Argentine inflections

Anticipating inflection points is the Holy Grail of investing: we all know that past trends, up or down, will not continue indefinitely; at some point, the curve will bend and change direction.  But when? 

When will the fundamentals of a company start to show an improvement after sustained restructuring efforts by its management?  When will financial markets start assigning to a company a stock price that is closer to its intrinsic value?  And more challenging still, when will a country abandon failed policies to save itself from chaos?

Argentina is the perfect – some may say terrible – example of a country that has followed bad economic policies for much longer than deemed possible.  Indeed, how bad these policies have been remains unrecognized abroad: not so long ago, I recall some reputed economists stating that the 2005 Argentine debt renegotiation was a model for Greece, that the Argentine economy was growing at a healthy clip.

That is nonsense, but the question remains as to why Argentina seems to defy gravity, and why it has done it for so long?  Two reasons may be given.

One is that Argentina’s growth is illusory.  Measured in US dollars, it is greatly exaggerated because of an “obese” official peso/dollar rate which stands today at 4.78.  This is to be compared with the implicit rate of around 7 when one compares the stock prices of Argentine companies on the local and New York exchanges.  In other words, the peso is overvalued by some 45%; this led the Colombian minister of finance to brag that, measured at true exchange rates, his country’s GDP had overtaken Argentina’s.

The other is that the Argentine government has picked the pockets of everyone in sight:  foreign creditors were squeezed in 2005 in a restructuring in which they lost 75% of their money; private pension funds were nationalized and their resources used to finance the public deficit; energy prices were frozen to subsidize consumer spending; official inflation calculations were fudged, defrauding everybody (and independent economists were heavily fined when their findings departed from the official ones[1]); more recently, insurance companies were forced to finance government-designated projects, foreign exchange controls were implemented to try and stop capital flight and the largest oil and gas company, YPF, was expropriated and no compensation has been paid to date.

As Mexican president Calderon said shortly after the YPF grab, anybody thinking of investing in Argentina should have his head examined. 

Despite grabbing other people’s money, Argentina is paying a very steep price for its policies. 

The refusal by Argentina to pay holders of non-restructured sovereign bonds has kept it from international financial markets since 2001.  After announcing an ambitious investment program, YPF, unable to tap these markets for billion dollar issues can only raise $100 million at a time locally; it is also unable to attract international partners to develop the vast Vaca Muerta shale oil deposits[2] because of the uneconomic pricing of hydrocarbons and pending lawsuits from Repsol[3]; electric utilities are on the verge of bankruptcy; and the ubiquitous intervention of the government in the economy has led to widespread corruption.

Starved for money and growth, Argentine companies carry low valuations.  That, plus the limited remaining number of pockets to be picked has led sophisticated investors to bet on a policy inflection point.  Eton Park, one of the most prominent US hedge funds, built a substantial stake in YPF between September 2010 and March 2012.  I estimate their average purchase price at around $40[4].  The stock closed today at $10.46.  When rumors of expropriation started to surface last April, I was tempted to buy the stock as I thought the government wouldn’t have the money to take the company over.  I just couldn’t imagine that they would just grab it, but they did.

Yet I think that we are getting close enough to an inflection point to dip a toe in Argentina.  I see three reasons for that. 

One is that having taken control of YPF, officially because its former controlling owner (Repsol) didn’t invest enough, the government now “is it”.  In other words, it must show it can succeed where others failed; it needs to attract deep-pocketed oil and gas multinationals as partners, but for that it must (1) improve hydrocarbon pricing, (2) settle with Repsol and (3) regain access to international debt markets.  This looks to me like a chicken-and-egg situation as to what comes first, a major oil joint-venture or the above three-point policy change.  Meanwhile, the clock is ticking because Argentina, once an energy exporter, is now an importer.

Second, the 2005 restructuring saga is turning sour.  Having the Navy frigate Libertad seized in a Ghanaian port is acutely embarrassing for the Argentine government and begs the question: what next? If Ghana is not safe, what more restrictive measures will the government have to apply to its movable assets?  Furthermore, the recent decision by a US judge that Argentina must pay interest on all of its external debt, including that portion which was not restructured, raises the pressure as it carries the threat of escalation in case of non-compliance.  Granted, Argentina has so far been able to delay the execution of court decisions, but it can’t expect to do so forever.  Justice may be slow but it is not dumb.

Finally and perhaps more importantly, the Argentine people are showing growing signs of opposition to the government policies.  The harsh measures taken to effectively prevent them from buying US dollars have been received , and this is understandable in a cvery badlyountry where there is little faith in the willingness of the government to pay its debts, and where real inflation is on the order of 25% p.a.  High profile corruption cases, where government members appear to have enriched themselves illegally, are especially grating when popular unemployment is high.

A large currency depreciation may be the next step, rather than better economic policies.  However this would only diminish people’s savings and living standard, which would hardly be helpful in president Kirchner’s bid to amend the Constitution in order to run for a third term.

As the above diagnosis may still be a bit optimistic - after all, Peronism in its current incarnation still has many followers - one has to look at valuation and to what extent it mitigates the risks to be undertaken.

In the case of YPF, the main risk is really that of full nationalization, a close second being delisting from the NYSE (since one buys the ADR at a 45% discount to the local share price).  Looking at its ADR stock price, YPF looks pretty cheap compared to its government-controlled peers:  Ecopetrol (Colombia) and Petrobras (Brazil):

 

	Ecopetrol	Petrobras	YPF
Market value (bn)	$115.3	$131.1	$4.1
Proven reserves (bn barrels)	1.9	12.9	1.0
Daily production (‘000 of  boe)	719	2,463	467
EV/boe of proven reserves[5]	$61.6	$15.28	$6.36
EV/boe of daily production	$162,880	$80,007	$13,615

 Of course, the above calculations are very rough and do not take into account non-upstream assets such as refineries, pipelines and other long term investments.  But they are informative nevertheless.  For example, while Ecopetrol and Petrobras have similar market values, the former has zero net debt while the latter is burdened by excessive debts.  Still, YPF looks quite cheap.

 YPF faces two specific challenges: as an oil champion under government control, it is in the quasi permanent threat of having its management and strategies politicized; it also faces a very onerous investment program.  Another, less politically risky way of playing the “Argentine inflection point”, is Telecom Argentina (TEO).

The controlling shareholder is a holding that includes Telecom Italia and the well regarded Wertheim group from Argentina.  TEO is well managed and has strong financials.  It is the second largest telecom company in Argentina after Claro (controlled by Carlos Slim’s America Movil).  Its investment needs are more modest than YPF’s on a relative basis. It has a lower profile than YPF.  Finally, its ADRs enjoy a similar discount to local shares.  On a per mobile subscriber basis, it is worth less than one tenth of America Movil.

As history shows, populist governments rarely act in an economically rational way; when they control rich countries, and when they resort to reprehensible policies, they can endure far longer than orthodox thinkers imagine.  But even they cannot repel the laws of gravity forever.  They usually don’t see the light or change their ways; their rule generally ends when they can no longer afford handouts and resort to heavy handed policies to stay in power.

I have started to build small positions in YPF and Telecom Argentina.

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[1]   It is ironic that one of them was the former minister of finance who had presided over the heavy-handed foreign debt renegotiation.

[2]   Which YPF estimates to hold 23 billion barrels of oil resources.

[3]   The Spanish company whose controlling shareholding of YPF was seized by the Argentine government this year.

[4]   Based on the average prices during the periods in which Eton Park reported building its stake.

[5]  EV: Enterprise value, i.e. market capitalization – cash and equivalents + debts.  For YPF we have used the official exchange rate to convert debt amounts to US dollars since most of these are dollar denominated to begin with.

 

 

 

The Gallois Report

One learns from experience at any age.  Look at me.  Having calculated that the odds of two consecutive once-in-a-century mega-storms were close to zero, I declined to purchase a standby generator.  Wrong.  The generator guy is coming by tomorrow.

In France and the US, politicians have become experts at kicking the can down the road, until they hit a wall and need to come up with Plan B.  In this country, we had the Simpson-Bowles Commission; its report was quickly buried but, within the next twelve months, it will likely resurface as the US margin of maneuver is squeezed and public finances are in dire need of fixing.  If our politicians succeed, they should send their French brethren a copy of their recipe, because France could learn from it.

Likewise, France commissioned a report on industrial competitivess from Louis Gallois, one of its most prominent grand patrons[1].  Mr. Gallois just delivered it today.  Having lamented the decline of the US industry, our politicians would do well to read his report, for even if our problems are not quite the same as the French, there is enough commonality to make it required reading.  The diagnostic of the French industry’s weaknesses and falling from grace is particularly instructive, because we could be next on that slippery slope. 

Generally, Mr. Gallois recommends a “competitiveness shock” where key measures are applied quickly rather than being diluted over a decade.  He also stresses that French society must debate the reforms and come together on a plan which will carry the conviction that sacrifices and benefits will be fairly shared.  Indeed, the plan is as much about mutual confidence as it is about specific measures.  

Such convergence of efforts and ultimate rewards (you think of Reagan’s motto “trust but verify”) calls for lower social charges for both employers and employees (1.5% of GDP), greater participation of employees and union representatives in the policy deliberations of large corporations and a robust support for small and medium-sized companies.

Although Mr. Gallois is reputed to be left-leaning, he sees a key contribution of the state as doing no harm.  In his view, any significant new law or governmental decree should be accompanied by a document estimating its impact on industrial competitiveness, and recommendations as to reduce adverse consequences, if any.  The state should also refrain from changing key provisions that affect such areas as R&D investment tax credit, incentives affecting the formation of new companies, among others.  But in typical French manner, the ghost of Five Year Plans of yore would return in the much milder guise of Commissariat à la Prospective.

There are twenty two recommendations made in the report, ranging from broadening and codifying employee participation on corporate boards to ways of fostering innovation, rewarding long term portfolio investors, developing shale gas resources, etc.  Many of these recommendations should be studied in this country because we could benefit from them.

On a higher level, the Report is daunting.  It calls on the government to reduce public spending and it aims at reshaping the French industrial fabric: creating more mid-size companies (think of the German Mittelstand model) and pushing the sector up market where higher quality products permit higher profit margins (think LVMH, Sanofi- Aventis and, I wish, Delage and Delahaye instead of dreary Peugeot).  That is a very tall order, hence the deliberate step-by-22 steps approach.

Equally instructive, and courageous, is Gallois’ call to stimulate capital investment in industry, which in turns necessitates toning down overregulation and the demonization of executives.  This capitalization drive also requires greater stability in the relations with stakeholders which Gallois hopes to achieve by (1) offering greater employee participation in corporate decisions (up to four but in any case less than 1/3 of the board of director seats at companies with over 5,000 employees) and (2) stronger voice for long term shareholders (doubling of their votes after two years).

The initial French government reaction was typical: countering Gallois’ 22 recommendations with 35 proposals, yet watering and complicating the proposed key reduction in social charges.  As the Shadoks[2] of my youth used to say, GA BU ZO MEU, why make it simple if you can make it complicated.

France like the US is faced with mounting pressure to reform itself, yet neither country is on the cusp of the abyss.  Their respective governments have been divisive so that there is no popular consensus on the necessary reforms and shared sacrifices. Yet well connected outsiders (Gallois, Bowles, Simpson) have started to speak up.  In the days of instant communication and interconnected economies we should and need to pick what they have to say, wherever they may be domiciled.

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[1]   Louis Gallois is a former CEO of Airbus, EADS, SNCF.

[2]  A popular and off-beat French TV series in the 1960s.