When adam kutas and Brent Bottamini, fund managers at Boston-based Fidelity Investments, took up the reins of Fidelity Latin America Fund (both A and B versions) slightly more than a year ago, Latin American stock markets were already sizzling hot and riding high on an optimistic outlook.

Nevertheless, the pair has managed to improve on success, ringing in a strong gain of 42.6% for the year ended June 30, in the process surpassing a 37.3% jump in the Morgan Stanley Latin American Canadian-dollar index. The pair have outperformed by departing significantly from the index and placing bigger bets on a smaller number of companies. Although the portfolio contained 110 names when they took over, within a week they had whittled it down to 48 and have since added selectively, now holding a total of 90 names.

“It’s impossible to outperform when you’re too close to the benchmark,” says Bottamini. “In places in which we had a ton of conviction, it made sense to concentrate our bets, and put distance between ourselves and the benchmark.”

Before taking over the fund, which is offered in Canada by Fidelity Investments Canada Ltd., the two men worked as analysts supporting the previous manager, Claudio Brocado. As part of Fidelity Investments’ training program for fund managers, they were running a small pilot Latin American fund seeded with Fidelity’s money. The pilot fund was essentially a “dry run,” so the pair had been analysing and trading companies in the region for two years and had strong ideas about what they wanted to see in the publicly available Fidelity Latin America Fund. They moved quickly to implement those ideas when they were put in the driver’s seat in April 2005, after Brocado left the firm.

Kutas and Bottamini increased the fund’s exposure to Brazilian materials, steel companies and banks. They also jacked up exposure to domestically oriented companies in a position to benefit from gains in consumer spending, particularly Brazilian retailers and Mexican home builders and airlines. They took the pruning shears to traditional telecom companies, particularly Telefonos de Mexico, and also trimmed energy companies and utilities.

“In terms of future growth potential, I was more biased toward the wireless companies, and negative on wire-line firms,” says Kutas. “When we were analysts on the fund team, we had some tremendous conviction in some of our recommendations, but we weren’t in a position to pull the trigger at that time. For example, we had recommended that the former manager trim back on Brazilian electric utilities. When we took over, we increased the magnitude of the reduction he had already done.”

Although the returns in Latin America have been jumping for a few years — Fidelity Latin America Fund has a three-year average annual compound return of 39% as of June 30 — analysts warn of the narrow scope of any geographically specialized fund.

“I generally prefer to see investors avoid narrow-mandate funds. That also applies to high-risk regions,” says Dan Hallett, president of Windsor, Ont.-based Dan Hallett & Associates Inc. “I would rather see an investor look to a broader emerging-markets fund rather than an Asian fund or Latin American fund.

“The reason is that the more volatile the fund, the more investors tend to get induced into making bad decisions on the timing of buys and sells. Emerging markets are so volatile that I prefer the more diversified mandate.”

Kutas and Bottamini employ a combination of bottom-up fundamental analysis and long-term secular trends to find attractive stocks. They apply some standard measuring sticks, such as price/earnings ratios, free cash flow and return on equity, to find a strong business, and also seek a strong management team with a viable strategy. They also like companies that stand to benefit from secular trends, such as the emergence of middle-class consumers in Mexico and Brazil, and China’s voracious appetite for commodities and materials.

“Countries like Brazil and Chile have what China needs, including iron ore, copper and oil and gas,” says Kutas. “As people in China want to buy cars, they will need steel to make them and gas to drive them. There’s also a massive number of people moving from an agricultural life to urban, and that’s creating a massive building boom.”

The bulk of Fidelity Latin America Fund’s investments are in the most developed countries in the region, with 53% of assets in Brazil, 33% in Mexico and 6% in Chile. Materials are the largest sector weighting in the fund, followed by telecommunications, financials, energy and consumer staples.

@page_break@“When there’s an improvement in trade, it tends to strengthen the profile of a country,” says Kutas. “The currency rallies, interest rates fall and the benefits start to flow through to the consumer class. Lower borrowing costs make it less expensive for people to buy a car or take out a mortgage. They have more confidence that they will have a job in the future, and they’re not afraid to spend money.

“Historically, Latin Americans didn’t know when there might be a political coup and a dramatic currency drop.”

When buying stocks, particularly in today’s booming markets, Kutas and Bottamini pay close attention to price. In the wake of the “tequila crisis” of the mid-1990s, when currencies and stock markets plummeted across the region, Latin American stocks traded at a significant discount to developed-world markets. Since then, the gap has narrowed significantly.

“A stock is not necessarily great, even if it’s a great business, if the valuation is not attractive,” says Bottamini. “Our style is ‘value with a catalyst.’ We are looking for companies trading at a reasonable price and possessing an underestimated set of opportunities that could serve as a catalyst to unlock value.”

Kutas says even a cheap company with a great outlook could be vulnerable to political change and currency volatility. He and Bottamini consult with Fidelity’s debt specialists to understand these risks. With recent elections in Peru and Mexico — and one pending in Brazil — the potential for political change could trigger nervousness in financial markets.

“It’s like a mosaic, and we’re always trying to fit different pieces together when analysing the outlook for a company, and may move the pieces one way or another to form the picture,” Kutas says. “Latin American countries are maturing in a political sense, and that mitigates some of the volatility that was previously associated with elections.”

Bottamini says Mexico has about a five-year lead on Brazil in terms of the maturation of its economy. “Mexico is a good map for where Brazil can go,” he says.

In Mexico, some investment opportunities have been created by home-building, which is supported by a young population, many of whom are in the “family formation” years. In addition, with greater wealth, the practice of many families living together under one roof is changing, and more individual families can afford their own homes.

“For long periods of time in the past, there have been economic and political issues in Latin American countries, and consumer behaviour has been stunted,” says Bottamini. “We’re positioned to benefit from the release of pent up demand.”

Major fund positions include basic retailers such as Wal-Mart de Mexico, as well as apparel retailer Lojas Renner SA.

Another successful position has been Cemex SA, a company that started as a regional Mexican cement producer several years ago and has grown into the third-largest global producer, with cash flow from its U.S. business now surpassing that of Mexico.

Kutas and Bottamini travel frequently to Latin America, visiting Mexico five or six times a year and Brazil about three times, with less frequent visits to Chile and Argentina. Neither speaks Spanish, but they say that, unlike 20 years ago, most Latin American executives now speak English, the international language of commerce. IE