SQM - Ditching The Dollar: A Little Bit Of Chile May Go A Long Way

Summary

• Chile is arguably the most resource-rich nation in the world, but its economy carries both currency and sociopolitical risks.
• Green mandates from governments worldwide will sustain the demand for lithium for many years to come. Chile is home to the majority of global reserves.
• The Chile ETF (ECH) is the only US exchange listed way to access broad exposure to the Chilean economy.
• I believe enough risk is priced in to make ECH an appealing speculative play.

Equity markets are expected to be turbulent for 2023, and perhaps beyond. Over the longer term, however, many companies are positioned well to grow profits for decades to come. The US Dollar, as I discussed in a recent Seeking Alpha article, has benefited enormously from over 100 years as the leading world reserve currency. Its leadership role has run its course and is currently being undermined by nations seeking to end dollar dominance. In this article, I will look at Chile, home to a growing middle class and the majority of global lithium deposits, as a candidate for diversification out of the USD spectrum.

Fund managers and Wall Street analysts have largely gone underweight US equities in favor of Europe. European equities garner lower valuations than United States counterparts, as they should given sociodemographic challenges and the threat of World War 3 on their doorstep. Countries traditionally thought of as emerging have emerged as beyond ancillary, but rather primary growth drivers of the global economy going forward. By 2030, China’s economy is expected to become the world’s largest and India’s, currently sixth, third largest.

China buys the majority of lithium on the market and India imports its growing demand. Before sifting through hundreds of NYSE and NASDAQ listed companies from behemoths China, India and Brazil, I wanted to decide if other countries deserve weighting in my portfolio. Chile seemed like the place to start, given worldwide green energy mandates and the booming electric vehicle industry.

As I compile a buy list, objective number one is to determine which stocks are attractive, regardless of valuation. Objective number two is to establish target prices to add shares. Equities in emerging markets are much more volatile than developed market counterparts. Establishing a comprehensive list of conservative entry point targets allows investors to diversify and objectify investing decisions, removing potential for emotional or reactive mistakes.

For example, an investor allocates 50% of their stock portfolio to diversify outside the USD and EUR spectrum. The other 50% remains in, let’s say, 10 large cap companies headquartered in the USA. Those 10 positions, each accounting for 5% of the investor’s stock portfolio, were each established via 4 quarter position buys. This quarter-position-per-buy strategy is recommended by a diverse spectrum of money managers, including Jim Cramer. It’s not technically difficult to implement, but does require discipline.

Particularly when it comes to emerging market equities, stock prices can go from “unbelievably” low to “impossibly” much lower. Piling into shares of a company trading with a 10% dividend yield and P/E of 5x can be appealing, especially upon first discovery of deep discounts that apply to less traveled corners of the globe, but cheap often gets cheaper and emerging markets tend to offer less linear earnings and yields than the dividend aristocrats most investors are familiar with.

Unlike said aristocrats, most of the stocks I’ll write about in this series trade well below all time highs. The run up to 2008 saw unprecedented speculation into emerging markets, with the Brazil ETF EWZ leading the way. EWZ went from $6 per share in late 2002 to $100 per share in mid 2008. Shares bottomed in 2009 almost exactly where they trade in early 2023, $29 per share.

Widespread corruption in Brazil came to a head with protests in 2013, and since then investors have been leery of parking any portion of their portfolios in South America. Similarly, South American stock prices never recovered from the COVID induced sell off that rattled markets in early 2020. Investors are often served well to look at areas of the global equity market that others aren’t. However, getting in early often means getting into a vehicle without positive momentum and warrants both patience and caution.

Whereas our investor in the example above made individual purchases of 1.25% in developed markets with a maximum allocation of 5% total per stock, emerging market volatility deems 0.5% a better transaction value with 1.5% our maximum allocation for equities we consider relatively riskier and 2.5% our absolute maximum for any emerging market stock. For clarity, in this series I will refer to stocks I consider worthy of a 1.5% allocation as “tier 2” and those worthy of a 2.5% allocation “tier 1.” If ideal allocation is 10 strong companies at 5% each in developed markets, it becomes 25 strong companies at 2% on average for an emerging market portfolio.

Alternatively, country specific emerging market ETFs such as China ( MCHI ), India ( INDA ) and Brazil ( EWZ ) are great ways to play the same structural shift. I prefer individual stocks to ETFs, both in order to avoid management fees and for the potential to outperform. But when it comes to Chile, not enough companies are listed on US exchanges for most investors to really gain broad exposure to the country’s economy.

No industries come to mind that today see a greater allocation of innovation and capital than artificial intelligence and electric vehicles. Investors may not agree on how they see anything Elon Musk does, or the quality of cars Tesla ( TSLA ) or its competitors make, but they have been paid handsomely to own shares of the world’s most profitable lithium miner, Sociedad Quimica y Minera de Chile ( SQM ). SQM doesn’t pick favorites in the electric car race, it smiles and collects equally from all participants. Operating exclusively in Chile,, shares of SQM first traded above $10 per share in 2005 and haven’t dipped back below since.

SQM peaked just over $115 per share in 2022 and the Company has paid dividends multiple times annually since 2008. Albemarle ( ALB ) is the global behemoth in lithium mining and only other major player in Chile. It boasts global mining, refining and sales channels. With China accounting for over 50% of global lithium demand, ALB is insulated from USD dependence despite being headquartered in Charlotte, North Carolina. In the short term, demand constraints have caused lithium prices to take a hit. ALB and SQM shares are each down approximately 25% from 2022 highs. While tomorrow remains unclear, green mandates from governments worldwide are set to demand more and more lithium for many years to come.

Chile’s natural resources are unmatched, with the country also home to planet earth’s richest copper deposits. Additionally, it is home to a growing and diverse middle class. In 2019, Chileans voted in leftist Boric to replace more business friendly Pinera as head of state. Investors and political scientists alike feared a Marxist takeover, a la Venezuela, but have been pleasantly surprised by what may very well be the early stages of the world’s most democratic nation.

Newly formed political bodies have been working on a new national constitution since 2019. Democracy, particularly its early development within a diverse society, should not be a quick and simple process. Still, socialism and a government takeover of highly profitable mines are legitimate concerns if leftist forces reign supreme in Chile.

It is worth noting that SQM has contractual rights to operate through 2030, whereas ALB owns operating rights through 2045. In the event of a sustained political stalemate, nationalization of SQM but not ALB seems like a real possibility, although a low probability one.

Diversified global operations and industry leadership earn ALB a “tier 1” rating in our emerging market portfolio. With SQM as its top holding, the Chile ETF (ECH) earns “tier 2” classification as a speculative play on Chile emerging as the economic jewel of South America. SQM offers a unique value proposition, but also comes with unique risks that make me more inclined to own ALB and ECH.

There are very few Chilean companies with shares listed on major US exchanges, and most are banks and miners. ECH offers the only US listed broad exposure to Chile’s economy and has historically paid dividends in excess of 4% annually. The ETF’s 26 stock holdings are mostly listed exclusively on the local exchange, including Chile’s largest captor of consumer discretionary spending, Falabella (FALABELLA.SN), as well as a handful of companies in the consumer staples sector. All of the consumer names have market caps above $10B, with attractive valuations based both on earnings and dividend yield. Cencosud S.A. (CENCOSUD.SN), for example, trades with a trailing P/E of 10x and dividend yield of 17%.

Banks and utilities make up almost half of ECH, offering traditional exposure to the country’s overall economic activity. Commercial real estate brokers Cencosud Shopping S.A. (CENCOSHOPP.SN) Plaza S.A. (MALLPLAZA.SN), and Parque Arauco (PARAUCO.SN) are all experiencing strong top and bottom line growth. Rounding out ECH are names in energy, industrials and materials, which collectively trade at a P/E under 5x with dividends over 10%.

Future articles will dig deeper into specific stocks that operate in more traditional sectors, but lithium has joined oil center-stage in the global energy boom and Chile is quite literally “where it’s at.”

ALB closed trading January 13 at $242.23 per share. Given current stock market dynamics and demand concerns for EVs in the near term, my target entry to initiate a position is $225 per share, which only requires a pullback to levels last seen on January 10. From there, my strategy would be to dollar cost average down if shares fell to $200.

Similarly, I’m looking to open a position in ECH at $26 per share. At $24 I’d dollar-cost average down, followed by a broader portfolio reassessment.

If I don’t get the pullback I’m looking for, I’ll probably chase ECH first given the depressed valuation.

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