Weekend Digest #250: CAAP Update, Mexican Peso Overvalued?, Aggressive Portfolio Results

Keeping tabs on CAAP, the Aggressive Portfolio, and the longer-term bullish on Mexico thesis.

Summary

• I talked to CAAP's head of investor relations last week. Some insights from that conversation and why the stock is ultimately set to double again.

• Is the Mexican Peso getting too strong for its own good? I examine the Peso's rally and whether it harms our long-term bullish Mexico thesis.

• Aggressive portfolio was up 8% in June, 17% YTD, and 174% since inception (January 2020). I review portfolio positioning and some individual holdings.

This is the 250th edition of the Weekend Digest. With that milestone, I'd like to thank all of you for making this possible. In 2016, when I launched this newsletter, remote work was still an uncommon concept and the idea of a hedge fund analyst quitting a six-figure NYC position and launching a one-man research service from Mexico seemed crazy. 

But you all have believed in the mission, and I hope the work here has made you some money and advantageous portfolio decisions in return. To the dozen of you who have loyally been here since 2016, I particularly thank you. It's a weird feeling sending out a 5,000-word missive when there are only have five or ten readers; your early support meant the world in keeping this publication going in the early years.

Today, the community here is 200 paid subscribers, and the past 12 months have been the best yet in terms of new readership.

With this 250th edition of the Digest, and 317 additional shorter posts over the years, we're coming up on 2 million total words published since launch. That adds up to a lot of good calls and a lot of terrible ones. While there will be countless more mistakes and bad picks along the way, I can promise that I will keep refining my investing craft and making this publication the best it can be in the years to come. And I thank you again for your continued readership.

Enough pre-amble, on to the show.

Quick Hits

Is The Mexican Peso Getting Too Strong?

Normally, for foreign investors, we are happy when oversee currencies rally. This causes our shares in those holdings to gain in value simply due to the favorable currency exchange.

For example, Mexico has had the world's strongest stock market (in dollar terms) over the past 18 months or so, and a solid chunk of that has been due to the peso's sharp rise against other world currencies.

At some point, however, a rising currency can become counterproductive, and I've started receiving reader questions on whether the Peso's move is becoming too much of a good thing. Ultimately, companies become more valuable from growing their earnings and cash flows, not from favorable currency exchange. So, is the Peso getting to a point where it would endanger Mexican companies' future growth prospects?

The Mexican Peso has been on an amazing run; it's been the strongest major currency since the early days of the pandemic. This year, its rally has continued, with the Peso moving up double-digits against the U.S. Dollar.

The Peso is now flat against the dollar dating back to 2016, and has appreciated roughly 15% (20 to 17) in more recent times. Zooming out, the Peso first hit 15 during the 2008 financial crisis. Fairly remarkably, the Peso is now coming close to retesting that level, which would make a 15-year period where the Peso held its value against the world's reserve currency. If you include carry interest (Mexican government bonds pay much higher interest rates than U.S. ones), owning Mexican debt has been one of the world's best fixed income trades in recent years.

This leads to the logical question though: Is the Mexican Peso getting too strong for its own good?

My wife and I moved to Mexico in 2015 and left at the beginning of 2018. During that period, the Peso depreciated from 15 to 20, with the bulk of that being around the election of former President Trump in November 2016. On election night alone, the Peso fell 10% as the surprise election results streamed in.

From my own experience (living in the industrial Mexican city of Queretaro) I can tell you Mexico was around reasonably priced compared to everywhere else I've been in Latin America at 15. At 20 pesos to the dollar, Mexico was incredibly cheap; I was telling everyone to come visit at that point.

17 was certainly a reasonable price for the Mexican Peso pre-pandemic. But should the Peso be more devalued now? Is 17 an overvalued level today? I'd argue it's not.

That starts with inflation. Here's the past decade in Mexico:

Mexico has a strong independent Central Bank which has built an admirable track record and is one of the most respected within emerging markets. The bank kept inflation under 4% consistently with the brief exception of the immediate period after the election of President Trump. Inflation was back down to 3% by the onset of the pandemic. And even during COVID-19, Mexican inflation topped out at 8% and has already plunged since then, putting up a more than respectable performance compared to several developed market peers (cough cough Great Britain).

Given Mexico's strong trade balance, responsible fiscal policy, and growing economic prospects, it's not surprising that local economic participants have confidence to hold their financial assets in Mexican Pesos. And, ultimately, if Mexico keeps inflation in check, there's no reason the currency should devalue significantly against the U.S. Dollar or other major currencies over time.

To sum this up, while a Mexican Peso at 20 was stimulative to tourism in particular, I don't see 17 as any sort of major headwind either.

That said, I'd start getting nervous if the Peso rallies to 15 or lower, as it would start becoming quite significantly expensive compared to other countries in Latin America, to say nothing of other parts of the world.

The long-term manufacturing thesis relies on Mexico being cost competitive with other major goods producers (Mexico is already cheaper than China on labor costs, to give one key comparative match-up.) China was notable for keeping its currency quasi-pegged, however, to avoid having its currency become overvalued and stifle its export sector.

By contrast, Mexico has a completely free-floating currency with no trade restrictions. So how does Mexico avoid becoming uncompetitive (a la the Asian Tigers in the late 1990s)? I think the key factor is in interest rates; namely, Mexico has had ludicrously high interest rates compared to the level of actual financial risk. Here's a long-term chart of Mexican 10-year government bond yields:

These are wild yields compared to the low level of actual inflation in Mexico over that stretch.

As investors come to appreciate Mexico's growing manufacturing base and political/economic stability, I expect a great deal of money to flow into its fixed income (and also equities!) which will bring yields down to more reasonable levels. Right now, due to the underdevelopment of Mexican financial markets, we're seeing the rush of new foreign direct investment into Mexico post-COVID causing an outsized move in the currency. As Mexico's financial markets deepen, however, it will become capable of absorbing a lot more foreign capital without causing the Peso to rally too sharply.

A final comment: Is a strong Peso going to crush tourism? Keep in mind there are two types of Mexican tourism.

Beach resort tourism (Cabos, Puerto Vallarta, Cancun, etc.) is already quite dollar-based in pricing. Stuff at beach locales usually costs about 50% more than in Mexico City or other interior cities, and prices have long been based on what owners thought dollar spenders would bear based on prices at similar resorts around the world. So a rise in the Peso doesn't matter too much, as hotel/restaurant/club/etc. owners were already pricing off international trends.

Interior tourism (Going to big non-ocean Mexican cities like Guadalajara, Mexico City, Monterrey, etc.) will be slightly more impacted by a sharply rising Peso. Generally speaking, the people that travel to a place like Mexico City are more budget-conscious than the folks that simply choose the closest international beach resort from their local airport. Someone planning a trip to visit Oaxaca food culture or the tequila culture in Guadalajara is more likely to go to a similar cultural experience in Peru or Costa Rica or whatnot if Mexico gets too expensive, whereas the beach resorts are much less price-sensitive.

All this to say that a rising Peso isn't going to cause a collapse in business at Sureste's Cancun resorts nor Pacifico's beach resorts on the West Coast. Mexican airport investors were consistently surprised at how little tourism traffic went up when the Peso devalued following Trump's election, and there will be similarly low elasticity as the Peso rallies now. And, for the interior airports, foreign tourism is generally not a major piece of the puzzle, so marginal losses there aren't a big concern.

Mexican manufacturing faces risks if the Peso rises too far, too fast. That said, it's the only real alternative for most goods located in the Americas (since no other country besides high-cost Canada has direct highway and rail access to the United States.) I believe the move out of Chinese manufacturing is a long-term inexorable trend (and as much driven by its dismal demographics as geopolitics) and that Mexico has a lot of wiggle room on competitive pricing given its profound geographic, cultural, and demographic ties to the United States.

If the Mexican Peso rallies 50% from here, that'd be a fiasco for the Mexican manufacturing thesis. But another 10% from here? Wages at a Monterrey car factory go from $4 to $4.40 per hour -- that's not going to upset the apple cart. In other words, keep an eye on the exchange rate, but we're far from a point where Mexico's GDP growth will strain itself due to an overvalued currency.

Reiterating The Bullish Call on Bioprocessing

I want to reiterate my bullish view on bioprocessing, and as such, recent portfolio additions Danaher (DHR) and Charles River Laboratories (CRL). I laid out my full thoughts on these recently, however, I'm not sure if I fully got across how great the opportunity and mispricing is on these stocks.

For Charles River, for example, my base case is a share price around $450 over the next 2-3 years. That's more than 100% upside from today's price, which amounts to a pretty favorable IRR. And I could easily see right tail upside above that price depending on how quickly sentiment comes back in the biotech arena.

As a reminder, these are two of the great healthcare compounders out there. $10,000 invested at the turn of the century would now be $280,000 in Danaher and Charles River would be $94,000 compared to $45,000 in the S&P 500:

Data by YCharts

And, as the chart shows, that's even after substantial pullbacks in the bioprocessors over the past 18 months.

It's rare to find cases of such incredible and reliable earnings growth married to fantastic secular tailwinds that are selling at such attractive and obvious entry points.

Both stocks have gotten punished over the past 18 months as industry spending around COVID-19 vaccines, testing, etc. has faded away. However, this was obviously going to happen - no one should be surprised that COVID-19 revenues didn't keep growing indefinitely. Anyone with a time horizon longer than a couple of quarters can see around the corner; those of us that don't have to play the quarterly earnings game get to take advantage of time arbitrage compared to the hedge funds that simply can't own a stock that is temporarily missing earnings, even if it is for purely exogenous reasons that will soon reverse themselves.

Usually when shooting for IRRs well above the usual "safe compounder" range, you have to take on more risk in terms of starting valuation, leverage, or management quality. In this case, however, something like Charles River is starting off at a sub-P/E multiple below 20 (compared to its usual mid-30s average). And if growth is only 10% a year instead of 15% because biotech R&D spending remains in a slump for many years to come -- well -- you're still going to do well buying a high-moat tax on the biotech industry at 20x earnings even if EPS growth is only 10%/year compounded for this decade. The base case on Charles River is so good that even a reasonable bear case outperforms the market from here.

Charles River and Danaher would be easy buys at these prices even if the S&P were at 3,500 now. Given that we're at a frothy 4,500 on the index, these are truly amazing buying opportunities, offering world-class growth at a bizarrely discounted price on a quality-adjusted basis compared with the market as a whole.

CAAP: Thoughts After Speaking To Investor Relations

This publication has been a long-time bull on Argentine airport operator Corporacion America Airports (CAAP), highlighting shares at $1.92 each in October 2020 as a misunderstood travel play that was likely to survive COVID, roll out its debt maturities, and become a multi-bagger on the other side once travel resumed. I reupped that call last year, saying that at $6, shares were poised to triple again. We hit $12 last week, so another double into the journey, it's worth updating on where things stand heading into the back half of 2023.

This is a particularly good time for an update, as I spoke with the head of CAAP's investor relations team last week. I asked about some common questions and concerns you all have had about the company, along with some things I'd been wondering about.

We'll start with capital allocation, as that has been a top question among you all, and with good reason. The Mexican airport operators are known for large dividend payments, with Pacifico and Centro Norte in particular being known for returning close to 100% of free cash flow as dividends to shareholders. This has led to incredible results; my personal yield on cost from both PAC and OMAB stock is now in the double digits thanks to their rapid growth in FCF and thus dividends.

CAAP, by contrast, does not pay a dividend or repurchase stock. This is due to a fundamental difference in strategy.

CAAP operates more than 50 airports in more than half a dozen countries. It is, in fact, the largest private airport operator in the world by number of properties held. That's in stark contrast to the Mexican airport operators, which have closer to a dozen properties in just a couple of countries, on average. Thus, the Mexican airport operators have fewer choices for internally redeploying capital as they manage a far smaller portfolio.

CAAP was formed from the first Argentina airport leases but over the past twenty years has added on properties in Armenia, Italy, Brazil, and elsewhere. It looks to acquire properties that have not been sufficiently invested in (quite a common problem with government-owned infrastructure) and modernize them which in turn brings more traffic and revenues.

When Mexican airport operators earn more money, their default impulse is to pay a larger dividend. By contrast, when CAAP earns more money, its default tactic is going to be putting more capital into its existing properties or perhaps buying additional airport concessions in a new city or country.

The IR head said as much. A dividend would be a low priority for the company in the intermediate future, as it has more than enough opportunities to deploy capital back into the operating business.

The company has a policy of holding Net Debt/EBITDA at approximately 3x. Currently CAAP is at just 2.1x, meaning it is already well below the target.

I asked if that might trigger a change in capital allocation policy, such as starting a dividend. He said a dividend was unlikely as the company has plenty of attractive reinvestment opportunities in the facilities that it already operates.

Florence (Italy) for example, is one of those. The current set-up in Florence is old and unattractive, which discourages usage there as opposed to other nearby airports. And it is also highly limited, it can only receive flights of three hours or less due to the inadequate infrastructure at the facility.

CAAP will be building new infrastructure that has multiple aims. For one thing, the terminal will be modern and come with attractive dining and shopping options, greatly increasing revenue per passenger that uses the facility. For another thing, the new airport will be able to receive long-distance flights, meaning that Florence can be a truly international airport going forward rather than merely being served by airlines in and immediately adjacent to Italy.

A key follow-up on this is that CAAP earns guaranteed IRRs on some of its contracts including a juicy 16% in Argentina and a stunning 20% in Armenia. This means that when CAAP deploys fresh capital (such as the gleaming new terminal that just opened in Buenos Aires this year), it gets contractual protection that it will earn 16% on this going forward. If increased passenger traffic alone doesn't get there alone, the company gets other measures (such as boosting the fee per passenger charged in USD) to hit that guaranteed IRR. 

Needless to say, as long as CAAP has a long menu of internal reinvestment options where it can earn IRRs such as 16% or even 20% on its capital, I have no need for them to pay me a large dividend. 

And this gets to the next related point.

As I did with my interview with Pacifico Airport's CFO, I asked CAAP's IR head what the English-speaking world should know about the company. 

He said that he feels the market shouldn't treat CAAP as an Argentine company. The firm is down to generating just 50% of its revenues and EBITDA from Argentina. Further to that point, of the 50%, 85% of that comes from dollar-based rather than Argentine Peso revenues. Additionally, in more than twenty years in Argentina, operating under various presidents and regulatory regimes, CAAP has not had significant problems operating its business; in other words, the Argentina discount here should be modest since its Argentine airports earn in dollars and get wide berth from politicians.

And on the other non-Argentine 50%, that's where the company's extensive growth strategy bears fruit. CAAP as a whole is trading at less than 6x EV/EBITDA which is a silly multiple considering that the Mexican airports are in the low teens, and that emerging market airports such as Thailand's group traded above 20x prior to COVID. Developed market airports, needless to say, also usually trade for and see M&A occur at or above 20x.

As CAAP derives a larger chunk of its revenues from more reputable markets such as Italy, the overall valuation on CAAP stock should move higher. In an absolute worst case scenario where CAAP's Argentine revenues (and associated subsidiary-held debts) were written off entirely, the stock would still be selling at a lower multiple than the Mexican airport operators to say nothing of the developed market ones.

Given the leverage at CAAP and low overall share count, adding just a couple turns of EBITDA leads to jaw-dropping returns. CAAP has 160 million shares of stock outstanding and is set to generate something along the lines of $625 million of EBITDA next year. An additional 1x EV/EBITDA turn adds nearly $4/share to CAAP's stock price. Taking the EV/EBITDA multiple up to 10 -- still a discount to the Mexican operators -- gets us a share price near $30 compared to today's $12 quotation.

For one recent example, the Sydney Airport group sold for A$32 billion ($21.4 billion) of enterprise value for a company that generated A$1.3 billion ($900 million) of EBITDA in 2019.

At its current growth rate, CAAP should be producing $900 million of annual EBITDA in around 2026-27. It currently has an enterprise value of less than $3 billion. The company currently handles approximately as much traffic as Los Angeles International on an annual basis and yet sells for half the enterprise value of humble Centro Norte Airports, which has Monterrey (Mexico) and nothing much else of note in its portfolio. You know I love Monterrey, but it's hard for me to argue with a straight face that OMAB should have twice the enterprise value of CAAP, an airport group which controls all of Argentina's significant airports, two major Italian properties, the capital city airports of Brazil, Uruguay, Armenia, and more.

People might complain about the lack of a dividend, but the value will (and indeed is) taking care of itself thanks to CAAP's large and rapidly growing EBITDA. If the stock price doesn't ultimately get to a more generous level, I wouldn't be at all surprised to see private equity come in and make an offer; you just don't see large world-class infrastructure asset packages with double-digit growth going for sub-6x EBITDA very often.

Finally, I should comment on the upcoming Argentine elections. CAAP's IR person urged caution; in his view, it's not a done deal that conservatives will win the election this fall and that even if they do, it would only modestly improve CAAP's financial outlook in the intermediate-term. I agree on both points; as for the election specifically, I'd put the odds at either the conservative or libertarian candidate winning at approximately 75% and the ruling socialists at 25%. That's a clear favorite, but not exactly a lock either. 

All that said, I still believe that CAAP stock will rise significantly if and when conservatives win the election this fall. As much as the IR head would prefer that the market view CAAP as an international business and not merely an Argentine one, I think Argentine equities will trade up fairly similarly in the immediate reaction to positive macroeconomic news without too much distinction between individual companies. I'll pull this chart of various U.S.-listed Argentine companies out again:

Data by YCharts

While there have been modest differences in the performance of some of these individual companies, just buying a basket would also have delivered rather satisfactory results. There's clearly a rising tide in Argentina that is lifting all boats. If you zoom in on the squiggles, CAAP has had arguably the lowest correlation to the Argentina basket of the bunch, but we're still talking about a fairly close trading pattern.

To sum everything up, I see CAAP being in the sweet spot going forward. The firm has moved sharply into GAAP profitability over the past year and is now going for a single-digit forward P/E, which attracts the value crowd. The appeal to growth investors is obvious with the firm likely to post at least high teens top- and bottom- line growth for the next couple of years. And the macro/event crowd can get excited about the Argentina election catalyst.

While the lack of a dividend may irritate some folks, there is also a sizable portion of the investment community that loves firms with high returns on invested capital. It's not too common that you can buy into companies that are deploying large sums of capital at 16%+ guaranteed IRRs for less than 6x starting EBITDA. The bull case practically pitches itself to fund managers once they see the high guaranteed returns, the long docket of expansion projects that are in the queue, and the defensive infrastructure assets that underpin the balance sheet.

Aggressive Portfolio Half-Year Results

The Ian's Insider Corner aggressive portfolio gained 8% for the month of June and is now up 17% year-to-date through the beginning of July. These are satisfactory results.

As always, my vision is centered around delivering alpha in down markets, such as 2022, when the portfolio was up 14% versus an 18% decline in the S&P 500. As long as the portfolio generally keeps up with the indexes in big up years, I'm happy. To that point, the portfolio was up 43% in 2020, and up 43% again in 2021.

Overall, a $10,000 investment in the Ian's Insider Corner aggressive portfolio at inception (January 2020) would now be worth $27,416 as opposed to $14,560 in the S&P 500.

As for where things stand now, the portfolio is a third in cash and will be more than a third in cash after next week when the Royal Caribbean high-yield bonds are sold. As a reminder, those bonds just hit the one-year hold mark and can be sold for long-term rather than short-term capital gains treatment. As previously discussed, I see little reason to hold for the mere 7.5% yield to maturity from this point, so it's time to sell those and lock in the 40% 1-year gain.

That said, this will cause the portfolio's cash position to grow even more. There may seem to be some temptation to put cash into something just to have it working. However, I'm not going to do that. I have a high threshold for deploying money in the aggressive portfolio, and I'm content to wait for fat swings.

The lithium trade, for example, has already contributed more than 300 basis points to 2023's results thanks to the combination of the Digest's immediate and correct analysis of Chilean politics (the foreign press' panicky nationalization talk was utterly ill-informed) along with the improving macro sentiment around electric vehicles and green energy. 

The focus here will always be on being ready to take immediate action when fat pitches present themselves rather than making marginal new trades just for the sake of "staying busy." Sometimes that means we make three or four new buys in a week when the market is panicking, other times that means sitting on our hands and letting the portfolio work for a month or two without a single trade. I'm happy with both; right now, the market and our holdings are solidly trending higher and I'm happy to sit back and watch that unfold.

What moved the needle in Q2? The lithium trades, as noted, were a key winner. The Albemarle (ALB) short put in particular has already dropped from $16 to less than $4, giving us the majority of our total exposure as profit. I'm likely to close this out prior to expiry as most of the potential gain can already be harvested far before expiry. That said, I'll let it keep riding for now as the combination of favorable price momentum and time decay is an option seller's best friend.

The New York Community Bancorp (NYCB) LEAP call option position is now a quadruple on our entry point from March. It was very kind of the FDIC to give us the assist there by allowing NYCB to buy the failed Signature Bank assets at a massive discount. Combine good external news with the fact that regional banks were brutally oversold at the time and this has worked beautifully. I'd be fine selling here, but the portfolio has enough cash and I think NYCB is worth closer to $15 so I'll hold for now. 

Meanwhile, Bladex (BLX), the LatAm trade bank, totally ignored the broader banking industry scare and has now sailed on to fresh 52-week highs:

There's a case for selling here because the stock has run so far, so fast. On the other hand, Bladex has doubled revenues and net interest income over the past year too. Is the stock going up 66% over the same time period so wild in light of that? Not especially. Shares are still only going for 6.5x earnings and earnings are growing at a double-digit clip. I'm happy to keep holding; good things happen to good companies that are currently in a rapidly-expanding part of their business cycle.

Barclay's also just launched coverage on Bladex with an Outperform/$32 target noting that:

"Small, off most radars, and oft-misunderstood, we believe Bladex offers a compelling risk-reward profile, providing exposure to LatAm’s growing foreign trade through a conservative, high-quality banking practice. We see its discount to book as unwarranted, particularly as the bank moves forward with its 2026 strategic plan."

Finally, I'd highlight that the Corporacion America Airports position passed the 500% gain on our cost basis mark last week. Don't be afraid to let your winners run -- that's the takeaway there. A 10-bagger is a stock that doubled, doubled again, and then went up another 150% after all; if the thesis is working, there's money to be made holding on tight.

On CAAP, see the section above, I believe we should be trading above $16 (i.e. above the pre-pandemic IPO price) after the elections this fall as the company is already earning more now than it was at IPO time and the only obstacle left at this point to new all-time highs is the bad governance in Argentina which should be resolved later this year.