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Today, it seems the equity markets of most countries are either very highly valued as in the United States, East Asia, and Europe, or in a state of high geopolitical risk such as Russia and Turkey. This is visualized well in a chart from Star Capital:
(Source: Star Capital)
One area where valuations are reasonable and political risk, though existent, is healthier than in other areas is Chile. Investors interested in Chile may want to look at the iShares MSCI Chile Capped ETF (ECH).
An Attractive Price Point
We will begin with a long-term view of the ETF’s price and its patterns since 2008:
(Data source: Yahoo Finance)
As you can see, since 2008 it has made for a poor investment. Latin America as a whole has struggled on reaching its economic growth potential, primarily due to the commodity price depression and issues with sovereign debt. However, with resource prices back on the rise and global investors needing more corners of the globe to invest (specifically, geopolitically neutral corners) places like Chile may fare very well.
The fund is hovering just above its long-term support area and had a strong uptrend from the commodity super-cycle bottom in 2016 to the return of volatility in 2018. In our opinion, the era of low volatility is coming to an end, but the next era of supply push inflation is just beginning. Overall, this technical level and its trend appear to be positive factors for investing in the country.
Fund Holdings in Stronger Sectors
Here is iShares’ current sector breakout for the fund:
(Source: iShares)
The sector weightings imply the ETF will benefit from slow growth (Financials and Materials) and will not be greatly impacted by a potential global recession (Utilities and Consumer Staples). The top holdings are: Enel Americas (ENIA) (which produces electricity for its four closest neighbors), Banco Santander Chile (BSAC) (an area of concern, but less levered than its Spanish counterpart), Falabella (apparel retailer), and the oil & timber producer Empresas Copec. Together, these four firms make up nearly 30% of the fund’s total, so it does have some concentration risk.
That said, these sectors are all relatively safe. Financial institutions in Chile do have some leverage risk, but in our opinion, non-European banks are globally much less of a risk than in the past.
Both Chilean materials firms and the health of financial institutions in the country are highly tied to the value of its exports. Here is the breakdown of Chilean exports:
(Source: OEC)
Roughly half of Chilean exports are derived from copper, so the price of that commodity is key for the ETF. To show this directly below is a scatter plot of the daily price changes of ECH and that of the Global X Copper Miners ETF (COPX)
(Data source: Yahoo Finance)
For those curious, the slope between the two is 0.35 and the R^2 is 0.35.
(Note: This is not copper directly, it is copper miners, which have a slope to copper above 1. So, copper and ECH likely have a slope closer to 1.)
Copper prices plummeted about 57% from their 2011 high to their 2016 low, and have since risen 35% to $2.7, for which they have strong support to move higher. Chilean copper production historically has been driven by Chinese demand, and the nation produces a quarter of the world’s copper. It does not seem likely Chinese demand for infrastructural development will return in full steam soon, but demand from the “Monsoon” region (specifically Malaysia, Thailand, Indonesia, and Vietnam) is poised to rise now and for decades to come. This will make for a strong long-term growth story for the Chilean economy.
Valuation and Potential
The ETF has an aggregated P/E ratio of 15.6 and a PB ratio of 1.54. According to Star Capital, the country as a whole has an average CAPE ratio of 17, which is associated with roughly a 7% average yearly return over a 10-15 year time frame (Note: CAPE uses 10-year average earnings to mitigate economic cycles). While many would prefer even lower valuation metrics, remember that of the United States is 31, which is associated with 3-4% average yearly earnings over the same time frame.
That said, we believe investors could possibly expect 10-12% average yearly returns, as Chile’s current earnings are depressed due to copper’s uniquely low historical price and the country’s considerable growth potential.
To illustrate this long-term growth potential, here is a chart of real GDP per capita in Chile (blue) to Argentina (red) relative to that of the United States. 
As you can see, both Chile and its neighbor have similar levels of income, but Chile has done a much better job at improving its economy. You can also see that the metal price crash since 2012 has been a drag on this factor. We would estimate that the trend over the next decade will be comparable to that of the 2000s, which would imply an average yearly income growth of about a half of a percent on top of that of the developed global economy. This estimate may be too low or too high depending on political factors.
Strong Political and Domestic Footing
Historically, Latin American economies have been subject to corruption and sovereign debt issues. This has been particularly true for Brazil and Argentina and less true for Chile. According to the 2018 Global Competitiveness Report, Chile ranks 33rd on the competitiveness index, which measures government policies/stability, value of human capital, market strength, and innovation ability. This is the highest ranking in all of Central and South America, and can be compared to Brazil at 72 and Argentina at 81.
Here is the breakdown:
(Source: WFC Global Competitiveness Report)
Most notably, the country received all the points on macro-economic stability, which is based on inflationary controls and sound fiscal policy. For us, this is the most important factor, as sound fiscal policy is perhaps the largest risk to the global economy today.
Chile’s government debt-to-GDP is only 25.6% (the lowest in South America), compared to 77% in Brazil, 86% in Argentina and 105% in the United States. As global government budgets continue to be forced to allocate more and more toward interest payments, GDP growth will likely slow for most developed countries besides the likes of Chile. It seems likely many investors will wish to move their allocations away from said countries to areas of high government financial stability like Chile.
Risks and Rewards
This is a long-term two-year or more investment idea. The primary short-term risk is the price of copper. Over the long run, this represents a reward, as inflation is likely to return in the next economic cycle, but short-term demand slowdown from China is likely enough to delay appreciation in ECH. Still, we believe that a series of bad years for a commodity results in a similar series of good years down the road. If anything, the depressed price of copper will likely rise over that 2-10 year time frame.
It is hard to give a sound long-term reward estimate for equity ETFs, but perhaps on average 3-6% above that of the global equity market can be expected, depending on the specific course of events and barring unpredictable black swan-type events. As with all Latin American countries, the fund is a bit more volatile than that of the U.S. or Europe but does have some low correlation benefits, so we would limit portfolio allocation to 10%.
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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