Alice in Wonderland from Caracas

June 11, 2012

I decided to take a trip to Venezuela in May of 2012 to see whether potential changes in the political situation could create investment opportunities. I had read many articles about Hugo Chavez traveling to Cuba to have multiple “baseball sized” tumors removed from his pelvic area. The stock market looks very cheap at first even though it has doubled in value over the past few years. Financials on Reuters were incorrect so we had to dig up the original PDF annual reports to plug-in the historical data into spreadsheets to look at the changes over time. I couldn’t find any companies earning return on equity above the nation’s 25% inflation, yet they were trading at what appeared to be very low price/earnings multiples, perhaps 1-4x. This quickened my pulse and I dug in more, reading three books on the history and trying to understand the troubles facing the private sector.

The International Money Fund has no program with Venezuela, and the government doesn’t advertise its finances, so I had trouble understanding its economic position. A few facts emerged. First, they have some of the largest oil and gas reserves in the world, and a significant current account surplus. Second, they have had 15%+ inflation and negative real rates most of the past 20 years. The inflation could be a problem, so I looked at the currency. During various periods of history, the Venezuelan government has had different exchange rate regimes. Now, they basically have a two-tier structure: the official rate at 4.3/1 USD, with an “informal” rate around 9.3. I struggled to find an appropriate historical value for the currency and finally came upon a dataset of the informal rate of the currency going back 15 years. This changed the picture. Companies growing sales by 20% a year at the "fixed" artificial rate showed declines using the informal rate. It's hard for any company to have revenues grow faster than 25% inflation.

What do I actually think would be an appropriate target IRR for a stock in Venezuela now? It’s hard to say, but probably over 25% in USD. The government bonds are trading around 9%. In normal circumstances, I may ask for 18% gross return, but the operating environment worries me in a way that is different from our other countries.

The trip presented unusual challenges. I had to pay for the hotel at the official exchange rate, making a $220/night hotel $440. Usually independent brokers set up my meetings when I travel abroad. But almost all of the independent brokers have fled to Panama or Miami after the government charged them for "profiteering" from the differences in official and informal exchange rates. So a consultant—a former banker with very good local relationships—set up the meetings and joined me. She warned me about terrible traffic in Caracas, perpetuated by gasoline prices of $.05 per gallon. I braced myself for the usual two to three meetings per day, sitting in stop dead traffic for hours at a time—basically something akin to my typical journeys to Dhaka, Bangladesh. But I was pleasantly surprised with the efficiency. The traffic is slow, but nothing more than any big city. And we managed to squeeze in five to six meetings a day. My consultant arranged for a Ford Taurus from the early 1990s so we didn't draw too much attention to ourselves.

Though in search for economic opportunities, I was able to check out the local gastronomical options too. One evening I checked out an outdoor café selling beer in what appeared to be 7 oz bottles, an apparent attempt by Polar, the locally owned de facto beer monopoly to avoid price controls by decreasing packaging sizes. I found a local restaurant serving plentiful portions of Venezuela's renowned comfort food. They love various forms of "white cheese" which tastes a bit like a sweeter mozzarella. I particularly enjoyed the "arepa" which is a large slice of cheese between two thick halves of an English-muffin like roll. (I also found out I had gained two pounds from my stay in Venezuela. It was worth it.)

Venezuela, or at least Caracas, is not a total mess. I was impressed with the quality of urban infrastructure. The roads in Caracas look like those in the United States, mostly built in the 1950s under a very different regime. They have per capita GDP of $12,700, and I expected that most of it would be "stuck" in oil and not available for the population. Yet I was encouraged by high levels of income. Young men walking on the street and cab drivers wore snappy, branded clothing, and pretty nice cell phones. When I mentioned this to Venezuelans, they told me that things were much different in the slums, pointing down into poorer sections of the cities. Here my eyes are skewed. The poor neighborhoods had red brick walls and relatively thick corrugated aluminum ceilings, terrible housing by the standard of the United States, but a huge upgrade from the rain-soaked wooden facilities in Lagos or the all-aluminum shacks in Mumbai. The point is that the higher GDP per capita does actually equate to a working class that is much better off than those in Bangladesh, even if a lot of it has come from oil. The cash has reached farther than one would, at least from my urban perspective.

One economist described something like a rebirth of local culture. He sits on the board of a publishing company, who has noticed much higher sales of books, of higher quality, even on politically critical topics and good quality fiction. The film industry—supported by giant subsidies from the government—was improving and producing higher quality films that were more pertinent to a modernizing society. The government was trying to promote computer usage, buying hundreds of thousands of laptops for students, and printing "two million copies” of Don Quixote and other Spanish classics in cheap paperback print. I suppose this is what a left-wing statist nationalistic cultural revival looks like.

Finally, on my last positive note before discussing the problems in Venezuela, the managers are known to be particularly strong. Though we may question the sources—managers touting their own strengths—this makes sense. The central bank maintains a dual exchange rate and has had currency controls for a long time, making importing and exporting particularly challenging. High inflation creates a manager that must be prepared for many different circumstances, not just a decline in margins. Venezuelans usually thrive outside of their home countries, where they can focus on driving the boat instead of fixing its leaks. Lest you are doubtful, I have heard the same thing about managers in Zimbabwe and South Africa, two places with persistent security and foreign exchange challenges.

Casual Friday was incredibly sloppy, even for a guy living in San Francisco. At one bank the men wore ripped jeans and T-shirt with band-names on the chest falling over their chubby bellies. One person told me that this is following the trend from above. Chavez and his supporters always wear a red T-shirt and dress down. Business suits brand its wearer as a stooge of the oligarquia. People used to dress up and look like they were in Barcelona—women in bright-colored blouses and fashionable skirts; men wearing starched shirts and well-cut suit jackets and slim pants—but now everything is so casual. Perhaps people want to dress down to avoid kidnapping, a new industry in Venezuela. One manager of a paint company didn't want to meet me at a restaurant at the end of the day because of the threat of kidnapping and preferred to come to my hotel instead.

I couldn't help but think about the decline in "civic virtue." A mall and an office building in construction in Caracas had been invaded and turned into apartments. Each studio was one-third finished, with people putting bricks on the windows so they didn't fall out. From the outside, the building looks like a hotel that began crumbling once they halted construction. One manager, pointing out the window, told me that guys in motorbikes drive the tenants up ramps to get to their homes on the 30th story. I suppose they shared two toilets on the floor. One lawyer told me that the rule of law was completely gone. One can't protest the government in the courts. This can change after Chavez goes, but it will be a long process.

Venezuela is an odd place to think about investing. The inflation means that you must find a company that has a very low PE, can grow despite inflation, and with a high dividend yield. I found a few companies that can grow, with a low PE, but inflation requires them to plow back 75 percent of their earnings just to reinvest in the business. For example, let's take a bank with 35% return on equity, trading at 1.5x book and 5x PE with a 5% dividend yield. For us to earn our 25%+ return, I must be confident that the bank can grow by 20% in USD-terms, which is extremely difficult in any environment.

Making this exercise more difficult, Venezuela's economic growth is low. Even Equatorial Guinea, which is horribly governed, musters high single digit GDP growth, and one would think something similar for Venezuela with so much oil. Instead, the economy has grown just 4% on average the last five years—good compared to the United States, but almost half of Nigeria's 7.5% growth rate. I think that Venezuela's greatest growth days are probably behind it, or at least the kind that I prefer. Urbanization is one of the greatest drivers of economic growth, and Venezuela is already 83% urbanized. The nation will have to improve productivity tremendously to grow much more. I don't think this will change much with a change in the style of regime.

Chavez has really managed to tear up the legal system. Policies are driven by his priorities and quasi-religious plans. Chavez announces nationalizations on television in emotional statements about the importance of cement or flour being in the hands of the people, but explains the sources of shortages of those products two years later. The rule of law is gone, and some companies must sell products to government companies at a loss to avoid nationalization. One CFO told me, "This is Emerging Markets." I almost laughed. After working in emerging markets since 2003, I had never seen these policies. Who would have thought I'd pine for the operating environment in Nigeria over Venezuela?

Chavez has cancer. We don't know which kind, and it is a state secret. We know that he has had two tumors removed in Cuba and looks weak. He is basically governing through Twitter. There are many different ideas and theories about what could happen if Chavez dies before or after the October elections, and whether he would appoint successor. Most people think that he will anoint a "believer" who would win a close election against an opposition that is much more united. Chavez has the support of the state employees and the third to half of households who receive some kind of handout from the state. He has 45% popularity now according to Datanalysis, a local polling firm. I'm told that even this level of popularity is extremely unusual and high for a Latin American country, where most leaders win elections with 20-25% approval ratings.

I am not sure whether I believe him, but one consultant told me that he would highly doubt a coup. He said that generals in Venezuela are actually concerned by the International Criminal Court, the possibility of sanctions from the Organization of African States, and improbably, condemnation by the global community. He had a further comment: Cuba has exchanged military support for cheap oil. They have around thousands of "advisors" in the Venezuelan government and military, amounting to tips for to Chavez and his party to hold onto power. In exchange, they receive subsidized oil that they re-export for a profit to keep the economy alive. The Cubans have an interest in stability because they need cheap oil—an odd theory, but interesting.

American companies are doing very well in Venezuela. I met with the head of the American Venezuelan Chamber of commerce who told me that Colgate, Heinz, and Diageo all get a disproportionate amount of their sales and profits from Venezuela. But Venezuela has exchange controls, which prevents them from repatriating dividends. Instead, they sit in the local currency pegged to the dollar bracing themselves for a massive devaluation, or else they invest the cash in real estate. Venezuelans hedge their currency risk by buying government debt, and then selling the cash and placing it in banks in Miami. Two different sources told me that over $200 billion sat in accounts in the United States and Switzerland.

Can the situation turn? How would you bet on it? I am not sure. The "yes" argument points to the $200 million in oil revenues the country earns each day. Even using a statist model, a better government could earn a much higher return on that cash flow. That could have a multiplier in society, and companies could grow as real GDP increases. But I don't like investing in political change. And as Philip Tetlock wrote in Expert Political Judgment: How Good is It? How Can We Know?, the best political bet assumes that the near term future will be like the recent past. I would bet that Venezuela will be mismanaged, even if in a different way, in the medium future. Subsidies and handouts are extremely hard to remove once in place.

As our readers know well, one can price risk in any country. To my eye, now, we aren't compensated for the level of risk in Venezuela. That situation may change in the next year, but as of right now I think that an 18% US-based IRR in Venezuela is not high enough for us. Despite a major change in government over the last 20 years, the spreads on USD sovereign debt has stayed in the range of eight to thirteen percent. This points to inherent and persistent weakness the government's relationship to its people that stretch back farther than Hugo Chavez.

I have one final comment. I noticed smart phones throughout my journey, and not just among CFOs and CEOs. The lady stamping my passport at immigration was charging her HTC phone on the counter. The "distraction epidemic" is spreading throughout the world. I noticed people checking their e-mail mid-sentence, over lunch with friends at a café, and uniformly in elevators. I have grown to expect this kind of thing now in the United States where we struggle to focus for more than five minutes at a time. This appears to be the future for the world's rising middle class. I think this will have far-reaching implications for culture and human character, though I have no idea quite how.

Enjoy the summer and let me know the next time you're in the Bay Area.