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Royce Funds Commentary - Chile: Reaching Potential for Future Possibilities

April 16, 2013 | About:
Holly LaFon

Holly LaFon

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While Chile is often overshadowed by Brazil and currently remains challenged by income inequality, pollution, dependent corporate governance, and copper price swings, Analyst Dilip Badlani believes the underlying economy has the potential to provide us with opportunities that fit our investment criteria.One of my first impressions upon arriving in Santiago, Chile was that the nation's infrastructure is modern and efficient. The road from the airport to the city center is up to developed-world standards, and the metro system is the largest in South America.1

Construction cranes dot the skyline, and the nearly completed Costanera Center, which will be the tallest building in South America, is clearly a source of national pride—highlighted to me by both taxi drivers and businesspeople.

There is a palpable sense of energy in Santiago and, while many other countries are running fiscal deficits, it was refreshing to learn that the Chilean government is required to generate a structural surplus.

The structural surplus rule means that the government considers its long-term sustainable revenues in making decisions on spending and avoids commitments that are based on revenue peaks, such as when the price of copper is high or when the economy overheats.2 On any individual year basis the country may run a deficit, however through a full economic cycle it targets a balanced budget.

Following this requirement has allowed Chile to run a relatively balanced fiscal budget over the last five years despite the impact of the 2008 global recession.

408735424.jpgThe adherence to fiscal discipline enabled Chile to become the first member of the Organisation for Economic Co-Operation (OECD) from South America in 2010. Chile’s GDP per capita of $11,827 is only second behind Uruguay’s in South America;4 from 1997 to 2012, its GDP grew at an average rate of more than 4% a year (1% on a quarter over quarter basis).5

The government's pro-business policies have also led it to be ranked highest in the "Ease of Doing Business" index in South America.6 Despite these positive attributes, Chile often gets overshadowed in the media by the continent’s powerhouse—Brazil—whose population is more than 10x larger than that of Chile (193.9mm7 vs. 16.6mm8) and which is part of the popular acronym BRIC—denoting the major economies in the developing world (Brazil, Russia, India, and China).

Development continues in Santiago, where the financial district has been dubbed "Sanhattan." Here you will find the offices of major multinationals as well as global hotel chains such as the W and the InterContinental.

Santiago is also the industrial center of the country, generating more than 40% of the country’s GDP.9 Vying with the skyscrapers of Sanhattan are the Andes Mountains. While they provided early settlers with a natural defense, they now exacerbate the city’s smog problem: pollution is above the World Health Organization’s recommended levels.10

The Santiago area is home to about 40% of Chile's population. The country has one of the lowest population densities worldwide, ranking 194th,11 and some sparse areas are largely devoted to mining. Chile is the number one source of copper in the world, responsible for producing 35% of the world's supply.

Mining makes up 20% of GDP and represents 60% of the country’s exports;12 copper alone provides one third of the government’s revenue.13 Chile also has the globe's largest proven reserves of lithium, a key material for the battery powered automotive industry.

The majority of its mining activities occur in the northern part of the country in the Norte Grande region that spans the Atacama Desert, far from Santiago. The arid landscape of red desert, salt formations, and lagoons—as well as the solitude—inspires comparisons to the planet Mars (in fact, NASA has done simulations here).

Passenger flights between Santiago and Calama—the regional airport for Atacama—are dominated by men, many of whom serve in the mining industry and commute to and from Calama on a two-week-on/one-week-off basis. Stronger education and health services, as well as entertainment options, are among the reasons workers prefer to keep their families based in Santiago.

The good news for employees of all sectors is that they can rely on a stable savings system. In 1981, Chile implemented a fully funded private pension system based on individual accounts managed by AFPs (Administradoras de Fondos de Pensiones)—or private pension fund managers. This replaced Chile’s pay-as-you-go Social Security system. All new wage and salary workers joining the workforce after 1981 were required to join the AFP system.15

As a result, all employees are required to have 10% of their earnings automatically deducted to fund their retirement. The employee can choose among six pension administrators that have been approved by a government regulator.

The employer is then required to send the contributions to the administrator. Employees are also able to make voluntary contributions to their AFP accounts in excess of the 10% minimum. There is no requirement for employers to make any contribution on behalf of their employees. Driven by strong GDP growth, Chilean AFPs' assets under management reached 77.5 ton pesos (U.S. - $165 billion) as of December 31, 2012, up 7.6% compared to the following year in real terms.16

While the pension system has largely received positive acclaim, one criticism is that only a quarter of self-employed individuals—who constitute close to 30% of the workforce—choose to regularly contribute into the system.17

One of Royce's investments in Chile is the largest pension plan manager in the country. The company has been a beneficiary of the growth in pension plan assets in Chile and has also used its experience there to expand into other countries, such as Peru and Ecuador, which are following Chile’s example of establishing pension plans for employees.

While Chile represents an attractive investment story, for value public market investors there are not many opportunities that currently fit squarely with Royce’s stringent requirements. In our company meetings in Chile, we were disappointed to find that the corporate governance of most of the companies we met lacked the independence that we typically require.

The Boards of the companies were not independent, making it difficult for us to get comfortable as minority investors. Chile ranked 38th in Corporate Governance Rankings conducted by GovernanceMetrics International.18

That being said, Chile has been making significant progress in this area through the adoption of a new law passed in September 2009 to protect minority shareholders.19

Additionally, Chile ranks highly in the Rule of Law Index, ahead of several developed markets.201377115355.jpgAnother challenge for Chile is its vulnerability to swings in world copper prices. In keeping with the government's rule to run a structural surplus over a long term, Chile ran a fiscal deficit in 2009 as the copper market saw a decline in prices due to the global recession of 2008. Recent increases in the price of copper have helped the economy.

Chile also faces a problem of income inequality, as the success of the economy has not trickled down to everyone. In 2011, the Organization for Economic Cooperation and Development (OECD) rated Chile as one of the worst of its 34-member countries in terms of income distribution. Chile's Gini coefficient in 2006, a measure of financial inequality, was 0.50: far higher than the overall average (0.31).

878750630.jpg

As the owners of Chile's private enterprises look to establish succession plans for their companies, they may choose to access the public capital markets as a mechanism for estate planning purposes.

Two thousand thirteen is expected to be a record year for IPOs in Chile, which has only seen a handful of equity listings over the past decade: one IPO in 2008, three in 2009, one in 2010, and four in 2011 and in 2012.23

At Royce & Associates, we will be paying close attention to these listings as well as the overall Chilean market in order to find companies that will fit our investment criteria as we are encouraged by the underlying characteristics of this South American economy.


1Metro de Santiago 2011 Annual Report

2http://www.hacienda.cl/english/frequently-asked-questions/budget/how-is-chile-s-fiscal-budget-prepared.html

3http://www.hacienda.cl/english/investor-relations-office/why-chile/economic-information/fiscal-statistics.html

4http://www.imf.org/external/pubs/ft/weo/2011/02/weodata/weorept.aspx?pr.x=72&pr.y=12&sy=2010&ey=2010&scsm=1&ssd=1&sort=country&ds=.&br=1&c=336%2C213%2C218%2C223%2C228%2C288%2C233%2C293%2C248%2C366%2C298%2C299&s=NGDPDPC&grp=0&a=

5http://www.tradingeconomics.com/chile/gdp-growth

6http://www.doingbusiness.org/rankings

7IBGE. 2011 Population Projection

8Población estimada residente de Chile alcanza los 16.572.475 habitantes" (in Spanish). Instituto Nacional de Estadísticas de Chile. Retrieved 16 September 2012

9Central Bank of Chile (Chile's 2011 Regional GDP in 2008 prices [chain-weighted])

10http://www.santiagotimes.cl/chile/health-and-environment/25809-air-pollution-in-santiago-decreases-but-is-still-above-who-limits

11http://www.censo.cl/2012/08/resultados_preliminares_censo_2012.pdf

12http://export.gov/chile/doingbusinessinchile/eg_cl_052197.asp

13http://www.indexmundi.com/chile/economy_profile.html

14
http://www.businesschile.cl/en/news/special-report/decentralizing-chile

15
http://www.brookings.edu/~/media/research/files/papers/2010/1/07%20retirement%20savings%20john/07_retirement_savings_john.pdf

16
http://www.bnamericas.com/news/insurance/private-pension-fund-assets-grow-76-in-2012[/url]17[url=http://www.brookings.edu/%7E/media/research/files/papers/2010/1/07%20retirement%20savings%20john/07_retirement_savings_john.pdf]http://www.brookings.edu/~/media/research/files/papers/2010/1/07%20retirement%20savings%20john/07_retirement_savings_john.pdf[/url]18[url=http://www.gmiratings.com/Images/GMI_Country_Rankings_as_of_10_27_2010.pdf]http://www.gmiratings.com/Images/GMI_Country_Rankings_as_of_10_27_2010.pdf[/url]19[url=http://www.oecd.org/corporate/ca/corporategovernanceprinciples/47073155.pdf]http://www.oecd.org/corporate/ca/corporategovernanceprinciples/47073155.pdf[/url]20Center for Financial Stability,[url=http://www.centerforfinancialstability.org/rli.php]http://www.centerforfinancialstability.org/rli.php

21
http://infosurhoy.com/cocoon/saii/xhtml/en_GB/features/saii/features/economy/2011/04/26/feature-02

22
http://www.oecd-ilibrary.org/sites/soc_glance-2011-en/06/01/index.html?content&itemId=/content/chapter/soc_glance-2011-16-en&containerItemId=/content/serial/19991290&accessItemIds=/content/book/soc_glance-2011-en&mime/html

23http://online.wsj.com/article/BT-CO-20130308-710028.html

Important Disclosure Information

The thoughts expressed in this piece are solely those of Dilip Badlani and may differ from those of other Royce investment professionals or the firm as a whole. Mr. Badlani's thoughts and opinions are given rendered as of the date of each posting and may change without notice. This piece is not intended to be investment advice or a recommendation to invest in any securities, region, or country. There can be no assurance with regard to future market movements. Data from third party sources used in the preparation of this piece may not have been independently verified by Royce, and Royce does not guarantee its accuracy. The historical performance data and trends outlined are presented for illustrative purposes only and are not necessarily indicative of future market movements

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