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The Copper-Bottomed Cash Machine

As we build up the Family Wealth Portfolio, one of our most important

considerations is proper diversification. We want to take advantage of the big

trends. We want to stay focused on deep value. But we also want to keep our

stock market investments spread around between different countries and

sectors.

This month, after much searching, I’ve found something that will help with our

diversification. At first glance, you might think this month’s legacy

recommendation sounds like a very risky investment. That’s because it’s

based in Latin America. And the industry is financial services. These are both

areas that normally scream “risk” to most people. Especially when combined.

But both the country and the specific business sector I’m going to talk about

today are actually very stable.

The country is Chile. The business is pension administration.

I realize that mentioning the word “pension” is not likely to generate a lot of

excitement in most people. But most good investing is not about excitement.

It’s about finding solid and growing cash flows (or assets) that are selling at

cheap prices. The company I’m going to recommend today fits that description

perfectly.

May 2011 Legacy Report #8

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Solid As a Rock

But first a quick look at Chile – a long, thin country wedged between the Andes

and the Pacific ocean, along the south-western coast of South America. Its

eastern border is with Argentina. Bolivia and Peru are to the north.

Chile is financially well managed. It has the strongest sovereign bond rating in

South America, large sovereign wealth funds and foreign exchange reserves,

and strong financial institutions. The central bank targets an inflation rate of

3%. And Chile was the first South American country to join the OECD (in May

2010).

Public debt is just 6.2% of GDP – the sixth lowest in the world. This is a huge

contrast to the over indebted developed countries such as the US, most of

Western Europe and Japan.

Chile also has a market based economy. The country claims that its 57

regional and bilateral free trade agreements are the most of any country in the

world. In 2010 its trade surplus was just over $10 billion. There is a current

account surplus as well.

Even better, Chile is rich in natural resources, especially copper. Over one

third of all global copper reserves and production are here. This means it

dominates the copper business. The US is the next biggest producer but has

only about 7% of global production. The Chilean government gets about one

third of its revenue from the copper business. So copper is very important for

the Chilean economy.

Economic growth is solid too. The Central Bank of Chile expects growth of

5.5% to 6.5% in 2011. Growth for the year to February 2011 was 7.2%.

Fiscal policy uses a rules-based approach that aims to be counter-cyclical.

During periods of strong growth and high copper prices the country

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accumulates surpluses in its sovereign wealth funds. In other words, it saves

money for a rainy day. Then when growth or copper prices turn down the

government uses those funds to stimulate the economy.

At the end of 2008 Chile’s sovereign wealth funds amounted to about $20

billion. (This is in addition to foreign exchange reserves of $26 billion.) In the

global downturn that followed the banking crisis the government spent about

$4 billion to keep things ticking along. We hear a lot about government

stimulus around the world these days. But usually it’s in countries that forgot to

save during the good times. Whatever your views are on the pros and cons on

this kind of stimulus spending, at least the Chileans make sure they save

during the good times.

Chile has a population of 16.9 million and a labor force of 7.6 million. The

country was under a military dictatorship from 1973 until 1990 but has been a

democracy since. Voting is compulsory for anyone over 18 years old.

A Penchant for Pensions

But that’s not the only thing that’s compulsory. Since May 1981 every

employee has had to make mandatory contributions to a pension scheme. The

military government set this up. And it is a flagship for private pension

provision in the world.

When I was working for UBS in Hong Kong I remember being in a meeting

with the bank’s regional chairman. The Chinese government had asked for

advice on how to set up a pension system in China. His idea was to bring in

“our man in Chile” to explain how the system worked over there. You can

imagine how important good relations with the Chinese government are for a

big investment bank. So this gives you an idea of how good the Chilean

pension system is.

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The basic idea is that all salaried workers have to make contributions of 10%

of taxable salary to a pension fund. From January 1, 2012, they will start to

phase in the self-employed as well. Workers can choose out of six different

pension administrators. They can also choose from five different fund

strategies at each pension administrator, subject to age restrictions for the

riskier strategies. People can also make additional voluntary savings on top of

the minimum requirement. But by law they have to make the minimum

contributions.

This is a crucial point for understanding why the Chilean pension business is

so stable. Come rain or shine, everyone has to save money into their

pensions. The pension administrators collect the money and invest it. Every

time money gets paid in – every month in other words – they charge a fee.

It’s also great news for Chile. Every worker has a stake in the pension system.

And the pension funds have a big amount of their money invested in Chilean

bonds and stocks. This means the people have a stake in the economy. And

the government is incentivized to keep running it well. Want to let inflation rip?

Don’t expect to get voted back into office when everyone’s stock and bond

portfolios get hammered.

It’s also a big source of funding for business. The pension funds control a big

pile of cash that can invest in company stocks or bonds, making it easier for

companies to raise capital.

So all in all, being a pension administrator in Chile is like having a license to

print money. If you can keep market share steady, and keep your costs down,

then the profits just keep rolling in. And growing. My latest legacy stock

recommendation is the market leader in this business.

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A Market Leader in “Cashing In”

The company is called AFP Provida (NYSE:PVD). (The full company name is

Administradora de Fondos de Pensiones Provida S.A. But I’ll just call it

“Provida” from now on.) I’ll call pension administrators in general “AFPs”.

Provida has a market value of about $1.7 billion. So it’s a decent sized

business. But as I’ll explain later, I think it’s worth a lot more than that. At the

end of March the company had assets under management (AUM) of $43.8

billion, with 3.5 million accounts and 1.8 million contributors. There are more

accounts than contributors because total accounts include retirees who don’t

save any more.

The company’s market share as a percentage of the industry is very

substantial: 29.6% of AUM…40.5% of accounts…and 37.8% of contributors.

New contributions come from 30.9% of the Chilean salary base that feeds into

the pension system.

The company was set up in March 1981 for 100 years. So it has at least 70

more years to run. (In fact, I’d guess it will just continue anyway.) In 1998 it

bought two competitors – AFP Union and AFP Proteccion – and gained 10%

market share. In July 1999 the Spanish banking group BBVA bought a

controlling stake and now owns 51.62% of Provida. The rest of the stock is

available to outside investors. BBVA Group is a huge global business with

100,000 employees and a market value of $52 billion. It’s also one of the

leaders in South American pensions, with $64 billion AUM.

It’s worth remembering here that Spanish banks have a lot of problems in their

home market. Before the banking crisis many of them lent a lot of money into

the Spanish construction sector or as mortgages. But construction has

collapsed and Spanish unemployment is 20%. So a lot of those loans have

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gone bad. The banks and government are working to resolve the problems.

And it’s also worth remembering that Spanish bank regulation has been pretty

successful in the past. None of the big banks had to be bailed out during the

2008 banking crisis.

Provida is a separately capitalized subsidiary company in a highly regulated

business. So any problems its parent company may have won’t affect it. Even

if BBVA gets into trouble then Provida will continue. BBVA has quite low

leverage and isn’t involved in investment banking in a big way. So in any case

it’s unlikely to get into serious trouble.

As you’d expect for an industry like pension administration, there is tight

regulation. A number of government agencies monitor the business and

change aspects of the law from time to time. For example, in the past the

AFPs had to provide life and disability insurance to all their customers as part

of the overall package. But this law was changed in 2009. And now this no

longer applies. The result has been lower fees but much lower costs as well.

Overall profitability appears unaffected by this change, but the business is now

simpler.

Company governance at Provida is also strong. There is a board of directors

that is separate from executive management…a host of committees that

oversee investment strategy…and internal audit and so on. The external

auditor is Deloitte, one of the global “big four” firms. Accounts are produced

under Chilean accounting rules and also US standards. The company files a

detailed 20-F financial report with the SEC every year. In Provida’s case this

runs to 192 pages of detailed financial information, business description and

performance review. This all helps to give us confidence that the numbers are

reliable.

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Provida’s revenues mainly come from fees. In a normal year these make up

80% to 90% of total revenues. And 98% of the fees are for the collection and

administration of the mandatory pension contributions. Because these are

fixed at 10% of the customers’ taxable salaries they are stable.

One of the rules of the system is that each individual pension AFP must

charge exactly the same fees to all of its own customers as a percentage of

their contributions. So the size of the salary or pension fund account doesn’t

matter…or the time that someone is a customer with the AFP. Everyone

paying into one AFP pays the same. Provida currently charges 1.54% of all

the monthly contributions to all customers. As soon as the money comes into

the pension funds, Provida takes its cut.

But there are competitive pressures in the industry. Each AFP has to set its

fee level to compete with the other AFPs. There is no legal maximum on the

fees that can be charged by one AFP. But each of them is trying to attract new

business and so will set fees at a competitive level to attract and keep

business.

It’s important to grasp that this fee-charging structure makes the Chilean

pension administrators different to normal fund managers.

Fund managers often charge a fee when you buy one of their funds. But they

make most of their money from charging a management fee – usually a fixed

percentage of the money in the fund. Sometimes they also charge a

performance fee linked to the investment profits. If the fund value goes up, so

do the fees. If the fund value goes down, the fees go down as well.

But the AFPs only charge fees on the new contributions. This means the fees

should be much more stable. Salaries rise over time due to inflation. And in a

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developing country such as Chile they also rise due to improved labor

productivity.

One risk, of course, is that Chile goes into recession and its unemployment

rate shoots up. This would mean fewer people earning money and lower

pension savings. But unemployment rates change over months or years, not

days or weeks. So the AFPs would have time to adjust their cost bases.

If the fees were the only way that Provida and the other AFPs made their

money then the system would probably have big problems. Since the fees

aren’t linked to how well the investments perform they would have no incentive

to manage the pension funds well.

But the pension system has another feature that ensures that interests are

aligned between the AFPs and the pension savers. By law, all AFPs have to

own at least 1% of the pension funds that they manage. They have to put their

own cash on the line in what are called “mandatory investments.” In other

words, they have to “eat their own cooking.”

This increases the risk of the business a little. In a normal year 10% to 20% of

revenues come from investment profits of the mandatory investments. And in

some years – such as during the 2008 financial crisis – this can result in an

investment loss. But Provida’s mandatory investments bounced back in 2009,

as markets recovered.

Apart from making sure the AFPs have an interest in sensibly managing their

funds, the mandatory investments have a second purpose. If Provida’s

pension fund performance is significantly below the industry average the

mandatory investments can be forfeited to make up the difference to the

pension savers. If there is still a shortfall, the government makes up the

difference.

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This is potentially a big deal, because the mandatory investments are over half

the total assets of the company. But when you look at the details you can see

why it’s not so dangerous.

The pension funds that savers can choose fit into five risk categories: A, B, C,

D and E. (“A” being the most risky. And “E” being the least risky.) These have

different maximum amounts that they are allowed to invest in stocks, with the

rest going to bonds. These limits are 80% for category “A,” 60% for “B,” 40%

for “C,” 20% for “D” and 5% for “E.” In practice, the industry invests the funds

in each category as close to the maximum limit for stocks as possible.

Each category also has a set range for how much it can put into foreign

investments. There is a sliding scale, with category “A” allowed between 45%

and 100% down to category “E,” which has to fall into the 15%-to-35% range.

Each category of fund is housed in a separate legal entity. So if there are

problems in one they can’t affect the pension holders that are invested in the

other fund categories.

At the end of 2010 Provida’s AUM was split between the categories as follows:

Category A: 19.5%

Category B: 19.4%

Category C: 44.5%

Category D: 14.1%

Category E: 2.5%

Since 2003, funds invested in category “A” have grown from 4.3% of the total.

And funds in category “C” have come down from 56.9% of the total. Category

“B” is about flat. And categories “D” and “E” are slightly down as a percentage

of the total.

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Of course, the total AUM has increase substantially over that time. But there

has been a shift into the higher risk, higher return strategy and away from the

middle ground. Another feature is that men and women above certain ages

and pensioners are prevented from keeping their money in the higher risk

strategies.

The way the performance benchmarks work is that each year a central

regulator sets a minimum level of return for each risk category. This is linked

to the returns of each category of funds managed across the entire Chilean

pension industry.

So for categories “A” and “B” the minimum level of return, after inflation, that

they must meet is the lesser of:

The weighted annual average real return for the last 36 months of all of

the same type of pension funds, less 4%, or

50% of the weighted average annual real return for the last 36 months of

all of the same type pension funds in the system.

For categories “C,” “D” and “E” it’s the same formula, except the first condition

subtracts 2% instead of 4%. This is because these funds take on less stock

risk, and so the performance should be less volatile.

This is a bit of a mouthful, so let me explain it some more.

“Weighted…average” refers to the size of the funds assessed. The bigger a

fund is, the more weight it has in calculating the result. “Real” means after

subtracting inflation.

So what they’re saying for the first condition is that you’ve got to beat the

annual industry average, after inflation and measured over three years, less a

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percentage. Or you have to beat half the annual industry average, again after

inflation and measured over three years.

There is a risk here that Provida could fail this test in one or more categories.

But there are also good reasons to think that it’s unlikely.

1. Provida points out that in its 30-year history this has never happened.

Even in the chaotic markets of 2008, the company didn’t have to hand

over any of their mandatory investments as compensation to customer

funds.

2. Provida is the market leader. It manages just under 30% of the total

pension funds, which means it has a lot of “weight” when it comes to

calculating the benchmark. This makes it more likely to be near to the

industry average.

3. All the AFPs have the same stock investment maximum limits in each

category, which they closely stick to. In fact, this system incentivizes

them not to stray too far from the pack, in case they get it wrong. So the

chances of failing the minimum return test are reduced again.

4. There are five fund categories. So the chances of failing in more than

one category in a given year is even slimmer than the chance of failing

in just one.

5. Finally, there is that “less 4%” for categories “A” and “B” and “less 2%”

for categories “C,” “D” and “E.” Provida’s average after inflation (“real”)

investment returns for the period 2003 to 2010 for each category were

as follows:

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Category “A” – 9.3%

Category “B” – 7.5%

Category “C” – 6.3%

Category “D” – 5.2%

Category “E” – 3.7%

You can see that taking 4% off categories “A” and “B” and 2% off categories

“C,” “D” and “E” is a big deal in relation to the size of these returns. If anything,

the risk is biggest in the “A” and “B” categories. But here the AFPs are given a

bigger margin of safety.

By the way, the Chilean central bank targets inflation at 3%. If Provida can

continue to make 9.3% above that in future, for a total return of 12.3%, it would

be doing a good job. That kind of performance would put most mainstream

developed-country fund managers to shame.

Provida is allowed to expand overseas provided it sticks to the pension

business. Right now, it has minority investments in Mexico and Peru. These

businesses are ranked second and third in their markets, with 15% and 23%

market share. Provida also wholly owns a business in Ecuador, which has

72% market share. But it is very small.

At the end of March 2011, Provida had 60 branches in Chile. It also had 452

sales agents and 900 administrative staff. In recent years Provida has been

outsourcing a lot of the administrative functions, such as collection and

administration of pension contributions. It has also been investing in new

technology to allow more functions to be carried out online. And the focus of

the business is increasingly on value-added sales through the branch network.

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Introducing the “Cash Machine”

Now, we’ve got the basics of how this business works, we need to decide if it’s

a good legacy investment.

Provida’s balance sheet is pretty simple. Fifty-four percent of its assets are the

mandatory investments. The rest is made up of a mix of the usual things. In

descending size order the main ones are goodwill from past acquisitions,

cash, real estate (branches) and minority investments in foreign and local

businesses. Shareholders’ equity is equivalent to 78% of assets. And debt is

virtually non-existent.

In other words, the only meaningfully risky items on the balance sheet are the

mandatory investments. But since these are spread between five different

investment strategies, the risk is reduced. In a normal year these should

generate investment profits. But there will be losses from time to time when

markets fall, as in 2008.

With the current mix of categories, if we have another bad year like 2008 and

each category lost the same amount, Provida’s funds would lose 24% of their

value overall. That is equivalent to 13% of assets and 17% of shareholders’

equity.

But it’s worth remembering that new cash coming in would offset this, as

Provida continues to charge fees on new contributions. In fact, in the very

difficult 2008 year tangible equity (shareholders’ equity less goodwill) fell by

only 4%. Also remember that losses of this nature are normally followed by

profits. In 2009 the funds would have gained back 27% at current weightings,

with further profits in 2010.

As I said before, revenues mostly come from fees charged on the mandatory

pension savings. Costs are made up of: 40% to 50% of salaries and bonuses

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for employees; 40% to 45% “administrative expenses”; 10% to 15%

depreciation (mainly of buildings); and amortization (mainly of goodwill). The

employee expenses are about one-third commissions and bonuses that are

linked to performance, and so aren’t totally fixed costs. “Administrative

expenses” aren’t broken down into detail but appear to mainly include the cost

of outsourced staff that work in areas like contribution collections and

processing.

Excluding the profits on mandatory investments and the goodwill amortization

expenses, which are both non-cash items, the net profit margin (before taxes)

was 57% in 2010. This is a very high level of profitability in any business.

Note that I haven’t adjusted for other non-cash depreciation here or in my

valuation, as the figures are not very big. Also any depreciation usually has an

offsetting capital investment, which is a cash outlay. This is to maintain

buildings, buy new furniture or invest in new technology. These items usually

pretty much offset each other in financial services businesses. And they are

small. So they can be ignored when estimating cash flows.

The only other significant profit item is the share of profits from companies

where Provida has minority ownership. This includes three companies in Chile

and the international investments in Mexico and Peru. The total contribution to

pre-tax profits is typically 8% to 10%. This is a meaningful contribution, but not

a significant factor in the overall case for investing in Provida. And remember,

these are also pension businesses.

Finally, corporate taxes have been in the 13%-to-16% range in recent years,

although this will go up in 2011. The Chilean corporate tax rate, on profits

made in Chile, has just been increased from 17% to 20%. Obviously, this

takes a bit out of net profits. But the rate remains quite low by global

standards.

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Apart from profit margins, another useful financial ratio to look at when

analyzing companies is the return on equity (ROE). Even better is to strip out

the effects of significant non-cash items when calculating this figure.

Specifically, this means excluding goodwill amortization costs from the profits

and deducting the intangible goodwill asset from shareholder’s equity. The

adjusted profit divided by the adjusted equity figure is called return on tangible

equity (ROTE).

There is a good reason for doing this. Imagine you have two identical

companies. They earn the same cash income and have the same cash

expenses. They also have the same business assets and liabilities. But

company “A” got there through building the business from scratch, whereas

company “B” also had to make some acquisitions along the way.

This means company “B” will have non-cash goodwill amortization costs and

also a big intangible goodwill asset on the balance sheet. Goodwill is the

difference between what was paid for an acquisition and its net assets in the

accounts when it was bought. So it’s a slightly strange accounting convention

that has no relevance to the value of the parent company today.

If we just used unadjusted ROE to compare companies “A” and “B,” we’d get a

much lower result for company “B” (lower profits and higher equity). Since they

make the same amount of cash profits, this would be misleading. So we use

ROTE instead, which allows us to compare apples with apples.

In Provida’s case, ROTE was 40% in 2010 – a very high number. I don’t think

even Goldman Sachs reached this level at the height of the pre-crisis financial

boom (the maybe got into the mid-30s). If we adjust the profits even more to

take out the gains on the mandatory investments the figure was still a high

31%. If Provida wasn’t forced to own the mandatory investments, this figure

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would be huge. There would be small equity requirement. But profits would still

be big.

From what I can see, Provida hasn’t issued any new stock for many years.

This makes sense: It has low capital requirements and generates a lot of cash

every year in the business. This is good news, as it means earnings per share

are unlikely to get diluted in future.

Net profits after tax, excluding goodwill expenses, grew 17.4% a year between

2007 and 2010. Net cash profits – which also exclude gains on mandatory

investments – grew 24.5% a year. Basically, fees have been climbing while

costs have stayed flat. It’s great to see that the company has tight cost control,

despite rising salaries in Chile. It has achieved this by reducing the number of

employees and also cutting the branch network due to outsourcing of certain

administrative functions.

So Provida has simple accounts, growing fees, tight cost control, very high net

profit margins and very high return on equity. It’s a cash machine in other

words: my favorite kind of investment.

An Extremely Attractive Value Proposition

So far so good… But what about valuation?

Provida is on a P/E of 9 times 2010 earnings and a dividend yield of 7.3%. Its

price-to-book ratio (P/B) is 3.14, using tangible book value (shareholders’

equity less goodwill).

The P/E of the Chilean stock market is a high 21.3. So Provida is valued

favorably compared to the market as a whole. Although only about one fifth of

the Chilean pension funds are invested in the local stock market, having this

constantly growing investment pool provides a constant source of local stock

demand. I can understand why Chilean stocks trade at such high levels –

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there is always new money being invested in Chilean stocks. This is at least

some justification for the high market P/E which doesn’t exist in most emerging

markets. Even so, I wouldn’t buy an index fund at these levels.

Over the last 10 years the MSCI Chile has returned 16.04% a year, measured

in dollars and excluding dividends. For comparison the MSCI Brazil has

returned 17.88% a year, the MSCI Russia has returned 16.71%, the MSCI

India has returned 17.12% and the MSCI China has returned 11.71%.

Provida must pay out at least 30% of profits as dividends. But at the moment

the management is planning to pay out 75%. I expect the dividend yield to

remain high; the company doesn’t need to keep cash to reinvest. So we

should expect dividend yield to stay in the 7% to 8% range.

I put together a detailed valuation model to work out what this company is

really worth. As usual, I’ve used conservative assumptions for the cash-flow

projections. The end result is for cash profits growing at about 4.5% for the

next five years. This is extremely conservative and far below recent

experience of 17% a year between 2007 and 2010. I also have shareholders’

equity (book value) growing at 11.5% a year, which is in line with recent years.

To get to these figures I’ve had to make a range of assumptions. The most

important ones relate to the growth of fee income and profits on mandatory

investments.

To get to fee income, I’ve assumed salaries rise 5.5% a year due to 3% target

price inflation plus 2.5% productivity gains (consistent with Chilean productivity

gains since 1990). Wage and salary rises from productivity gains are a

common feature of developing countries, as workers acquire new skills and

move into jobs that add more value.

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I’ve also added population growth of 0.8% a year, which is the current rate of

expansion. More people mean more workers, which means more compulsory

pension savers.

Offsetting that – and because Provida is the market leader – I’ve assumed a

steady loss of market share that eats into fees, reducing them by 2% a year.

This is consistent with market share development since 2007. Market leaders

usually find it hard to defend their dominance forever. That said, Provida will

probably stay No. 1 for a long time. And it may even keep or gain market

share in the future.

For profits on the mandatory investments I’m assuming that the investment

funds, across all categories, make a return of just under 9% a year. This is 1%

below Provida’s compound real returns since 2003, once inflation is added

back.

Other assumptions include costs at 42% of fee income – again in line with

current levels. Also that taxes rise to 18.5% from the 15.5% paid in 2010 to

reflect the 3% increase in Chilean corporate tax rates.

Finally, I’ve worked out a cost of equity for the company. This is what investors

should want to make from the stock to justify owning it based on the risks. The

formula is complex. But it uses Chilean sovereign bond yields, plus an

additional amount for the extra risk of owning stocks, adjusted for the price risk

of Provida stock.

The resulting cost of equity is 10.6% – again, using conservative assumptions.

This is not to say the stock will return 10.6%. It’s just what investors should

look for to justify their investment.

With all of that (and more) I’ve come up with some future projections of cash

profits that we can use to find an estimate of the “fair value” of the company.

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What it should be worth in other words. I can also value it by calculating a

theoretical P/B ratio.

Valuation is an art, not a science; there is no “right” answer to the question of

how much a company is worth. But if we use conservative assumptions and

the result is still way ahead of the current market valuation, we are building in

a solid margin of safety. And we can be more confident of making money over

the long run.

Using this model I reckon the P/E of this business should be 15.3 and the P/B

should be 4.1. When compared to these ratios at current market prices, this

means the stock should be 70% higher on a P/E view and 31% higher on a

P/B view. Averaging these two we get 50.5% upside. In other words, the stock

looks cheap.

The theoretical P/E ratio of 15.3 looks about right. Asset management

companies in developed economies usually trade on P/E ratios of between 15

and 20 times. For example, Blackrock has a P/E of 16.9 at the moment.

Provida is based in a developing country. But it also has a stable business

that’s mandated by government and high profit margins. If anything, 15.3 is on

the low end of what this stock is worth. This is due to my conservative growth

assumptions.

15.7% a Year for the Last Decade

With this information we can get an idea for what kind of investment profits we

should make in future. These will come from dividends, profit growth, currency

gains or losses and changes to the valuation multiples (P/E and P/B). Of

course, short-term market price moves can give a very different result. But we

can form an idea of what to expect over the long run.

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The Chilean peso has gained 2.8% a year against the US dollar since May

2001. Given Chile’s sound finances – its low debt, its trade surplus, its foreign

exchange reserves, its cash-rich sovereign wealth funds and its huge copper

deposits – and the poor financial management of the US, I’d expect the

Chilean peso to keep gaining on the dollar over time. Let’s assume a very

reasonable 2% a year.

For dividends, I estimate 7% a year – slightly below the current level. For

profits, I estimate 5% growth – which is slightly above my valuation model but

way below recent actual growth since 2007. Add these to the currency gains of

2% a year, and we get 14% a year.

This is in line with what investors made over the past 10 years or so, when

measured in dollars. I can only go back 10 years, since I only have dividend

information back to 2000. (The stock has been listed in New York since 1994.)

If you had bought Provida stock for $21.50 in December 1999, you would have

picked up dividends of about $22.77. And the price is now $76.26 giving

additional gains of $54.76. So the total profit in that time, before taxes, would

have been $77.53 – or just over 360%. This works out as an annual average

gain of 15.7%.

So an outlook of an annual gain of 14% looks reasonable. Of course, the gains

could be more than that. If the stock revalues to the average of my two

valuation methods there will be upside of 50.5%. If it took 10 years for this to

happen (and it could be much quicker) that would add 4.2% compound return

to the total. Rounding to 4%, this takes the total potential pre-tax return up to

18% a year over 10 years.

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What Are the Risks?

The biggest risk here is another major downturn in stock and bond markets.

This would cause losses on the mandatory investments. But I believe

investments would bounce back later on. And since fee income from

compulsory pension saving is the main revenue source, any write downs

should have only a temporary effect on profits.

Also, there is the risk that some or all of the mandatory investments are

forfeited to make up shortfalls in investment performance. But as I explained

above, there are good reasons to think this is unlikely. But if it did happen, the

effect could be substantial in that year.

Another risk is of a major change in the pension rules in Chile. But this system

has been in place for 30 years. If the Chilean government took steps to

increase competition, Provida might lose market share. But this would likely be

a slow process. And so the company would have time to react. For example, it

could develop new marketing campaigns to defend market share or cut its

costs further.

Also, the Chilean peso could fall against the dollar. But it is much more likely

to keep rising for reasons explained above. But if the copper price falls sharply

or global investors dump foreign currencies, it could certainly take a hit in the

short term.

In 2008 the Chilean peso lost 31% of its value against the dollar at one point.

But most of that loss was made up again during 2009. And it has kept climbing

since. So this would most likely only be a temporary setback. And as ultra

long-term investors, we shouldn’t be too concerned about this happening

again.

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Finally, a big recession in Chile could cut the salary base if unemployment

went up a lot. The unemployment rate was 7.3% in February 2011, so an

increase of say 5% is easy to imagine for a time. This could cut 5% of the

pension contributions, assuming that all salary levels were hit the same. But

Provida would have time to react and cut costs – recessions happen slowly.

And the economy would recover in time. So, again, it would only be a

temporary effect.

In the short run Provida stock has the potential to fall sharply. In fact, in 2008 it

fell 61% at one point. But it bounced back by the end of 2009 and is now way

above the pre-crisis highs. This kind of move doesn’t matter to us much, as

the long-term returns should still be strong. And if this kind of extreme short-

term fall happened again it would just be a chance to buy more of the stock at

ultra-low levels.

In Conclusion…

So here’s a summary of why I’m recommending Provida as the latest legacy

investment for the Family Wealth Portfolio:

Chile is extremely financially stable.

Chile has had compulsory pension saving since 1981.

Provida is the market leader in pension administration.

Most of the company’s revenue comes from steady and growing fee

income.

Fees are inflation hedged – if inflation rises, salaries are likely to rise as

well, so pension contributions will as well.

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Costs are low and well controlled.

The company has very high net profit margins and return on tangible

equity.

It has a low market valuation at current stock price with about 50%

upside to fair value.

Expected pre-tax returns for dollar investors are of between 14% and

18% over the long run…and maybe more.

Welcome to the copper-bottomed cash machine.

Action to Take: buy AFP Provida (NYSE:PVD) up to $85. Hold for the

ultra long term. Price at time of writing $76.26.

Rob

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