Heading South for Higher Yields

Until this decade, investing in Latin America was similar to a canoe trip on the Amazon River: a potentially rewarding journey -- but watch out for piranhas. A country's stock market reflects its economy, and most Latin American economies were characterized by instability, unpredictability, and wild boom-and-bust cycles.

But since the turn of this century, we've witnessed a sea change in Latin America. Thanks to the confluence of several positive factors the region's largest economies have become paradigms of stable, strong economic growth -- and its stock markets have surged as a result.

Three factors, above all, have contributed to the change: stable, economically rational governments; increased exports thanks to globalization and trade liberalization; and rising commodity prices. And because of this, Latin America has attracted plenty of investment capital and delivered great returns for investors in this decade.

Compare this decade's total return of the S&P 500, the commonly used proxy for the largest U.S. stocks, to those of the major stock market indices in each of the four largest countries in Latin America:

It's important to note that stock prices in the region have risen not only because of economic growth, but because investors have also grown more comfortable investing in the region. Latin America always had its share of well-managed companies with attractive businesses, but their share prices had to be discounted to account for the implied political and currency risk and the associated volatility. Now, these concerns have lessened, allowing foreign investors a chance to invest in one of the most attractive regions in the world without the dramatic risk it once carried.

The good news for income investors today is that even with the run-up in Latin American markets, discounts still remain on certain stocks, and investing in the region's high-yielding stocks offers a further buffer against any risks.

(1.)  The Currency Boost

In addition to strong economic growth, Latin American stocks have and will continue to benefit from another trend: the falling U.S. dollar. When the dollar falls versus another currency, it's good news for U.S. investors holding securities denominated in that foreign currency. When it comes time to sell and convert the proceeds back into U.S. dollars, the total return from the entire transaction will be boosted by the gain the foreign currency enjoyed versus the U.S. dollar -- meaning higher returns, even if the share price didn't move a cent. And the same goes with dividends denominated in a foreign currency -- even if they don't go up at all, a falling dollar means they are worth more when converted back to U.S. currency.

As one example of the currency trend, witness the performance of the U.S. dollar versus the Brazilian real over the past few years: update



As you can see, the dollar has fallen about -50% against the real since 2003. If you invested your money in 100 shares of a Brazilian stock trading at 50 reals in 2003, it was worth about $1,400 in U.S. dollars. Now say that same stock still trades at 50 reals -- thanks to the falling dollar, it would now be worth more than $2,800 when converted back to U.S. dollars -- a gain of over +100% without any appreciation in share price. The story is the same with any dividends paid by the company. Obviously then, the weakening dollar can boost a U.S. investor's income stream assuming they are investing internationally.

While we don't think the U.S. dollar will continue to fall as sharply against the real or other Latin American currencies, we predict the downward trend will still continue, for two main reasons.

First, the U.S. continues to run huge trade deficits -- we are importing more than we are exporting, sending a lot more dollars out of the country than are coming back in. While other countries send dollars back to us by investing heavily in U.S. financial assets, such as Treasury bonds, that isn't enough to prop up the dollar's value. And it's likely that some of the largest purchasers of Treasury securities, notably China, will spread their bets around more in the future -- for example, by investing in Europe. This will only further weaken demand for the dollar.

Second, looking at a shorter-term trend, the slowing U.S. economy has caused the Federal Reserve to lower short-term interest rates, which eventually brings longer-term bond yields down. At the same time, U.S. corporate earnings are expected to slow in the coming quarters. This makes foreign bond yields and corporate earnings look more attractive. What does this mean for the dollar? Investors around the world are likely to shun the lower return U.S. market in favor of more attractive regions -- leading to lower demand for U.S. currency and a lower-valued dollar.

(2.)  Brazil: A Case Study in Latin American Growth

(3.)  Happy Hunting for High Yields

(4.) Telecomunicacoes de Sao Paulo S.A. (NYSE: TSP)

Snapshot:  The name is a mouthful, so it's fortunate this major Brazilian telecom-services provider is usually referred to by its shorter nickname: Telesp. The company is the incumbent telephone company in the state of Sao Paulo, which is the most affluent in Brazil, and includes Brazil's largest city (Sao Paulo). Telesp has about a 90% share of the fixed-line market in Sao Paulo, with about 12 million customers. It also provides Internet service to about 1.6 million customers.

The stock trades on the New York Stock Exchange as an ADR (American Depository Receipt).

Like other fixed-line phone providers around the world, Telesp has been hurt by competition from wireless and Internet telecom services. Nationally, Brazil's number of wireless subscribers has risen about +50% over the past three years, while the number of fixed-line subscribers has fallen -2%.

Competition is growing in Brazil's telecom-services markets. While that is a risk for Telesp, there are opportunities. Although competitors are likely to make inroads in the Sao Paulo area in the coming years, Telesp should be able to establish footholds outside its core territory -- including Rio de Janeiro and Brasilia. By building market share in new regions, Telesp can boost its customer count, cross-sell more services and make up for profitability declines that generally accompany increased competitive pressure.

Dividend:  Telesp's dividend payout has increased steadily over the past several years. The company pays regular dividends twice a year but also makes frequent payments of "interest on capital," according to Brazilian law. Based on 2007 payments, TSP yields an enticing 8.0%.

Shareholders owning Telesp's ADR shares, which trade on the New York Stock Exchange, receive dividends in U.S. dollars. Yet the amount of the payout varies based on currency fluctuations, because the payment is originally established in Brazilian currency. Over the past few years, the Brazilian real has appreciated versus the U.S. dollar -- giving Telesp's dividend a boost for U.S. investors.

Telesp has paid out all of its net profit to shareholders in the form of dividends for the past five years, plus interest on shareholders' equity -- resulting in a payout ratio above 100%. That ratio must logically come down, so the growth rate in the dividend will slow -- but with sales growing +4-5% a year and operating income growing +2-3% a year, the company should be able to at least maintain its dividend going forward, with small increases likely.

Brazil does not impose a withholding tax on dividends paid to U.S. shareholders, but it does withhold 15% of distributions of interest on capital -- which are occasionally made by Telesp. The amount withheld can be recovered by filing a foreign-tax credit on your federal income-tax return.

Performance/Outlook:  International telecom giant Telefonica, which owns about 86% of Telesp, owns separate wireless businesses in Brazil. Therefore, Telesp hasn't expanded into that area, instead focusing on rolling out high-speed-Internet services. That business has grown about +40% annually over the past three years, allowing Telesp's overall revenue and profits to continue to grow, albeit very slowly, despite the continuing erosion of its fixed-line business.

Although Telesp's revenue and earnings are growing only slowly, its cash flows are robust
-- thanks to monthly bill payments by its millions of customers. The company has to spend about 12% of its sales as capital expenditures to maintain and expand its service network and offerings, but there's little risk that it won't make enough cash to continue to meet these needs. Telesp's free cash flow (cash left over after funding the business) amounts to more than 20% of its total revenue.

Telesp has paid out all of its net profit to shareholders in the form of dividends for the past five years, and we think it will be able to continue to pay a strong dividend for several years to come. If the Brazilian real continues to appreciate vs. the U.S. dollar, that will only boost the value of Telesp's payments.

The firm is an excellent way for income investors to play Brazil's growing economy without assuming a lot of risk. In addition to a solid current yield, investors will benefit as the stock's share price rises. We also could see dividend increases over time, and we're likely to see a currency boost given the trends for the U.S. dollar and the Brazilian real.

(5.)  Administradora de Fondos de Pensiones Provida (NYSE: PVD)

Snapshot:  Known as AFP Provida, this company administers pension plans for corporations and other enterprises throughout Latin America. AFP Provida is the largest South American pension-plan administrator by number of affiliates, and the second-largest by assets under management. The company operates in Chile, Mexico, Columbia, Ecuador, Peru and El Salvador -- and even owns a subsidiary in Poland. AFP Provida collects contributions from its clients (known as affiliates), invests them in pension funds, and makes distributions to beneficiaries based on health, disability or retirement eligibility.

About 80% of the company's revenue comes from fees, based on a percentage of the assets -- 0.56% a year, on average, for pension-asset management. Fee-based businesses like pension plan management are relatively stable, with rising revenues over time. Also, this is a high-margin business; AFP Provida's operating-profit margins have averaged around 32% over the past three years. One of the best qualities of asset-management companies is that it's possible to invest a large asset pool with only a fairly small group of portfolio managers and analysts -- meaning as assets grow, margins continue increasing.

Dividend:  AFP Provida pays two dividends a year -- the first, in late April or early May, typically accounts for about two-thirds of the annual dividend; the second, in October, accounts for the other third. Together, these payments give AFP a yield of about 5.5%.

Note that currency changes have greatly benefited the dividends paid to U.S. shareholders. AFP Provida's payout ratio has ranged between 45% and 58% over the past six years. It's currently only 34% -- and the most recent goal set by the company's board of directors was for a payout ratio of 50% -- meaning the dividend will likely rise in 2008.

Chile withholds 17% to 35% of the dividend as a tax, based on whether or not AFP Provida qualifies for a certain type of corporate tax. Most recently, the withholding rate has been 21.7%. The amount of that withholding can be retrieved by filing a foreign-tax credit on your U.S. income-tax return.

Performance/Outlook:  Thanks to strong economic growth in the countries it operates in, AFP Provida's revenue has grown rapidly in recent years -- from $192.5 million in 2004 to $220.6 million in 2005 to $272.4 million in 2006. Meanwhile, earnings per share have increased at a +13% annualized rate for the three years ending 2006.

As long as Latin America's economic boom continues, AFP Provida is likely to continue accumulating assets by attracting more customers and by investing the assets well -- both of which it has shown it can do. Asset growth is crucial to revenue and profit growth, because the company earns fees based on a percentage of assets under management.

The company's management team has done an excellent job investing in future growth, as evidenced by a return on equity of 24%. Academic studies have shown that over time, a shareholder's return is similar to a company's return on equity -- indicating that in addition to the solid dividend yield, the stock could appreciate +20% or more annually. While we aren't promising that will happen, we do look for further upside in the coming year or two in addition to the hefty dividend -- all thanks to the economic rise in Latin America.

(6.)  Popular (Nasdaq: BPOP)

Snapshot:  Popular Inc. is the holding company for Banco Popular, the dominant bank in Puerto Rico. Its Banco Popular de Puerto Rico unit (BPPR) has a 25% share of the bank-deposit market on the island territory and generates strong profits. As a Puerto Rican bank, Popular does not pay federal tax on U.S. Treasury-security interest, which boosts its profit margins. BPPR's return on assets was 1.4% in 2006, an excellent profitability level for a retail bank.

Popular also has a U.S. banking unit, Banco Popular North America (BPNA), which bills itself as the largest Hispanic bank in the country. It operates more than 140 branches in New York, California, Illinois, Texas, Florida and New Jersey. In addition to community banking services and mortgage loans, Popular is a major small-business lender.

Popular has grown robustly thanks to deposit growth in both Puerto Rico and the U.S. mainland. From 1998 to 2006, the company's net assets doubled from $23.2 billion to $47.4 billion. Meanwhile, revenues rose from $2.5 billion in 2002 to $3.9 billion in 2006.

The company is strong financially: its so-called "Tier 1" capital ratio -- equity capital divided by risk-weighted assets, the core measure that regulators use to measure a bank's financial strength -- is 10.6%. The level necessary to be deemed "well capitalized" is 6%.

Dividend:  Popular has paid a regular a quarterly dividend of $0.16 per share like clockwork for the past two years. This total yearly payout of $0.64 gives the firm a solid yield of 6.0%.

Popular's payout ratio has risen from 32% in 2005 to around 65% in 2007, due to short-term earnings problems (see below). But given its financial strength, solid Puerto Rican operation and the steps it has taken to deal with losses in its U.S. division, we believe the bank will be able to maintain at least the $0.16 quarterly payout going forward, with the strong likelihood of dividend increases once the current U.S. mortgage crisis eases.

Because it is domiciled in a U.S. territory, Popular is similar to a U.S. company in terms of taxation of dividends -- there is no foreign withholding tax.

Performance/Outlook:  Popular's earnings have taken a hit over the past few quarters due to its exposure to the U.S. mortgage-loan market. In the third quarter of 2007, for example, net income fell sharply due to a loss from the mainland-U.S. BPNA operation. Provisions for loan losses more than doubled in reaction to the subprime-loan meltdown.

Although the news has been poor for Popular, its future looks brighter -- yet the stock has fallen to a point where it more than discounts even the worst-case scenario. Popular exited the wholesale subprime loan market early in 2007, limiting its exposure to further erosion in this area. And the bank seems to be taking a conservative, transparent approach to its loan portfolio to reassure regulators and investors that it isn't hiding a thing. We think that will help the stock rebound earlier than some of its counterparts.

In addition, BPNA should benefit over the long run from the growing population and wealth of the Hispanic community in the U.S. Its branches are located strategically to take advantage of this long-term demographic trend, and the company is starting to look to boost profits by raising fees and expanding services.

The main point to keep in mind is that Popular is much more than just U.S. operations. Its unit in Puerto Rico, from which it derives 75% of its income, is an extremely successful, well-managed and profitable bank, with a dominant market share. Its competitive position has only grown stronger in recent years, as several smaller competitors were caught up in accounting scandals that Popular avoided. The bank's overall net-interest yield is rising, which will boost future profitability.

Popular's troubles are temporary and largely behind it. Looking forward, we see a dominant banking franchise with a high dividend yield -- and an interesting play on the growth of the U.S. Hispanic population.

Investors should keep in mind that its earnings and dividends are accounted for in U.S. dollars. As such, you shouldn't expect any boost from the falling dollar.

Thanks for reading today's special report, Heading South for Higher Yields.

-- Nick Lanyi
Editor
High-Yield International
http://www.streetauthority.com/

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