Why you should be excited about Mexico

Last Thursday an explosion at the headquarters of Mexico's national oil giant ripped apart one of the country's biggest skyscrapers and killed 36 people. It was a devastating event. And the rumour mills quickly sprung into operation. US geopolitical analysts Stratfor suggested that Mexico's drug gangs may have played a role. And these stories were picked up by mainstream international news outlets, who began speculating who was behind the attack.

In the end, however, it emerged that the cause of the disaster was much more prosaic, with investigators finding evidence of a gas leak and an electrical fault.

The speed with which the international press jumped on the violence rumours shows just how badly Mexico is perceived by the mainstream media. When I first told people to invest in Mexico back in July, it certainly proved controversial. Several readers pointed out the country's problems in the comments section, with security and corruption topping the list.

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But despite all these problems, the market tracker that I tipped is up 20%, breaching new highs. And to be honest, I don't think British investors should be ignoring what is actually happening in Mexico. I'll tell you why today.

$57bn pours into Mexico in three quarters

Now, in this issue of The New World, I'm not going to downplay the social impact and human suffering that the drug war is causing. And I'm not ignoring the unfairness and inequality created by the pernicious spread of corruption. But the fact is, Mexico's economy is powering on regardless of these evils. And while high-profile accidents and drug battles are scaring away retail investors, a lot of the smart money' is already in the country.

For example, during the first three quarters of 2012, institutional investors poured $57bn into Mexican stocks and bonds. That's five times more than went to Brazil.

Why is that happening?

Firstly I'm not surprised. I've spent a lot of time in Mexico, including a stint reporting there for a US mining publication, and I've always been impressed how far removed life in Mexico City is from the drug problems. Indeed, if it wasn't for the local press's penchant for gory pictures of bloodstained drug lords lying sprawled on roadsides, I would have forgotten all about it. But it's been a few years since I was last there, so I got in touch with one of my contacts, Eduardo Gonzlez, a lawyer with Mexican firm Creel.

As a corporate finance lawyer specialising in mergers and acquisitions, Eduardo is involved in some of the country's biggest business deals and has a pretty good idea of the mood among international investors. And he had an interesting perspective. He told me that many foreigners have a misperception about the drug war.

"You have to understand that this is an issue related to certain specific towns in parts of the country. Most multinational companies can carry on with their business without problems. Sophisticated international investors know that, which is why they are so optimistic about Mexico."

So what is it that has the smart money' so excited?

A great reason to buy Mexico

In a word: manufacturing. Over the last twenty years, Mexico has transformed itself into one of the world's most competitive manufacturers. One reason is demographics. Mexico is currently in the midst of a huge demographic boom that is seeing the working-age segment of the population grow faster than children or pensioners. The mass of workers is keeping a lid on wages exactly the opposite of what's happening in China. As a result, the gap between Chinese and Mexican manufacturing cost is closing.

Free trade is another factor. Mexico is arguably the world's most open economy, and has free trade agreements with more than 40 countries. Tariff-free imports keep factory input costs down, while the deals also give exporters free access to huge swathes of the world economy.

Mexico's ability to make things for cheap has coincided with a boom in demand from its main markets. Since 2000, Latin American economies have enjoyed a commodity-fuelled growth spurt. And a significant chunk of that new-found wealth has been spent on fancy new imports. As a result, the Latin American share of Mexico's total exports has shot up. Meanwhile, demand from the US, which is still the main market for Mexican exports, is growing too.

I am bullish on the US as it looks the most promising of all the developed world economies. And, as regular readers will know, I am also bullish on Latin America. So buying Mexico which is one of the most competitive manufacturers and traders in the Americas is a great way to play growth along the whole landmass.

The oil problem

Paradoxically, another of the things that I like about the Mexican economy is that vast swathes of it are terribly mismanaged. One of the biggest problems is energy as Mexican oil production has steadily declined in recent years. That's not because it's running out of oil like the UK, but because the state oil firm, Pemex, is used as a government piggy bank and therefore unable to invest in new fields. Another problem is the cosy system of oligopolies and duopolies that drive up costs for Mexican consumers.

New president Enrique Pea Nieto was elected on a platform of tackling those reforms head on and if he could achieve significant success in just one of those areas, it would be a massive boost to the economy. For example, Capital Economics estimates that partially privatising Pemex could add almost 1% to annual GDP growth.

Don't get me wrong, delivering these reforms won't be easy. After all, the previous administration had similar goals and got nowhere in six years. Indeed there are serious obstacles to both. Oil is a populist issue and privatising Pemex would require a change to the constitution. "Many Mexicans believe they own the oil", says Gonzalez, "and it is hard to convince them that it is more valuable to make money by selling it than leaving it in the ground".

Another problem is that energy reform can't come without a change to the tax system. That's because if Pemex is no longer the government piggy bank, someone else is going to have to pay the bills. Unsurprisingly, politicians are cagey about confronting this telling people they have to pay more tax is rarely a vote winner.

Then there are the oligopolies. Given that many of these supported Pea Nieto's campaign, it is going to be a bit awkward when he tells them to break up their business.

But so far, Pea Nieto is making a decent fist of it. Just two months into the job, he has already passed some minor legislation to improve the country's underperforming education system and private-sector unions. He's also come up with a unique strategy for the more thorny problems. Realising he can't take on the unions, oligopolies and populists alone, he's convinced the other political parties to sign a 'Pact for Mexico'. While the wording of the pact is understandably vague, it basically commits to sorting the economy's most obvious problems.

I'm not being naive, I don't think that Pea Nieto has a magic wand that will suddenly solve Mexico's problems. In fact I think he will probably fail with most. But he looks like the first Mexican politician in a long time that might just be able to fix one of them. And if he does, it will provide extra spice for an already sound investment.

Sorting the security problem is more complex.But readers shouldn't wait for the situation to heal completely before investing. I think you should seize the opportunity now...

How you could invest

Obviously private investors don't have the same access to Mexican stocks as fancy institutional funds. But it is easy enough for you to invest in the Mexican story. In fact, Lars and Ihave nearly finished a report that spells out exactly what you need to know to invest overseas.

For the last few months, Lars has been working on a hugely exciting project that is almost ready to launch. This is a project that could deliver enormous gains over the next year. I've read the report he has put together and it's hugely entertaining. There are run-ins with gangsters. There are riots. Lars has lived quite the life!

But the most important thing is that he has written one of the most exciting emerging-market investment stories I have ever read.

The point is, Lars and I believe that many British investors are ignoring hugely promising opportunities. Take Mexico. One of my favourite sectors is banking. At present, Mexicans are underbanked. The total sum of credit made available by banks and other financial intermediaries stands at just 34% of GDP, compared to 63% in Brazil and 93% in Chile. But in the last few years, as Mexico's economy has picked up, more Mexicans have started to use banks. And in a big way!

Between 2006 and 2012 the total number of bank clients in Mexico rose 62% to 52 million! Indeed between 2009 and 2011, the share of the adult population that uses some form of banking or financial product has risen to 58% from 48%.

As a whole,total bank credit to the private-sector is growing at around 14% per year. This is good for the wider economy as extra credit fuels expansion. It is also good for Mexico's banks, which are growing at great speed.

My favourite is Grupo Financiero Banorte (GBOOY:US). Despite a recent run up in the share price, it is still one of the cheapest Mexican banks on a price/earnings (p/e) ratio of 14.4. It is the only Mexican banking operation that is Mexican-owned and controlled. It has been at the forefront of a buying spree that has seen local investors snap up Mexican banking interests from retreating Europeans.

For example, it recently spent $800m to buy half of Spanish bank BBVA's Mexican pension assets. Not having a struggling European parent company to support means that it can devote more attention to exploiting opportunities in the local market. And, judging from its latest set of results, it is doing just that. In the last quarter of 2012, profits rose 20% as the bank rolled out new products to consumers.

Another advantage with buying Banorte is that owning a well-run, diversified bank gives you exposure to growth across all sections of an economy. I'll bring you more opportunities like this in The New World. But keep an eye out for Lars'hard-hitting report.

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.