After rallying 25 % from the March lows, Brazil’s stockmarket performance is prompting investors to consider whether the country could finally be turning the corner. The country is the only major emerging market to retest its 2008 lows and has become a consensus underweight after four years of frustrating growth and political mismanagement.
However, some of the more pressing concerns have faded in the last few weeks and the market has started to move up earlier than expected. These concerns include:
The Petrobras “ Car Wash” scandal
The threat of water and power rationing
Brazil depends on hydroelectricity for around 75% of its electric power supply. After a worrying period of relative drought, recent rainfall has gone some way to replenish reservoir levels ahead of the dry season.
Most important of all is the appointment and backing given to market-friendly Joaquin Levy as Finance Minister. He is committed to retaining Brazil’s investment grade rating and has made most of the changes investors were hoping to see in an attempt to deliver the 1.2% primary surplus target for 2015. In doing so, the likelihood of Rousseff continuing with her unfunded populist polices such as fuel subsidies and cheap financing for select industries has declined significantly. Each time he is able to cut spending or subsidies, the market gains confidence in his ability to balance the books. This is reflected in the reduction in 10 year government bond yields from 13.5% to 12.5% in recent weeks. This move could continue (yields were 11% just before the election last year) and would be supportive of equity market performance.
While the risks highlighted above have waned, the currency has also experienced a significant adjustment. At its weakest, the Brazilian real had lost one third of its value against the US dollar since the elections. This tempts foreign investors to take another look, and we have seen a flurry of attempted delistings as international parents such as British American Tobacco see value in their local subsidiaries. A weaker currency is also part of the solution for Brazil as it helps to rebalance the terms of trade, lower the current account deficit and reduce import competition for domestic manufacturers.
The monetary and fiscal policy tools being utilised by Minister Ley are a painful necessity in a country which has already seen growth slow to subpar levels. Indeed, GDP will likely shrink by 1% in 2015. We continue to expect a final leg down in corporate earnings estimates as the fiscal adjustment process hits the consumer and economic growth. This is underway as we write and if the market follows earnings lower then this would be a clear signal for us to turn much more positive on the country. In the short term, unemployment, interest rates and inflation are all rising, while confidence and investment remain at multi-year lows, on hold while investigations into construction sector corruption continue. However, if Rousseff allows Levy to continue on this path, investors will probably start to look forward to rate cuts and a positive GDP print in 4Q 15 or early 2016 and we can start to put a difficult first half of 2015 behind us.
Share Price Valuations
With all the challenges well known, the likelihood of new negative headlines from this point has declined.
The final factor in our consideration of Brazil positioning is valuation. With earnings falling but markets rising in the last few weeks, we have seen an upwards re-rating of Brazil to 12.5x PE compared to a long-term average of 10.5x. One could argue that in absolute terms this is still relatively cheap for a market which contains many high quality durable growth companies, especially in relation to developed and other popular emerging markets reaching new highs. A temporary re -rating is always to be expected at inflection points such as this where the market start to price in positive earnings momentum for the years ahead before the near-term growth data supports it, especially when long -term rates are falling. Relatively high valuations are however a sign that careful stockpicking is required in order not to overpay and have a buffer against the ongoing risks.
Our headline 4% underweight in Brazil reflects our concern on valuation and the macro challenges that still face the country over the medium term. However, this underweight is more than accounted for by a zero position in two index heavy weights, Petro bras and Vale. Combined, these are 9% of the index and if we disregard these names, we actually have a 5% overweight in Brazi . They obviously have a big impact on our headline country bet, but the reasoning is very much stock specific.
Although Petrobras has now released its results, there is stll very little to support a position in the company from a fundamental point of view. At close to 9x EV/EBITDA, with much heralded production growh falling to 2-3%, negative free cashflow for at least another four years, leverage at 6x net debt/EBITDA and a balance sheet highly exposed to further currency weakness, there still seems to be a 50/50 chance of a dilutive equity offering or debt to equity conversion at some point in 2016.
Vale is a good company doing the right things but with other major iron ore producers bringing on new supply sooner and at a lower cost than them, there is little hope of a sustained price recovery in their major commo dity. Earnings and cashflows are unlikely to grow for the next three years, leverage will rise and dividends have already been cut. Both companies plan asset sales to aid funding pressures but will be attempting to sell their unprofitable assets at a time when most potential buyers are focused on cutting their own investments. The strong rally seen in both names in April is more linked to technical and positioning so we expect fundamentals to prevail in the coming months.
Investing in Quality Companies
Inevitably both stock prices are somewhat dependent on factors such as currency and commodity price moves outside of their control. The holdings we have in Brazil are more concentrated on those companies that can deliver resilient growth in the domestic markets and have more control over their destiny. All of our largest holdings earn returns comfortably above their cost of capital and will gene rate earnings growth even as the economy slows. The lower quality names which are struggling operationally this year but will inevitably be in favour for a short while as we enter an inflection point are still not appealing to us from a valuation perspective and particularly when we consider that the recovery is likely to be gradual with perhaps 1% GDP growth in 2016 and 2% from 2017 on wards. With half the Latin American portfolio invested in the country we are well positioned to take advantage of the expected revival of fortunes, but it is fair to say that the beta of our holdings today are at the low end of their historical range. We avoid those companies that have become dependent on cheap government debt or subsidies for themselves or their customers as this is one area which is low hanging fruit for the cost cutting Finance Minister.
We are often asked how valuations look if we ignore the traditionally low multiple cyclical commodity companies. However, companies such as Petrobras and Vale are trading on such depressed earnings today that their valuations look far from cheap and many of our core holdings have seen a de-rating on the back of macro concerns, closing the perceived gap between the two groups. The market PE ratio may be slightly above average, but the fact that commodity names are now smaller within the index suggests that other quality growth stocks and staple sectors are trading at cheaper multiples than we have seen over the last decade. Indeed, 15x PE for our portfolio of high quality companies that will deliver a high teens ROE and comfortable double-digit earnings growth looks appealing to us in absolute terms.
Brazil is underowned by global funds but has a big pool of liquid, well-run companies to choose from, as well as a middle class of 100 million people with a propensity to spend that are an appealing asset for international firms. Private equity firms with a longer term view have been very active in the country recently.
Although Problems Remain . . .
We are far from outright bulls on Brazil as the long-term structural challenges linked to low productivity are still present. For now these prevent it from being a traditional growth story and it remains to be seen whether President Rousseff has the appetite to undertake major reforms of the pension, tax and labour systems. Lula and then Rousseff failed to take advantage of the commodity boom years to boost competitiveness with reforms and infrastructure investment. There are some early hints that Levy and the current leaders of congress (from the opposition party) are starting this process which would be a positive. Currency headwinds are a further concern for international investors over the medium term as most economists agree that the real should weaken a further 10-2 0% from current levels to better reflect underlying inflation in the economy, and bring the current account deficit back to a level below 3%. In delaying rate hikes, the US Fed has opened a window for Brazil to make some of the adjustments described earlier and doing so may begin to set the country on a path to reach its growth potentia.
. . . the Outlook is Positive
Having seen the positive effect that reform minded politicians can have on markets in India, China and Mexico, we think that Brazilians may have finally grasped what needs to be done. After underperforming for so long, a clear change in policy direction and removal of tail risks may be alll it takes for the Brazilian market to show some meanigfully positive returns. Much of our recent bottom-up work has been focused on names we will buy when either we gain more confidence that the worst is behind us, or valuations are appealing again, but we cannot be certain that we are at that point just yet.
Ian Simmons, Magna Latin American Fund
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