Mexico - Wiring-up retail investors

Mexican trading: 60% is done offshore

By the end of 2000 banks offering on-line services are expected to double in number and bourse authorities estimate some 10% to 15% of orders will be made through the internet. "This will open the possibility for a greater number of Mexicans to participate in the stock market directly and will radically change the structure of the Mexican market," says Alvaro Mancera, general director adjunct of the Mexican Stock Exchange.

The banks, which own most brokerages, are making a play for the country's vastly underexploited and largely ignored domestic investor market. By dropping commissions and lowering minimum investments to $3,000 in the case of AcciTrade, the on-line trading service launched by Banamex, Mexico's largest bank, intermediaries are looking to boost the exchange's meagre client base of 131,000 accounts, some 0.4 per cent of the population.

The latest gambit by the industry to increase slender volumes and low liquidity is a tall order for a sector that has yet to bounce back fully from a devastating crash in 1987. At the time, client accounts numbered 430,000 - triple current levels - when the main IPC index plummeted 74% in 28 days - a world record.

The boom and bust cycle was repeated again in 1994 with the peso currency devaluation and to a lesser extent in 1997 when a financial crisis in Asian markets spread to emerging markets worldwide. As of February 2000 the bourse's market capitalization of $180 billion was, in dollar terms, still 13% off its $222 billion peak exactly six years earlier and trading volume was down 50% on the same period.

"The full memory of the [1987] crash still hasn't dissipated in terms of the average Mexican investor," says Timothy Heyman, former head of ING Barings in Mexico and author of the book Mexico for the global investor.

Yet the exchange has also been one of the world's most profitable, with an average annual compound growth of 16.5% between 1950 and 1998 compared with 10.7% for the Dow Jones during the same period. Last year Mexico quickly bounced back from devaluation in Brazil to grow 85% in dollar terms and break the psychological ceiling of 7000 on the index for the first time.

The euphoria has continued. The market is up 30% since January, buoyed by robust economic growth and an announcement by rating agency Moody's Investors Service that it may promote Mexico to investment grade.

"We're very excited about this year," said Alvaro García Pimentel, director of exchange operations for Merrill Lynch in Mexico. "We've lived through three crashes and now it's time for the market to reap the benefits."

García predicts the index will reach 8500 this year, but much of the gain will go to foreign institutional investors. Market observers estimate that some 75% of trading on the exchange is done by foreigners despite the fact that dedicated funds to the region are down 69 per cent from 1997.

"Foreign inflows are what rules," says Carlos Peyrelongue, manager of variable income funds for Santander Investment Mexico. "One of the most important variables is not the operating results of a company but whether international funds are entering or leaving Mexico."

Mexico is also distinctive in that more than 60% of trading is performed offshore. The country boasts the largest number of American depositary receipt listings of any emerging market and Mexican telecoms provider Telmex was the first important emerging-market issuer to list ADRs on the New York Stock Exchange.

The listings have provided an important source of financing for many Mexican companies as well as arbitrage opportunities for investors. At the same time however, they pose a serious challenge to the domestic exchange in its struggle to attract new business. "The way things are going the equity market will cease to exist in this country," says Rubén Shiffman, former regulator at the National Banking & Securities Commission and head of derivatives trading for Mexico's Inverlat bank. "It's already emigrated."

Shiffman points to a number of shortcomings at the exchange compared with the more developed US market. Share purchases on the local market can't be leveraged as can ADRs and a heavy trading concentration in a handful of shares and low volumes (equity represents only 2.8% of exchange trading) makes prices highly volatile. Inexperienced and easily manipulated authorities, Shiffman adds, are slow to implement new regulations, which, in turn, are not readily enforceable.

"These are not international standards," says Shiffman. "Trading is not attractive or efficient, regulations and technology are still behind the US and there's more cheating going on. For sophisticated investors there is a lack of transparency."

Exchange authorities are not ready to surrender, however, and in a bid to compete have embarked on measures to streamline operations, introduce new technology and new products and make trading more transparent. In recent years the exchange has added a second-tier market for medium-size company listings, launched a derivatives market called MexDer, and unsuccessfully dabbled in cross-listing Argentine companies.

Perhaps the most radical change came in mid-January 1999 when the trading floor was closed and the exchange went fully electronic. Although some traders found the adjustment difficult, the move has paid off spectacularly. Spreads have narrowed by 54% and the number of trades has risen by 375%.

"We thought we would lose the feeling of the market but it's the same feeling, there's more information and decisions are made faster," says García. Daily trades at Merrill Lynch, he says, have jumped from an average of 450 to 900 with a third fewer traders.

Trading has also become more transparent, say the authorities, since trades are now executed almost instantaneously and all orders are channelled through a central book. Before the introduction of electronic trading many floor traders operated more like mob bosses - if a junior trader beat a senior trader to a lucrative sale, the losing trader would send five colleagues to rough him up, recalls a mutual fund operator.

Securities commission authorities are now contemplating sanctions against trading abuses, adding to a host of regulatory changes in recent months designed to increase transparency and add fluidity to trading. Together with the introduction of e-trading, new procedures for executing ordinary and extraordinary orders will look to avoid abuses, allow more orders to flow and ensure that smaller, retail players are not discriminated against in favour of the large institutional orders that represent the bulk of trading.

Similarly, changes are under way to make the positions of the brokerages more flexible in the absence of market specialists or market makers. Restrictions placed on brokers trading after the IPC index drops more than 3% will be eliminated and the time which brokerages have to buy or sell their own positions will be reduced. When not buying or selling directly, brokerages will have one hour, compared with the previous eight days, to reveal an auction position to the market.

Brokers will also be able to trade directly an expanded range of stock. Where before they were limited for reasons of liquidity to directly buying and selling approximately 35 of the exchange's 144 listed companies, brokers will shortly be able to trade an additional 35 stocks deemed to be of medium liquidity. In addition, the minimum share lot will be reduced from 1,000 shares to 100.

"This represents a fundamental change in the market," says Efrén del Rosal Calzada, general director of the Mexican Association of Exchange Intermediaries. "These new norms are looking to give the Mexican market the modernizing jump it needs as an emerging country to satisfy client needs."

Reforms have also sought to increase the number of brokers. Under the leadership of Manuel Robleda, stock exchange president since 1992, the price of a seat on the bourse has dropped from $10 million to less than $1 million in a bid to attract new players to the marketplace.

To cut costs, the board factored out the value of the 18-storey headquarters from the shareholder cost. The building, renowned in Mexico City for its unique mirrored dome, is up for sale just 10 years after the bourse moved its operations there. Staff has also been reduced from 600 to 300 despite the addition of new business ventures, contributing to a 70% decline in operating costs for intermediaries since 1993, says the Mexican Stock Exchange's Mancera.

As an added incentive the board has paid out $86 million in dividends over the last five years despite a 29% decline in earnings since 1992. Net profits have remained flat.

Despite these efforts few new brokerages are taking the bait. Market observers point to prohibitive regulations that make establishing operations in Mexico not only costly but complicated. Newcomers like Patagon.com, an on-line trader with operations in Brazil and Argentina, have been unable to launch operations in Mexico, Latin America's second-largest market, because of rules forcing brokers to establish a local subsidiary in Mexico. Capital requirements for the operations are also high at $2.4 million and wholesale brokers don't exist, only full-service broker-dealers.

Although some say the restrictive regulations are a reaction to the overly flexible rules that contributed to the 1994 crash, critics argue that the restrictions are a front for banks and brokerages loath to cede control of their otherwise cozy market positions. In the first six months of 1999 the system's two dozen brokers registered $96 million in profits.

"The worst thing the board [of the exchange] has done is to keep the stock market isolated," says Shiffman. "They don't want to lose control and the moment they open it up to foreigners everything is going to change."

At the same time, the local banks have done little to promote stock market investment, preferring to concentrate their efforts on staying afloat. Still reeling from a banking crisis triggered by the peso devaluation, the banks have little incentive to encourage the once-budding mutual fund industry. The industry is valued at $2.4 billion, half of which is managed by one broker, Inbursa - the bank owned by Carlos Slim, owner of Telmex and Latin America's richest man.

Santander Mexicano was forced to close its Emerging Mexico Fund, a New York-listed closed ended fund, last July, and though it manages $2.5 billion in variable and fixed-income funds through its private banking arm, the bank administers just $140,000 through its retail operations. The interest rate spreads for the banks, which are forced to meet daily balance sheet requirements, are too low, says Pablo Mancera, executive director of Santander Investment.

"We are ready for the clients who ask about the product but it is not being promoted because as long as banks, for structural reasons, have almost daily income obligations, it will be very difficult to distribute retail funds," he says. And though independent mutual fund operators such as Prudential and Fidelity have appeared on the scene in recent years, brand recognition is low and volumes remain thin. The obstacles, however, have not stopped supporters from touting mutual funds as a prime motivator for renewed interest in the market.

"The Mexican industry is very underexploited," adds Santander's Mancera. "There is enormous potential and with the success mutual funds have had in the US and Europe, the industry in Mexico is positioned to be the greatest growth sector for the next 10 years in terms of financial instruments."

Crucial to unleashing the floodgates will be Mexico's recently launched private pension fund system. The system already has $14 billion under management but until now has been prohibited from investing in equity markets. Observers predict that new rules allowing pension funds to invest in stocks will be in place by early next year, helping to trigger a savings culture shattered by the banking crisis and adding a depth to the equity market never before experienced in Mexico.

The new investors will find no capital gains tax and a number of financially sturdy firms at almost fire-sale prices. Heyman estimates the price to book value averaged 1.8x to 2x for the major Mexican corporates as of February and 1.4x for medium-size companies.

If Telmex, which represents 20% of market volume, is removed from the list, the average discount in firm value to cashflow (Ebita) is 50%, says Santander's Peyrelongue. Last year the yield on three of Santander's leading funds ranged from 81.11% to 65.37%.

And Mexican stock is expected to get even cheaper if the country is rewarded with an investment-grade rating as most observers predict. The move should bolster appetite for already popular telecommunications, media and internet plays such as Telmex and Televisa, the leading television broadcaster, and raise depressed valuations for well-run but largely ignored Mexican globals such as Cifra, a leading industrial conglomerate and Bimbo, Latin America's largest bread manufacturer.

Nonetheless, the wager is not risk-free. Many domestic investors, wary of successive economic crises during each of the past five presidential successions, are waiting for elections in July to pass peacefully before stocking up on Mexican equity. Foreign investors less attuned to the country's political inner workings have largely shrugged off the threat but remain mindful of external shocks.

Although Mexico is increasingly following the rhythms of the US economy, it still has a long way to go when it comes to investor protection and corporate governance issues. Blatant disregard for minority shareholders among family-run companies frequently make the headlines, most recently with the spectacular bankruptcy of Ahmsa, Mexico's largest steelmaker, and TV Azteca, the number two television network controlled by Mexican businessman Ricardo Salinas Pliego.

There is a new code of corporate ethics released by the National Banking and Securities Commission last June. Critics argue, however, that the securities commission, fearful of antagonizing powerful business leaders or alienating companies looking to list, has not gone far enough. Although companies must, as of 2001, reveal their level of compliance to the code, they are not obliged to adhere to it.

"We can't ignore the Mexican reality," says Salvi Folch, vice-president of stock market supervision for the commission. "The important thing is to put the issue on the table so everyone recognizes its importance and tries to raise the benchmark of public companies." Shrewd investors apply their own version of corporate governance indirectly by placing premiums and discounts on company management

Meanwhile, still on the books are long-promised plans by exchange president Robleda to seek regional and even overseas alliances with other bourses. He has flirted with the idea of cross-listing stocks on other exchanges in Latin America as well as Europe and the US and has often talked of a possible public listing for the bourse modelled on the lines of Milan and Stockholm.

Such a move might entice Mexican companies to list on the exchange. After a record number of listings between 1991 and 1994 during which time Mexico led emerging markets with $16.6 billion in issues, companies have been largely cut off from market financing. In 1998 there were no listings and in 1999 just five public offerings worth $440 million. As a result, market sector financing represents only 33% of corporate funding.

This year market observers, encouraged by Mexico's upbeat economic performance, expect a wave of new public offerings mainly coming from the booming telecommunications sector. If the companies can pull it off, it would put an end to a long drought and could further encourage investors looking for a reason to buy into the market.