Investment Adviser:

INCA Investments, LLC

(November 2014)

Last year was a disappointing one in terms of performance for Latin American stocks, but so far this year things have been more positive. Do you think investors are now more positive on Latin America specifically or is the region benefitting from better sentiment towards emerging market stocks in general?

We believe investors have been both concerned about region-specific issues and about how global trends may impact the region. On the region-specific issues we’d point to the Brazilian elections and the country’s deteriorating economic fundamentals (rising inflation, slower growth). Global factors have included the consumption levels and prices of commodities like oil, steel, etc.

At the start of this year were you predicting better performance from regional stocks than you have seen so far and if so, what has held regional markets back? Conversely, has anything specific helped regional stocks’ performance in 2014?

After a challenging year in 2013, we expected better, albeit not necessarily good, performance from regional markets in 2014, particularly as the macro outlook for countries like Brazil continued to deteriorate. However, we did see this persistent weakness as an opportunity to look for companies that the market was offering at a significant discount to intrinsic value to add to our portfolio, as we generally have a longer investment horizon than twelve months. What surprised us most were (1) the persistent weakness in consumption growth in Mexico, and (2) the sheer level of volatility the regional markets have experienced, despite Latin America’s relatively flat performance YTD.

Presidential elections in Brazil have had an inevitable effect on local equity indexes. To what extent has this been mirrored in the performance of the Fund in the last few months’ run up to the election?

We see Brazil as having a very challenged economic outlook in the next couple of years regardless of the president elected. As such, we have positioned our portfolio accordingly, investing in companies that we think have a strong fundamental outlook and are attractively valued. However, much of the short-term Brazilian market reactions to the election news flow occurred via high-beta plays or names heavily weighted in the index, like Petrobras, which are outside of our investment philosophy. Thus, when Brazil was rallying in recent months, the Fund generally did not outperform and the reverse was also true – when Brazil was declining, the Fund outperformed.

How important are political developments in Brazil, or any other Latin American country, to your investment strategy for the Fund? How much influence do, say, presidential and parliamentary elections have on investment in the region, and is it to a lesser or greater degree than in other emerging market regions?

Election results have limited impact on our current view of the Brazilian market or how we are managing the portfolio of the Fund. Partly, this is because we believe that Brazil under any administration continues to face the most difficult economic prospects of any of the major economies in the region. More importantly, it is because we consider macro and political factors in any Latin American country as (1) extremely difficult to predict and (2) as relevant only to the extent that they directly affect specific companies. In the latter respect, the political changes in Brazil are not relevant enough at this time for us to change our view regarding the consumer-oriented companies that we prefer for the portfolio. Having said that, we recognize that (1) elections or other significant macro events can create an opportunity from a valuation perspective to invest in companies that we like and that (2) sometimes, the macro/top-down view becomes relevant enough to drive the bottom-up analysis as well. This has recently been the case with Argentina, where we have been investing opportunistically as we see a potential turnaround in the offing as a change in government looks likely in 2015. As the example above illustrates, presidential/parliamentary elections can have significant influence on investment in the region. However, we would argue that this influence has less to do with the elections as events and more about what they mean for economic administration and its impact on growth and private enterprise. Having said that, it is difficult for us to assess how much more significant these events are for Latin America vs. other emerging markets.

With the president now elected, what expectations do you have for the Brazilian economy and, subsequently, equity markets over the next few years? Are there any specific sectors set to benefit or lose out, or any important reforms you expect to see carried out?

Dilma Rousseff’s economic policies for her second term, or the next four years for Brazil, remain unclear, making it difficult to assess the impact to any specific sectors or industries.  We believe, however, that even if Brazil is steered with a more market-friendly approach than generally expected, the country faces one of the most difficult short-term economic scenarios in Latin America. We could draw numerous scenarios. To cite a couple: if the government finds itself in a position to curb spending, this could impact social programs such as “Minha Casa, Minha Vida” which has been a driver of low-income residential real estate, or education loan programs. On the other hand, if the government continues to up taxation, it could curb growth/profitability of the targeted segments –as we’ve seen in beverages or cosmetics.

You have previously said that Brazil has strong business franchises across a broad range of domestic sectors—such as those tied to consumption or increased economic formality (e.g. technology, banking services). How is the Fund taking advantage of this? Are there any companies in these sectors you have targeted specifically in the portfolio and have those investments paid off?

These are broad top-down themes, but ultimately we invest based on attractive bottom-up opportunities.  Positions in Brazil that reflect these themes include financial services companies Banco Bradesco and Banco Itau, Hypermarcas, Localiza, Arcos Dorados, to name a few.

A number of reforms are being, or have already been, undertaken in Mexico and one in particular – energy reform - has been widely cited as crucial not just to the economy but investment opportunities in the country. Could you tell us a bit about Mexico’s energy reforms and how they will affect the economy and local companies and equities?

While we could make it complicated, the concept behind the reforms is pretty simple: end an inefficient state monopoly and open the door for private and foreign players with more capital and better technology, thereby allowing the sector to become more efficient and productive. With this, you could add a new growth engine for the Mexican economy, to complement the economic growth link to US manufacturing. While there seems to be significant investment interest from the industry, the final terms of the contracts and the nature of the regulation will be relevant in driving actual investment, particularly as Mexico’s opening is occurring in an environment where there is significant global pressure on energy capital spending. The rolling (annual) nature of auctions is a pragmatic approach that should let companies pace themselves and learn in the process, contributing to a potentially higher success rate. In general, reform appears to be running on track, but it is unlikely to be a near-term driver, and should not have a material effect on Mexican economic growth in 2015. Due diligence should begin before year-end for the first round of auctions and within the first half of 2015 for the Pemex farm outs.  We also believe it is reasonable to expect delays as the undertaking is considerable. Nevertheless, we believe the reforms do have the potential to be transformational for the country.  To illustrate, the government expects total capex requirements of USD12bn related to Round 1 alone, which represents ~1% of GDP and would imply a 50% increase versus existing capex from Pemex, which is expected to remain flat.  Over multiple rounds and years, these investments should have a positive effect on general economic growth and thus on local companies and equities.

Is the Fund already taking advantage of some of these opportunities and if so, how?

While the reforms certainly bolster the “positives” side when considering the long-term outlook for Mexican equities, it does not alter our investment process. We believe the best way to take advantage of an improving Mexican economy is to be invested in franchise companies at attractive valuations that have solid fundamentals, with macro tailwinds as a “bonus”. Even if benefits from the energy reforms are pushed out, the stocks in our portfolio are well-positioned, and we are exposed to various segments of the Mexican economy, including telecom, steel, consumer, financials and real estate.

Colombia is also seeing some important changes, namely the implementation of the most ambitious infrastructure program in its history. What investment opportunities is this throwing up and how have you developed the Fund’s investment strategy to take advantage of this?

The increase in infrastructure spending taking place in Colombia has been of particular interest to us, as the country has begun to embark on the most ambitious infrastructure programme in its history. In the last decade, Colombia has invested on average less than 1% of its GDP in transportation infrastructure. Beginning in 2012, the country began to implement a much needed increase to the 2% of GDP level, which is still considered to be well short of the 4% level needed to significantly improve the country’s level of competitiveness. This ramp up in infrastructure spending begins this year and should continue for many years to come. We expect benefits from this program to trickle-down to other segments of the economy. We have direct exposure to economic growth in Colombia via our BanColombia position, as well as through stocks such as Cencosud, which have local operations.

There is significant growth in infrastructure spending in Peru at the moment. Will you be following a similar strategy there too?

The Peruvian growth story has been one of the most compelling in Latin America during the past few years, with high growth rates, low inflation and a commitment to market-friendly policies. The political environment has improved as left leaning President Humala has acted very pragmatically.  Even if investments in mining projects slow going forward (today this stands at 15-20% of GDP), low debt to GDP ratios should allow the government to increase spending. Currently, expectations are that a total of roughly USD20bn will be spent in infrastructure projects between 2013 and 2016.  Given this favourable backdrop, Peru should be the fastest growing country of the primary Latin American markets, with Peruvian companies benefitting from this rapid growth. Currently, we are exposed to these trends in the portfolio via our position in Credicorp.

The Fund has recently taken some positions, albeit smaller ones, in Argentina and Panama. Some investors tend to shy away from the former because of political and economic concerns while the latter is less well-known as an investment market. What is your thinking behind investing in these two markets?

Argentina is a unique case - we have indeed recently turned our focus to Argentina, as we believe there are some companies there trading at very low valuations, particularly if we factor in a shift in economic/political direction for the country, as we believe the upcoming presidential elections (October 2015) may finally bring regime change. Our investment team has been spending time analyzing the opportunities and travelling extensively to the country and we are confident that the risk:reward is compelling on a multi-year outlook. We recognize the significant hurdles Argentina’s political and economic turnaround will face, and assume a slow, gradual pace in our outlook. But even a modest economic improvement over the next 5 years may spell outsized returns from current levels. Our key position in Argentina currently is Banco Macro. As for Panama, we invest there the way we do in any other Latin American country.  We look for bottom-up opportunities in companies that are attractively valued and with healthy fundamental outlooks. Copa is a Panamanian-based airline that we believe is uniquely positioned in servicing a Latin American business hub. It has the highest connectivity versus competing hubs in the region, and intra-region traffic is expected to grow at a 30-year CAGR of 6.9% (based on Boeing estimates), the second fastest growing region worldwide. Having said that, it does benefit from high exposure to Panama’s fast growing economy (2014-15 GDP CAGR 7%, based on IMF estimates), which is a growing regional headquarters base for multinational companies.


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