MXF: Beware The 'Nearshoring' Optimism In Mexican Equities

Mexican equities have rallied in recent months on 'nearshoring' hopes triggered by labor shortages and rising costs in the US, as well as geopolitical tensions with China. If the CHIPS Act is any indication, the supply chain shift is poised to accelerate as US corporates look to capitalize on Mexico's geographic proximity and competitive labor costs (despite a series of minimum wage hikes in recent years). But the 'nearshoring' theme is now a consensus view, and the key to further upside lies in its progress. Here, things get less straightforward – the Mexican labor market is also tight, and wage pressures could emerge, while the 'stickiness' of certain supply chains (e.g., the tech hardware ecosystem in Asia) means a large-scale shift will take time. And with Mexican equity valuations re-rated to a multiple turn premium vs. LatAm on a P/E basis (using respective MSCI indices as proxies), the market is vulnerable to corrections should 'nearshoring' fall short of expectations or if political risk escalates ahead of next year's elections. Even with the Mexico Fund (NYSE:MXF) offering a wider than usual NAV discount, investors may be better off sitting this one out.

Fund Overview – Actively Managed Mexican Investment Vehicle with High Expenses

The actively managed, US-listed Mexico Fund seeks to deliver long-term capital appreciation relative to its benchmark MSCI Mexico Index primarily through investments in securities listed on the Bolsa Mexicana de Valores (i.e., the Mexican Stock Exchange). The fund also has the option to deploy capital in peso-denominated fixed-income securities and time deposits. Per its investment policy, MXF's mandate is to stay >80% invested in equities (except for extraordinary circumstances or temporary defensiveness) but is limited to a <20% allocation to Mexican-listed issuers based outside of the country.

Per the latest factsheet, the fund held $313m of net assets and charged a ~1.4% expense ratio (mainly investment advisory fees). The latter seems pricey relative to the portfolio turnover and composition, suggesting investors may be better off with more cost-effective US-listed ETFs like the iShares MSCI Mexico ETF (EWW) and the Franklin FTSE Mexico ETF (FLMX). A summary of key facts about the fund is listed in the graphic below:

As highlighted by the fund's latest holdings disclosure, MXF is fairly concentrated from a single-stock standpoint. The largest exposure is to telco América Móvil (AMX) at 13.0%, followed by Mexican banking and financial services leader Grupo Financiero Banorte (OTCQX:GBOOF) at 10.1%. Beverage and retail company Fomento Económico Mexicano (FMX) is the only other holding with a >10% allocation. Other notable holdings include Wal-Mart de México, Walmart's Mexican and Central American division (OTCQX:WMMVY), at 8.7% as well as mining, transportation, and infrastructure conglomerate Grupo México (OTCPK:GMBXF) at 7.6%. The top ten holdings accounted for 67.4% of the overall portfolio, closely tracking its benchmark MSCI Mexico Index.

Fund Performance - Modest Outperformance, but the NAV Discount is Wider than Ever

On a YTD basis, the fund has risen by 11.7% in market price terms, trailing comparable Mexico ETFs such as EWW and FLMX (+21%). Over longer timelines, the fund has underwhelmed on a relative basis as well – in market price terms, the fund has annualized at -1.4% over the last decade vs. the MSCI Mexico Index at +0.3%. In NAV terms, however, MXF has compounded slightly above its benchmark at +1.0% annualized, though the persistent NAV discount means investors have still been worse off.

At first glance, distributions seem strong at a total yield of ~4%. But most of last year's distribution came out of realized capital gains, leaving the yield from recurring income closer to ~2%. Thus far, distribution levels in the initial quarters of 2023 indicate modest growth in recurring income distributions, though comparatively lower capital gains (recall MXF has risen strongly post-COVID) could translate into a lower overall yield this year. In the meantime, the fund now trades at a persistently wide high-teens % NAV discount (vs. low to mid-teens % in recent years), reflecting worsening investor sentiment on the fund's prospects. While the buyback authorization should help, its impact is limited to 10% of MXF's outstanding common stock, so there isn't a strong case for the NAV discount to narrow anytime soon.

Sound Economic Fundamentals but Bull Narrative is Well-Understood

Across all fronts, Mexico's economic policy ticks the right boxes. Think prudent fiscal policy and no currency controls, as well as an independent central bank targeting price stability; alongside the long-term potential from the 'nearshoring' of global supply chains, the macro setup is appealing. Thus far, Mexican exports, particularly electronics, have already surpassed pre-COVID levels. Meanwhile, the peso (MXN:USD) has also seen a stronger real effective exchange rate, reflecting a vote of confidence from investors on the structurally sound fundamentals. Also positive is the Banxico's efforts on the monetary policy side, with a steep increase in policy rates (now at 11.25%) keeping inflation under control.

Despite the positives, it's hard to look past the valuation. With 'nearshoring' increasingly becoming a consensus view among investors over the last year, Mexican equities have already seen a steep re-rating vs. the rest of the LatAm region. Yet, progress on 'nearshoring' supply chains into Mexico is not a given, and progress could disappoint. For one, the country lacks the key infrastructure required to facilitate a full supply chain shift from Asia (think roads, electricity, and security), while political risk will also be a hurdle heading into next year's election. Plus, the network effects of the manufacturing ecosystem in the greater China region will take years to replicate in a best-case scenario. Also worth watching will be near-term pressure from a tight labor market (the <3% unemployment rate is well below pre-COVID levels), which could reduce Mexico's wage competitiveness vs other 'nearshoring' beneficiaries. With the MSCI Mexico IMI 25/50 Index at ~11x P/E (multiple turns above the LatAm equivalent index), caution is warranted.

Beware the 'Nearshoring' Optimism

Alongside geopolitical tensions with China, labor shortages and wage pressures in the US have prompted a 'nearshoring' trend, which could benefit emerging low-cost manufacturing hubs like Mexico. Case in point - recent legislation by US policymakers, such as the CHIPS Act, specifically aimed at reducing the region's dependence on China. The issue, however, is that the 'nearshoring' narrative has become a consensus view, with Mexican equities already re-rating over the last year (now at a wide relative valuation premium to the rest of Latin America). Yet, the road ahead is a tricky one, particularly in light of wage pressures from a tight labor market post-COVID, underdeveloped infrastructure, as well as political risks ahead of the upcoming election. While MXF's current high-teens % NAV discount is appealing, it may not be enough to outweigh the optimism embedded in Mexican equities currently; I would remain on the sidelines here.