The Hidden Upside In The Coming Mexican Crisis (HPQ, GE, GSK)

While the peso falls, these stocks should rise on stronger earnings power

If there is one certainty during a Trump presidency it’s that America’s relationship with its southern neighbor will be changing.

President-elect Trump has not only promised to reassess America’s trade agreements, most of all the North American Free Trade Agreement (NAFTA), but to also reinforce the nation’s border with Mexico.

Most investors took these policy commitments as a negative sign for the Mexican economy. Accordingly, the peso has acted as a barometer on Trump’s popularity since the primaries, depreciating against the dollar when he rose in the polls and rising after his stumbles.

Now that Trump is set to change his address to 1600 Pennsylvania Avenue, investors are bracing for the potential of a full-blown crisis as Mexico stands to lose some of the $250+ billion it books as exports to the United States every year.

As usual, the market has failed to see the potential upside in the headline news. Focusing on the bigger picture, investors have missed a trade that could pay off big time over the next several quarters.

Is A Mexican Crisis Imminent?

The Mexican peso plunged 10% in overnight trading on November 8. This represented a huge change for currencies — which rarely move more than a few percent on any given day. The depreciation against the dollar to nearly 21.0 pesos to $1 was the final drop in a roller-coaster that had been whipsawing markets since February.

With the writing on the wall of what a Trump presidency could mean to the Mexican economy, the peso had been at the mercy of Trump’s popularity nearly all year.

Note in the chart below that higher value is a depreciation in the peso versus the dollar.

Trump has promised to renegotiate or withdraw from NAFTA, putting in jeopardy the $259 billion in Mexican exports that benefited from the agreement last year. Trump has also said he would secure the border and deport all the estimated 11 million illegal immigrants in the United States, many of whom send money back to family in Mexico.

Not only has the peso sold off but the iShares MSCI Mexico Capped ETF (EWW) is lower by 19% over the last year, falling 8.5% when trading resumed on the 9th of November.

NAFTA article 2205 does allow any country to withdraw from the agreement six months after written notice. Trump will have no loss of talking points in his negotiations with the Mexican government or other stakeholders. Politifact estimated earlier this year that the United States has lost more than 850,000 manufacturing jobs to Mexico since the 1994 agreement and another study found that 4.5 million manufacturing jobs have gone to other countries as a result of trade agreements.

Manufacturing In Mexico Just Got Cheaper

But the investors are missing two very important points that could mean short-term upside for companies with production in Mexico.

There’s reason to believe that the new administration may not be so quick to follow through on campaign rhetoric. The United States hasn’t withdrawn from a trade agreement since 1866. Starting a trade war with Mexico could also have far-reaching consequences that wouldn’t be popular with consumers. New tariffs on Mexican exports to the United States could cause prices to surge — and the country is America’s second largest market, buying $214 billion in U.S. goods last year.

The plunge in the peso has also made production cheaper for companies with factories in Mexico. The Mexican peso is now trading at the lowest it’s been for more than two decades. Even during the 2009 global financial crisis the peso only reached 14.04 per USD. The peso has lost 23% against the dollar and the euro over the last year.

That makes production in Mexico much cheaper in dollar terms and could boost the bottom line for companies producing goods in the country for sale in the United States.

In particular, let’s look at three that may see the benefits fall to investors…

HP Inc’s (HPQ) plant in Guadalajara assembles computers and designs memory boards. While printing and supplies isn’t the growth market it used to be, the company has the scale to take market share as smaller rivals leave the space. 3D printing and emerging markets represent a growth upside while developed markets provide cash flow.

Shares trade for just 10.1 times trailing earnings and the company generated $3.9 billion in free cash flow last year. The company has nearly a third of its market cap in balance sheet cash and pays a 3.25% dividend yield. The company recently announced a 3-year restructuring plan that will reduce costs and drive cash flow even further.

General Electric Company (GE) employs more than 11,000 people and has 17 plants in Mexico with operations since 1929. Operations in the country are extremely diversified across everything from medical equipment, aviation to information technology and this diversification may protect the company if tariffs are levied on particular segments rather than across all trade.

GE stands to benefit on increased infrastructure spending and fiscal stimulus under the new administration as well. The company has $33 billion in net cash on the balance sheet, over 12% of the market cap, and generated $12.6 billion in free cash flow last year.

GlaxoSmithKline plc (ADR) (GSK) employs 1,700 people at its plant in Mexico which it has operated since 1964. Shares jumped 3.62% on the day after the election on the belief that drugmakers may face less government scrutiny into pricing under the new administration.

Shares trade for just 15.1 times trailing earnings versus a five-year average multiple of 18.1 times. Shares have been under pressure this year after the company’s blockbuster inhaler Advair lost patent protection. The company’s scale helps it continuously introduce new drugs to make up for lost sales to generics and Advair revenue losses may turn out to be smaller than expected if generics find it difficult to replicate the unique delivery method for the inhaler.

It will take the new administration time to form a trade policy and then at least six months to renegotiate or withdraw from NAFTA. Normal tariffs on goods from non-trade agreement countries for some of the biggest import categories like autos and electronic equipment are low anyway, around 2.5%, so there may not be cause for alarm even if tariffs go up. In the meantime, costs are going down for companies with factories south of the border and may bring a surprise upside come first quarter earnings.

Risks To Consider: Headline risks as the new administration talks up its policy goals could dent investor sentiment in countries with Mexican factories even if the fundamentals still point higher.

Action To Take: Position in companies with a large production footprint in Mexico to benefit from falling costs on the peso depreciation.

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Article printed from InvestorPlace Media, https://investorplace.com/2016/11/the-hidden-upside-in-the-coming-mexican-crisis/.

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