Another way to profit from a Chinese slowdown – buy Mexico

Investment banks like to group 'hot' countries together. Not only is it a great way to grab investors' attention, sometimes it even makes money.

In 2001, Goldman Sachs came up with the BRICs Brazil, Russia, India and China. Those four markets did very well during the 2000s.

However, as we've pointed out already, these four seem to have hit the buffers. So now Goldman has come up with another shiny package of must-have' nations.

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The catchy acronym this time? MIST Mexico, Indonesia, South Korea, and Turkey.

As with the BRICs, there's no real reason to group these countries together beyond branding. Each has its own merits and individual problems.

However, of the four, Mexico looks the most interesting to us. Here's why

Why China's woes are great news for Mexico

One major attraction of Mexico is China. More specifically, the Chinese slowdown is good news for Mexico.

Why? Since the end of the 1970s, China has become the workshop of the world. Market reforms meant it could use its huge supply of cheap labour to flood world markets with low-cost goods.

This had a big impact on US industry. But it also DEALT a knock-on hammer blow to Mexico. American firms who would once have outsourced production to a factory 'south of the border' instead moved to the Far East.

This model couldn't last forever. And as China has become richer, wages have started to rise. This has reduced its cost advantage over middle-income countries. Indeed, wages in Mexico are now only 10% higher than those in China.

So if you're the head of a multinational, you start to become less interested in the wage bill, and pay more attention to other factors, such as transport costs and governance. This makes Mexico look much more attractive as a production location for firms exporting to, or supplying, the US. Despite its many flaws, Mexico is a market-based democracy that is just a truck drive away from many major US cities.

In contrast, the state still plays a massive role in the Chinese economy. Property rights are also weak. And in any case the distance mean that any finished goods have to be shipped halfway around the globe, which costs time and money. Indeed, if productivity is taken into account, Mexican wages are now much lower than those in China.

So it's no surprise that Mexico has grown strongly in recent years, even while the US has stagnated. GDP went up by 5.5% and 3.9% in 2010 and 2011 respectively. Indeed, Mexico also outpaced Brazil, which only grew by 2.7% last year.

One of the things that makes emerging markets risky in general, is that they tend to have high levels of public and private debt. This means a slowdown can quickly turn into a deep recession, as government and consumers are forced to deleverage.

However, Mexico's finances are generally in a good shape. Net government debt is only 35% of GDP, while private debt is relatively low. Ironically, this solid fiscal position is due to the fact that the personal banking system is underdeveloped. This means that most people have limited access to credit.

As Mike Riddell of bond fund manager M&G points out, the Mexican government has also made a big effort to reduce the amount of debt it issues in foreign currencies. The downside is that this means it has to pay more interest on its bonds. But it also leaves Mexico far less vulnerable to a panic by foreign investors. It also means that if necessary the country could stimulate growth by making the currency cheaper, without worrying that this would make it harder to repay debt.

How to invest in Mexico

There's no getting away from it, Mexico is not dirt cheap by any measure. The attraction here is growth, not value or income. The iShares MSCI Mexico Investable Market Index (NYSE: EWW) has a price/earnings (p/e)ratio of 15, with a yield of only 1.49%.

However, it's worth remembering that the US market itself trades on a p/e of 14. Given that growth is expected to be much higher south of the border, this makes the Mexican market look almost cheap by comparison.

If you have an appetite for something more high-risk, then homebuilder Desarrolladora Homex (NYSE: HMX) might be worth looking at. While the Mexican property market has grown solidly in the past two years, houses are still cheap compared with other markets.

Prices per square foot in Argentina and Brazil, both middle income countries, are respectively 50% and 83% higher than in Mexico (Homex's Brazil operations account for only 0.6% of total revenue). With property remaining relatively cheap, growth in the market should continue.

Homex is not completely dependent on housing. It has a growing infrastructure business, which accounts for nearly 15% of revenue. It has also been contracted by the Mexican government to expand the prison system. Clearly, it's risky it's a cyclical company in an emerging market. But on ap/e ratio of just 4.7 times, it looks priced for the risk.

My colleague James McKeigue will be looking at Latin America's most promising economies including Mexico in the next issue of MoneyWeek magazine, out on Friday. If you're not already a subscriber, subscribe to MoneyWeek magazine.

This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

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