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Argentina has a habit of surprising investors. Since 2014, the country has had four major currency devaluations with the last occurring early Monday morning as the conservative Argentine president Mauricio Macri suffered a major defeat in primary elections.
The Global X MSCI Argentina ETF (ARGT) lost roughly a quarter of its value while the Argentine Peso lost a fifth. Investors in the fund have actually done quite well until today as the fund was up about 45% on the year and was the best performing Latin American fund. However, in one weekend, most of those gains are gone.
As is almost always the case following a financial panic, it is important to separate objective reality from irrational fears and judge whether ARGT is a sell or buy at this level. It is also key to understand what exactly caused the panic and if more sharp declines are on the way.
The discussion is two-fold, there are the companies the ETF holds and the currency which the fund is exposed to. With Argentina, it is safe to say that the companies are overall fine and some value can be found, but the currency is very weak. For the ARGT ETF to perform well, both must be strong and a weak currency requires very low valuations to make for a safe investment.
Introduction to the ARGT ETF
The Global X MSCI Argentina ETF invests in large cap stocks in the country and is not currency hedged. It tracks the MSCI Argentina 25/50 Index which has diverse exposure to the Argentine economy. The fund has a normal expense ratio of 0.6% and $100M in AUM so it is liquid, but only for smaller accounts.
Despite the emerging market status of Argentina, the companies in the fund are not cheap. According to Global X, the fund has an average P/E of 23X and an average P/B of 2.3X. Of course, we will dig into these fundamentals more closely to see if there is a reason for the high numbers, but with a 1.1% dividend, it does not look like a value play.
The fund is slightly more heavily weighted toward risky sectors with a quarter of the ETF being allocated to consumer discretionary and 20% energy. While the fund only has 26 holdings, because the sector weighting is balanced, it is safe to say the fund is generally representative of the Argentine economy.
Here is the sector weighting:
Source: MSCI
What is interesting is that, on the surface, the fund should have been hit hard by the country’s recession, but ARGT has rallied significantly this year. One reason this may be true is because the sectors are slightly inflation hedged. Consumer discretionary has done well as inflation in Argentina has been mirrored by an increase in retail spending. The energy sector also benefits because energy prices often rise asymmetrically with inflation.
Holdings Fundamentals Indicate Slight Overvaluation
Let’s dig in deeper to the fundamentals of the companies in ARGT. To do this, I have aggregated the fundamentals for most of the companies in the fund. One important issue with the fund is 22% of its weight goes to a single company, the online retailer MercadoLibre (MELI). That company has doubled in value over the past year and is likely to blame for the fund’s outperformance this year. Luckily, the other stocks are more evenly distributed. Here is a chart of the fundamentals of most of the holdings:
Note: “Typical” denotes harmonic mean for valuation statistics and median for others to avoid skewed results.
Source: UncleStock
Overall, most of the companies in the fund are now trading around or above fair value. The reason Global X publishes the P/E as 23 is because nearly a quarter of the fund is in MELI which generates essentially no earnings yield. Looking at the rest of the companies, we can see that they have a typical P/E of 9X which is right in line with what I would expect for an emerging market.
That said, because they lack monetary stability, investors may place higher risk premium in coming months. Other EMs with non-stable currencies typically have P/E ratios around 5-7X and usually a much higher dividend yield.
Some of the companies have poor liquidity with current account ratios less than one. Revenue growth is strong for most, but it is also heavily skewed due to the high inflation rate in the country. The stocks also have decent ROEs with most being just under 15%, indicating their book assets value is likely in line with market value.
Put simply, there is not much value here. I would not say these stocks are overvalued, but in my opinion, it is not worth touching single-country funds with unstable currencies unless valuations are lower.
Argentina Unlikely to Emerge from Stagflation Soon
Argentina will likely make for a good investment once their currency is stable. Long recessionary periods are typically followed by long and profitable bull markets. The key, of course, is timing and I don’t think the time has come.
Since 2008, Argentina has had four periods of negative GDP growth and its current recession, which began Q2 of 2018, has been worse than the others with -6% GDP growth. The unemployment rate has risen from 6% in 2016 to 10% today and appears to be accelerating higher. Inflation in 2010 was a stable 8%, now it is 55%.
Unfortunately, this is not the form of inflation that comes from rabid retail demand and a growing economy, it is the “sovereign debt crisis” that comes from high external debt which causes currency weakness. Argentina currently has roughly $300B in external debt between the public and private sector; this corresponds to roughly 45% of its GDP. Most of that debt is priced in the U.S dollar, so as the dollar strengthens, more pressure is put on the Argentine economy and monetary system.
The Argentinian Central Bank has been using the tools they have available to try to combat inflation and further currency devaluation. This has been through selling foreign exchange reserves to prop up the Peso, as occurred on Monday, and by raising the interest rate. Indeed, the interest rate and inflation rate are both currently around 60%. See below:
Note: Inflation rate is left axis while right axis is interest rate
Source: Trading Economics
While the last read of inflation showed a slight decline, the next will almost definitely be higher due to the recent currency crash. The currency has been declining at a faster rate than inflation so the real economic cost of their large external debt effectively increases in tumultuous times like this.
This is exactly the problem. The country’s debt is high and the government has struggled to remain solvent as it currently runs a -6% fiscal deficit and is faced with high interest payments. This situation makes the currency very prone to “black swan” events like this because the government must take drastic austerity measures to fix the situation.
The great hope of Mauricio Macri was that his center right political stance would help him fix the budget. Indeed, Macri is the first democratically elected non-radical or Peronist leader of the country in over 100 years. He ended the sovereign default, removed currency controls, and lowered tariffs. But, perhaps he did too much as he lost the first round of elections which increases the chances of a populist victory. The market expects that the populists will be more inclined to default on government debt.
This is the core problem with the Peso and therefore with the ARGT ETF. If anything negative occurs that increases default risk, the currency will devalue. If the currency devalues, then the country effectively owes more U.S. debt, which increases default risk even further.
The Bottom Line
The only way this can end is by improving employment and creating real economic growth that can be used to pay down debt. Normally austerity could work, but leaders like Macri who do the necessary austerity measures are outed.
As you can see below, it appears that unemployment may soon rise even higher:
Source: Trading Economics
Overall, it seems that the Peso will only weaken further. Real GDP growth is unlikely to strengthen so then it will be up to the IMF to, once again, bail out the country. So far, extreme currency weakness has not been feeding all the way into the ARGT ETF, but that may be changing soon. See the Argentine Peso vs. the ARGT ETF over the past two years:
Source: Trading View
The ETF has been surprisingly resilient as it has declined with the currency during crashes but usually picks up steam when the currency is flat.
That said, I find the recent divergence to be a sign that the equity market will weaken soon. Remember, the fund’s recent performance is a bit of a mirage as its top (23% weighted) holding (MELI) has more than doubled in value since January. As the bull rally for that company as well as the other equities (when priced in Pesos) continue to fade, they may fall much further.
While the recent crash is likely to bring in some buy-the-dip investors, it seems that the ETF is a clear sell. The government can choose between economic stability and political stability, and politicians almost always prefer to keep their job via political stability. There is no limit to how far the currency can fall in this situation as it is a viscous cycle that usually ends in hyperinflation or an extreme bailout.
That would be OK if valuations were lower and equity fundamentals were stronger. But that is not the case. Valuations are normal for an emerging market economy, but Argentina is below the mark in currency stability. Overall, I would give the fund a price target of $18 by year-end.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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