODELOC.MX/Ps68.67/Overweight) Heineken (HEIN.AS/€36.34/Neutral) Itau Unibanco Holding SA (ITUB4.SA/R$41.14/Overweight) Redecard (RDCD3.SA/R$22.50/Neutral) SABESP (SBSP3.SA/R$39.79/Neutral) Southern Copper Corporation (SCCO/US$43.08/Neutral) Souza Cruz SA (CRUZ3.SA/R$86.60/Neutral) Telesp (TSP/US$24.24/Overweight) Vallourec (VLLP.PA/€74.75/Overweight) Vivo Participacoes (VIV/US$28.18/Overweight)
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