On first impressions, Central Americacan feel like it's too early to invest there. Its capital cities are among the most violent places on earth, the infrastructure is terrible and over the last decade the Central American economies have lagged behindthe rest of Latin America.
What's more it's barely possible for UK private investors to gain direct exposure to the region as the tiny economies have very underdeveloped capital markets. Nonetheless, I think Central America has lots of potential and I believe that now is exactly the right time to invest there. I've even managed to find a great way for UK investors to do it I'll tell you about it today.
Why I'm so bullish on Central America
Central America is made up of Belize, Costa Rica, El Salvador, Guatemala, Honduras, Nicaragua and Panama and home to around 41 million people. The largest is Guatemala with 14 million people, the smallest is Belize with just 300,000 people, while the rest have betweenthree million andseven million people each.
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Of course its always dangerous to generalise about a group of countries evenin a regionas small as Central America. Indeed despite the obvious similarities there are many differences between the countries.
Take Nicaragua, the poorest country in Central America. It's capital, Managua, is probably one of the world's least impressive cities. An earthquake destroyed much of the old town and the proliferation of low, squat buildings since then gives it a flat, uninspiring skyline. At ground level, it's not much better. The chaotic pavements often disappear halfway down a street, which turns going for a stroll into a real challenge.
Panama City on the other hand feels completely different. It has skyscrapers that wouldn't look out of place in New York and, thanks to its status as an international transport hub, has a very cosmopolitan feel. It's also one of the wealthiest spots in Central America.
But while these types of differences are important to acknowledge, it's the similarities that are really interesting for investors. There are several attractive shared traits that make me very bullish about Central America.
One of the most striking things about the region is its strategic location. It is sandwiched between the northern and southern hemispheres and also provides the shortest link between the Atlantic and Pacific Oceans. Indeed, in a meeting in London last week, Guatemalan foreign minister Fernando Carrera said it was amazing that, Panama aside, the rest of the region wasn't doing more to take advantage of its incredible location.
Apart from Panama, Central America has somehow contrived to miss out on the Latin American renaissance. To the south, most economies enjoyed commodity-led growth, and in the north, Mexico steadily turned itself into a manufacturing powerhouse, yet all the while Central America struggled.
The region has two main economic strengths, agriculture and light manufacturing. Thanks to its tropical climate, rich volcanic soil and abundant freshwater supplies, almost anything can and does grow in Central America. The area is a major exporter of coffee, bananas and tobacco. It's also built up some impressive value-added industries.
For example, Nicaragua's Flor de Caa seven-year Gran Reserva is, in my humble opinion, one of the best dark rums in the world. And across the region a range of producers make premium rums, cigars and coffees.
Central America also has lots of light manufacturers. Largely focussing on textiles, cheap electronics and machine components, these plants can be found in tax-free export zones across the business-friendly region. These maquiladoras were first set up in Mexico to make goods for the US. However, as Mexico has moved up the manufacturing value chain, they have become more common in Central America.
Given that Central America's agricultural base and cheap factories are nothing new, why am I getting so excited about them now? Well there are several structural factors that look likely to give these industries a big boost over the next few years.
Four great reasons to buy in
The first is growing trade with the EU. Central American exports to Europe have grown from €14bn in 2009 to more than €25bn today. That growing trade with Europe, now 8% of the total, is helping the isthmus diversify awayfrom its traditional dependence on the United States. Moreover, it looks set to increase.
Last June, Central America and the EU signed an historic trade agreement. Once it comes into force it needs to be ratified by the individual Central American governments the EU will cut tariffs on 92% of Central American imports. One group that should benefit is the banana growers, as their tariffs will fall from €176 to €75 in just eight years.
Central American producers of quality value-added goods, such as rum and cigars, should also see a European sales boost. Meanwhile, textile producers, who have built their business on selling to the US, will gain another 500 million tariff-free customers.
Another catalyst is China. Ever since China joined the World Trade Organisation in 2001, it has gobbled up an increasing share of the world export market. In particular, China's cheap textile producers and light manufacturers made life difficult for less efficient Central American operations. But now this is starting to change, notes Michael Henderson of Capital Economics.
One reason is that the growth of China's share of the world's export markets is slowing. The other is that "as Chinese manufacturers have begun to edge up the value chain, their dominance in sectors such as textiles has started to slip. This is good news for many Central American economies".
Central America also benefits from being closer to the American economy than its Asian rivals. The final point in Central America's favour is demographics. It might be a small region but it has a young and growing population. That creates a growing labour force, which keeps wages competitive and gives industry room to expand.
I still watch for gang tattoos in the cantinas
Of course, the big elephant in the room with Central America is organised crime. Again this varies greatly from country to country. For example Managua might not be ber-fashionable but it is safe and walking around at night is no problem.
Guatemala City on the other hand is far more intimidating. Even going for a casual drink at your local cantina involves gun-toting security guards. And if you like striking up conversations with strangers, which I normally do, you learn to quickly scan them for tell-tale gang tattoos.
Central America's crime problem isn't going to go away overnight. Indeed, Foreign Minister Carrera made it clear just how challenging the situation is. "It's tragic that we can't guarantee the safety of people in our country. At the moment we are focussing on making sure that at least the instruments of the state such as the police are not harming the people themselves."
It's a sober, yet refreshingly realistic, assessment. But the fact is these economies are managing to grow, regardless of the crime. Moreover, there are tentative signs that states in some Central American countries at least are becoming stronger and better equipped to cope with the challenge. It is always hard to be an early investor in these countries but that is when the opportunities are greatest.
How can you invest?
Now, as I mentioned earlier, playing Central America is not easy. There are some small domestic exchanges and local companies that issue debt but nothing that a UK-based private investor can get their hands on. Even if you could access those exchanges, the other problem is that many of the region's best companies are still family-owned, making it difficult to get a piece of the action.
But there is one way for investors to get in on the story Copa Airlines (NYSE: CPA). Based in Panama City, it is one of the region's largest airlines. One of the things I like about Copa is that it takes advantage of Central America's geographical location. "Simply put", notes JP Morgan analyst Jamie Baker, "connections are virtually mandatory when traversing Central and South America, and Panama City affords the most geographically logical point for most travellers."
As a result Copa uses the hub and spoke' model to offer 300 flights per day to 64 destinations in 28 countries in North, Central and South America and the Caribbean. It also offers another 130 destinations through an alliance with American carrier, United Airlines.
One of the advantages of this model is that many of its destinations don't merit direct flights between them, which makes it difficult for competitors to set up a rival point-to-point' service on these routes. The strategy has paid off. Since 2001, operating revenues increased by 775% to $2.25bn.
Of course as an international carrier, Copa is not a Central American pure play. Its fortunes are affected by the economic situation in the markets it serves. JP Morgan estimates that the average GDP growth rate of all the countries in Copa's network is 4.5%. But while it may not be completely centred on the region, it has got a strong Central American focus.
Around half of all Copa customers regard Panama City as their destination or origination point. That means that as Panama's economy continues to expand for example it is widening the Panama Canal Copa should continue to benefit. Moreover, the growth of the other Central American countries will provide opportunities for Copa to expand its network.
Of course, it's worth remembering that airlines have often proved terrible investments. Many have been bogged by high capital expenditures, labour issues and rising fuel prices. But Copa's management has proved very skilled at controlling costs. That's reflected in a profit margin of 17.9% that is far better than its competitors.
Copa's not cheap as it's long been recognised as a success story. However, shares dropped by about 10% earlier this month when it missed an earnings target. Given the firm's long-term potential that seems an overreaction. It's also given us a buying opportunity as Copa now trades on a price/earnings (p/e) ratioof 11.46, against its historical average of almost 14.
This article is taken from The New World, MoneyWeek's FREE regular email of investment ideas and news from Asia and Latin America. Sign up to The New World here.
