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Stock Strategist

Latin Stars for Your Portfolio

After a trip south of the equator, we share our Latin American picks and pans.

How better to profit from Latin America's economic expansion than by owning the firms that power the region's homes and businesses? To explore this question, we flew south of the equator and interviewed representatives from four Brazilian utilities, from Brazil's Ministry of Mines and Energy, and from two of Chile's largest power companies.

On the balance of things, we found reason for optimism. But investors seeking exposure to the region are wise to be selective; just as we unearthed appealing stories, we also picked off a couple that we think are best avoided. Here are a few thoughts on the broader market and regulatory environments in which these firms operate, followed by our picks and pans.

Emerging-Markets Volatility: Foe�or Friend?
Latin America, like other emerging markets, carries above-average market risk. Devaluation, inflation, and social unrest have been routine. Usually, such risk is appropriately priced. But from time to time the stock market discounts Latin American firms for reasons that are unduly punitive, in our opinion. The resulting volatility, to the extent that it serves up solid assets on the cheap, can be a gift to the patient investor. Cemig (CIG)--a Brazilian utility whose operations have held steady for decades but whose ADR has ranged in price from $3 to $23 over the past five years--illustrates this point.

With cries of "socialism or death!" ringing out from some corners of Latin America, observers are understandably wary. But those who shun the entire region on the basis of a few bad apples risk missing out on the rest of the harvest. Beyond the antics of Chavez and his band, governments in countries like Chile and Brazil are quietly consolidating democracy, while companies are going about the business of making money. For the discerning investor, this can be fertile ground.

Not only is the market bad at appraising country risk, it is not always up to speed on the progression of individual industries. We think Latin American utilities offer a case in point.

Latin American Utilities Have Evolved
Privatization and regulatory reform have propelled the investment merits of several Latin American utilities to the ranks of their global peers. Regulators in the region's more progressive countries--notably Chile, Brazil, and Colombia--have abandoned heavy-handed policies in favor of a transparent, market-based framework. Chile has led the way with its sophisticated model, while Brazil's regulatory environment has also progressed meaningfully. Power generators in these markets bid for supply contracts under competitive auctions and negotiate deals directly with large end-users. Distributors, meanwhile, are assured risk-adjusted returns and operational protection against rising input costs and currency devaluation. Some regulatory kinks still need ironing, but then, the same is true throughout much of the United States.

Latin America's major economies are, by several measures, stronger now than they have been at any time in the past 25 years. The region is a prime beneficiary of heightened global demand for a range of commodities and industrial goods. Inflation is at a 40-year low, interest rates have fallen, and GDP growth is ramping up. Serious concerns--including persistent income inequality, crime, and stifling labor laws--continue to beleaguer the region, to be sure. However, overall economic winds have been favorable and should continue to benefit the region's utilities. In Brazil, for example, sales of power-thirsty appliances and electronics goods increased by 16% last year alone.

While we're mindful of Latin America's troubled past and ongoing challenges, we think both macro- and sector-specific advances have transformed various local players for the better. Of the seven Latin utilities in our coverage universe, some boast brighter prospects than others. We present here our top two picks--and a further two to steer clear of for now.

Stocks to Consider
 CPFL Energia  
CPFL Energia--Brazil's largest privately owned utility--stands above its peers. Unlike some utilities in both Latin America and the U.S., CPFL's returns exceed its cost of capital--and we expect that they will only strengthen.

Scale and natural monopoly status confer CPFL a sustainable competitive advantage. The firm's difficult-to-replicate distribution networks, which are concentrated in the economically robust southern states of Sao Paulo and Rio Grande do Sul, represent a sizable barrier to entry. We expect that CPFL will build further scale as it acquires local utilities in the fragmented Brazilian market. Rising per-capita consumption (currently one fifth U.S. levels) will also help drive CPFL's top line. Operating costs, meanwhile, should remain in check, as Brazil's revised regulatory scheme rewards efficiency.

Unfortunately, a widespread drought could entail power rationing in Brazil's hydro-dependent electricity market. Although such a scenario is unlikely, rationing would squeeze CPFL's margins, as revenues would fall while costs would remain largely fixed. An economic downturn would lead to similar challenges. Despite these risks, we think CPFL's investor-oriented management, attractive service territories, and operating scale bode well in the long run.

The market has caught on to CPFL's story, but at its current 4-star price, shares in this powerhouse are close to being on sale. At some point, CPFL's price/fair value ratio is sure to fall further. Our suggestion: Keep this one on your radar.

A balanced mix of generation and distribution assets positions Chile's Enersis to profit handsomely from South America's fast-growing demand for power, in our opinion. We think Enersis' dirt-cheap hydroelectric assets give it an edge over competitors that rely more heavily on higher-cost thermal plants. On the distribution side, regulated rates assure steady cash flow. Even where retail competition is expanding, Enersis collects a toll for the use of its infrastructure.

As with CPFL, above-average business risk cools our enthusiasm somewhat. Enersis is vulnerable to a depreciation of the Chilean peso and other major South American currencies. And while the economic and political base of the company's Chilean domicile is relatively sound, nearly two-thirds of operating income is generated in less-stable markets, including Argentina and Peru.

With its current four-star rating, shares of Enersis are underpriced, but still not a screaming buy. The bottom line: this is another good company to tack onto your watch list until the next dip in price.

A Couple to Pass On
Sabesp (SBS) and  Copel (ELP)
Sabesp, which distributes water and treats sewage in the Brazilian state of Sao Paulo, and Copel, which distributes power in neighboring Parana, possess inherently attractive business models. After all, people will always need water and electricity, and these are best provided by natural monopolies. But if history is any guide, these firms will leave money on the table. Their government owners, not surprisingly, seem inclined to place consumer interests ahead of minority shareholders'. The evidence lies in tariff increases that have barely kept pace with local prices. While a populist pricing policy may be palatable in Brazil's current (low) inflation environment, it could spell ruin if inflation were to spike. In the meantime, artificially low tariffs are a drag on value creation. A fundamental shift in mandate could unlock these firms' potential, but until then, we'd stick to the sidelines.

Ryan McLean does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.