How to profit from Latin American small caps

Latin American stock markets have had a rough year. Down about 18 percent year-to-date on average across the region, the major stock markets seem to be struggling to come out of a rut. Is there anywhere in Latin America now that shows promise for investors?

Investors may want to consider investing in small capitalization stocks in Latin America. Historically, small investors have been told to steer clear of Latin American small caps because they are hard to buy and sell (i.e., they have lower liquidity), information on them is scant and they are even riskier than U.S. small caps. But there are several reasons why these factors have changed over the last few years for small investors.

Plus, there are significant reasons for investing in small caps in Latin America now as an asset class: their correlation to U.S. stocks is lower than large-caps; their access to capital has increased; and they are tied more closely to the growth of local economies than are larger cap companies, which could be a significant benefit over the next few years.

1. Lower Liquidity

To be sure, buying and selling small caps (stocks with market capital of less than $5 billion) was historically difficult because investors had to buy them directly on the local markets, and that meant going through local brokerages and dealing with conversions of currencies. Now, not only are these equities available via online brokerages to small investors, but many brokerages also translate the currencies to U.S. dollars for tax purposes. Plus, many small caps are now made available in the U.S. as American Depositary Receipts (ADRs), making it even easier to trade.

This heightened availability has leveled the playing field for small investors. What’s more, large investors typically won’t touch many small caps in Latin America because of the difficulty of getting in and out of their investments quickly. For many large funds, their investment mandates specifically preclude it. For small investors, this isn’t as much of an issue: it’s a lot easier to sell 100 shares than it is to sell a million shares!

2. Information Gap

Now let’s look at the “information gap.” By this, I’m referring to the large gap between small investors and large investors — those who have the means to gather information and conduct local research and then compile the data into spreadsheets so it can be analyzed by highly paid research staffs back in New York or London. How can small investors hope to compete?

But again, small caps in Latin America tend to be avoided by large investors. This gives small investors who are willing to put the time and effort in to doing their homework an advantage. First of all, one has to consider it a hobby. If we assume the other 90% of your portfolio is in a 401k or other diversified income stream, that leaves 10% of your portfolio to play with. Becoming an investor in a region like Latin America means taking the time to do it right. It may even require becoming an expert on a specific industry.

In researching small caps in Latin America, small investors need to look at fundamentals, but they also need to look at access to capital. To some extent, fundamentals are already extensively researched by large investors. Thus, the price of the stock already contains most if not all of the information available on any one company. Small investors can spend their time doing cash flow analysis or looking at earnings trends, but are unlikely to add much value.

By looking at access to capital, small investors have a better chance of finding something that large investors might have missed. A company, particularly a small company, isn’t going to grow if it doesn’t have access to capital. This means reaching out to one of four sources: government financing and subsidies, bank financing, the bond market or the equity market. Find out who recently raised capital, and who stands to gain even more? What companies have agreements in place with banks or governments? You can often find out by calling analysts in an individual country.

Alex Barrientos, an investment banker at Aegis Capital in New York, says they are looking to raise capital right now for Latin American companies, especially in the energy and service industries.

3.Risk

Small companies are riskier than large cap companies simply because of their smaller stature and volatility. And when you take that even further to Latin America, the risk is greater. Price volatility, for example, was 5.8% over a recent 11-month span for the iShares S&P Latin America 40 Index ILF +0.02% as compared to 4.6% for the S&P. But if you’re considering investing in them, you have to consider how that risk affects your overall portfolio. If, for example, a stock goes down one day, but the other stocks in your portfolio go up, and vice-versa, then your risk may not be so bad.

Consider the correlation of the Market Vectors Latin America Small-Cap Index ETFLATM +0.48% , which is an exchange-traded fund. Its correlation to the S&P was 65% over an 11-month period, versus 87% for the large-cap weighted ILF. If diversity is what you’re looking for in your portfolio, LATM has a lower correlation than larger cap companies.

Speaking of LATM, investors may want to consider this ETF as a good alternative to many small-cap funds, even though it’s only been around for a year and a half and it’s one-year performance of negative 23% isn’t exactly impressive. But its 80-company portfolio has the advantage of being slightly tilted toward the consumer sector, which is a plus for investors looking to get away from large-cap industrial and commodity driven companies.

To find attractive smaller companies, you will likely have to do more than scratch the surface. Take a look at Gafisa GFA +1.09% , a homebuilding company in Brazil. Worldwide, the housing market has suffered over the past four years, and Gafisa is no exception. It’s down 50% year to date. But when the housing market does turn, Gafisa could be poised to gain more than a comparable U.S. small cap, both due to its brand name and the fact that real estate development is still fairly new to Brazil and there’s more room for growth.

Also, you may have to venture to some of the lesser-known countries like Colombia, where you’ll find companies like EcoPetrol EC +1.95% , Latin America’s fourth-largest oil company. EcoPetrol has grown steadily and now trades at a market cap of $1 billion. Although it still pales in comparison to its larger cousins like Petrobras PBR +0.21% of Brazil, which at a market cap of $175 billion has been the darling of many large institutional investors. Still, EcoPetrol has a long way to go before it reaches its promise of hitting 1 million barrels of oil equivalent per day (boepd). Exactly where are those reserves going to come from?

Sound like a lot of work? It is, but the returns to small investors could be promising if you’re prepared to do the research and to hold on to your investments for the long term — oh, and to ride out a few ups and downs!

MarketWatch.