The Three Best Companies South of the Border

As I often write about in the International insert of our StockInvestor newsletter, while emerging-markets stocks are often characterized by risk, stock price volatility, and uncertainty, there are certain emerging-markets companies that are absolute gems, in my opinion. These firms can hold their own against the best companies anywhere.

Stock price volatility is often looked on negatively, but for investors with a long-term investment horizon--a strong stomach doesn't hurt either--it can be a blessing in disguise.

Often in times of emerging-markets panic, solid firms with excellent long-term prospects see their stock prices tank for reasons not related to the business's actual performance. It's at times like those that I start to drool because it usually is a great opportunity to buy first-class companies for coach prices.

We saw one of these opportunities a couple of months ago when emerging-markets stocks were being pummeled and some of our favorite names came tumbling down into 5-star territory. In our view, there were no company-specific reasons for the decline, and the intrinsic value of the firms had not changed just because emerging markets had fallen out of favor. Indeed, you did not see many changes in Morningstar's fair value estimates for emerging-markets firms during the downturn.

Mexico
Currently in Mexico, there is well-documented political unrest because of a close call in this summer's presidential election. Andres Manuel Lopez Obrador, the liberal candidate who lost by a hair, has spearheaded mass protests that many fear might degenerate into violence or potentially even revolution. While we don't know what may become of this issue, investors might panic and Mexican stocks could become bargains again. We believe that the three gems highlighted below have strong businesses that transcend short-term worries and would gladly own any of them at the right price.

 Grupo Aeroportuario del Sureste (ASR)
We recently initiated coverage on this fantastic little wide-moat firm--otherwise known as ASUR--and we've also added it to the International Stalwarts watch list in StockInvestor. ASUR is one of only two wide-moat emerging-markets stocks in Morningstar's coverage universe. ASUR is the sole operator of nine airports in southeast Mexico, including its flagship airport in the vacation destination of Cancun, which boasts the most international tourist traffic of any airport in Latin America.

This company is essentially a monopoly; there are no competitor airports in its region, and it has a license from the Mexican government that allows it to operate its airports for more than 40 more years. About three fourths of its sales come from passenger fees, which are regulated by the government. The remaining fourth of its sales, from things like food and shopping, are unregulated and highly profitable because of the inherent captivity of travelers who are less price-sensitive. (Even a cheapskate like me will pay $3 for a $1 hamburger at O'Hare when I'm hungry.)

It's hard not to like the financial position and profitability of this firm. ASUR is in excellent financial shape, carrying no debt on its balance sheet. It also boasts very handsome operating and free cash flow margins.

While the firm isn't quite cheap enough at this writing to qualify for our 5-star rating, it won't take much of a hiccup for this company to fall into buying range. That said, we do recommend waiting for a large margin of safety for this firm because it's subject to the cyclical nature of tourism, combined with weather-related risks and the possibility that the Mexican government will build a competing airport in Cancun as it said it might do.

 Telefonos de Mexico SA de CV 
Commonly known as Telmex, this company is the incumbent telecommunications provider in Mexico. Although it faces competition from wireless operators, the firm has what amounts to a monopoly in fixed-line phone service. The firm controls roughly 96% of all local lines in Mexico and holds about 75% market share of the domestic and international long-distance market.

Its chairman and largest shareholder is Carlos Slim Helu, the third-wealthiest man in the world. Slim has proven to be an excellent operator, but just as importantly, he's extremely well-connected politically in Mexico, which has been a huge benefit to the firm. Despite being officially open to competition, fixed-line competitors have struggled mightily to gain ground in Mexico, and we attribute at least part of this to Slim's influence on the regulatory environment.

While we think its moat is only narrow because of its forays into markets in which its dominance is not as great, Telmex is an attractive firm on almost all levels.

As you'd expect from a monopoly, Telmex sports excellent margins that are among the highest of any of our international coverage universe. Its operating margins have averaged about 35% over the past 10 years, and although margins have declined somewhat over time as the firm moves out of its Mexico stronghold, its operating margins are still around 30% today. Similarly, free cash flow margins have averaged about 25% over the last 10 years.

While there are certainly risks inherent in the rapidly changing telecom industry, we think Telmex will continue to gush cash. Also, given the firm's track record for making prudent use of its cash flow, we believe the firm would make an attractive investment if bought cheaply.

 Cemex SAB de CV (CX)
From our Analyst Report: "Cemex purchased RMC in March 2005. The combined firm is one of the largest cement and ready-mix producers in the world. Cement contributes roughly three fourths of EBITDA (operating profit before depreciation and amortization), while the rest comes from aggregates and concrete (a mixture of cement, aggregates, and water). Mexico now contributes significantly less than half of EBITDA, reducing the risks of overexposure to one market.

Cemex's assets would be nearly impossible to replicate. This narrow-moat firm enjoys enviable positions in some of the world's most attractive markets, and its seasoned management team boasts one of the lowest cost structures in the industry.

While similar grades of cement are essentially commodities, transport costs act as a barrier to entry for incumbents in geographically protected markets. The cost structures at the cement plant as well as the distribution level--Cemex is a leader in both, thanks in part to its flexible energy strategy and advanced logistical capabilities--determine the baseline economics in a market. If production costs are lower in another region, this disparity can be profitably arbitraged only as long as transport costs don't chew up the difference.

While waterborne transport is by far the cheapest, this service has recently doubled in price because of tight ship supply and escalating fuel costs. Despite this, cement continues to be traded among coastal regions to alleviate supply and demand imbalances. As one of the industry's largest cement traders, Cemex benefits not only from its well-protected inland plants, but from seeking out underserved markets as an outlet for highly profitable incremental production."