"I want to go back to Brazil, get married, have lots of kids, and just be a couch tomato."
- Ana Beatriz Barros, Model
Buy low. Sell high. Sounds easy, right? Just not for human beings. There are very good reasons why investors find it so hard to pull the trigger and buy assets that have been clobbered. It's scary. It's cheap for a reason. Value trap. It's different this time. Falling knife. Falling piano. Things are always darkest before they turn pitch black. Don't be a hero. Right?
Oftentimes, the point at which a security looks "low" or "cheap" isn't the bottom. How many times as an investor have you reached out for that cookie only to have your fingers scalded? Even if the cookie ultimately proves to be tasty, what sticks with you is the pain. Studies by behavioural economists such as Daniel Kahneman have documented that losses are twice as powerful, psychologically, as gains (a concept known as "loss aversion").
The great thing about managing a diversified portfolio of long and short ideas across different asset classes is that, on any given day, there is almost always something going up and something going down. It helps psychologically and is a Quaalude-free way of staying calm during bouts of volatility (in the investment world it is considered gauche to talk about "losses", there are only gains and "volatility", nothing else!).
With U.S. equities at record highs, interest rates still near historic lows, and credit spreads tight for even the junkiest of junk bonds (despite recent volatility in that space), it's fair to say at this point that the easy money has been made. Sure, there are pockets of value here in there with individual securities or even sectors, but it's tough to find whole economies or markets that are cheap or even stupid-cheap. But thanks to our old friend volatility, I believe there is huge opportunity presenting itself in Brazil.
It may have gone unnoticed by many, but the Brazilian stock market is in a severe bear market. Since March 2012 the Bovespa index is down nearly 30% as shown below:
But in U.S. dollar terms, factoring in the weakening of Brazil's currency (the real), it's even worse - down a whopping 46%:
Interestingly, while small cap stocks in Brazil have also been pummeled, in USD terms the Market Vectors Brazil Small Cap Index is down "only" 30% over this period (more on that later):
Looking back a little further, since peaking in November, 2010, both indexes have essentially been cut in half. The 3 year chart shows both the large cap and small cap indexes, plotted against the S&P 500 (indexed to 100 at the July 23, 2010 starting date):
Someone please tell the Brazilians that there is a liquidity-fueled asset bubble being reflated and they are expected to participate.
There are several reasons why Brazil's market has underperformed. I will start at a high level and then get more granular. Put simply, the market is down because profits are down. Below shows the trailing 12-month earnings before extraordinary items (orange) and EBITDA (green) which is a more stable measure of overall profitability:
Compounding investors woes, not only has profitability suffered but valuation multiples have contracted. Below are the Price/Sales (yellow) and Price/Book ratio (orange) for the Bovespa since 2005. I chose these metrics to illustrate the point as earnings have been more volatile:
As you can see, the Bovespa is now trading about 0.9x book value - far below the P/B of 1.35x we saw during the Lehman meltdown. In fact, one has to go back 10 years to find a P/B below 1x:
US-based investors have hit the trifecta with lower profits, lower multiples, and a currency that has fallen out of bed. The chart below shows that the value of the Brazilian real has crumbled vs. the USD (-33%) to levels not seen since the depths of the global financial crisis:
Scary stuff. Not surprisingly, investors have hit the sell button with gusto which has only added to the selloff. The chart below shows the shares outstanding for both the iShares MCSI Brazil Capped ETF (EWZ), and the Market Vectors Brazil Small Cap ETF (BRF) for the past 3 years, normalized:
While Brazilian large caps and small caps have both suffered significant outflows, the panic selling in small caps has been particularly striking. Indiscriminate panic selling gets me excited, but I won't truck out that tired Buffett quote about being greedy when others are fearful.
While hard to pick a bottom, I believe what we are seeing now in the Brazilian market is significant buying opportunity for long-term investors not unlike the post-Lehman stock market meltdown we saw in 2008/2009 in the U.S. and elsewhere. As a sense of the magnitude of the drop we've seen in Brazilian equities, below compares the 2013 year-to-date return of BRF to the 7 month period for the S&P 500 from September 2008 to March 2009:
If you had purchased the SPY on March 2013 you would have enjoyed a total return of 130%+ over the subsequent 4 year period (21.4% annualized). There is no guarantee whatsoever that Brazilian equities will follow suit, but it seems the wind is sure at the back of whoever takes the plunge now.
Drilling down further, a cross-sectional analysis of the Bovespa index highlights where the pain has been most acute over the past year:
The 3-Year returns are also interesting:
Several things jump out after looking at the charts above. It's clear that the pain and gain have not been distributed evenly. Basic materials and energy have been mauled, as has anything with a small ($2B or under) market cap. What gets lost in the shuffle is that those industries more focused on domestic consumption (e.g. consumer services, consumer goods, and healthcare) have done relatively well. Intuitively this makes sense - while Brazil remains a high growth emerging market, the stock market is dominated by commodity firms such as Vale (VALE) and Petrobras (PBR). These industries are generally price-takers, with little ability to pass on cost increases. As world growth has slowed, profits have been squeezed accordingly.
Financials, Basic Materials, and Oil & Gas make up about two-thirds of the index. The relative strength in the commercial and industrial sectors has been swamped.
A major problem investing in the Bovespa index (e.g. through EWZ) is that it's dominated by a handful of companies. The top 3 companies alone, Vale (iron ore), Petrobras (oil), and Itau Unibanco (banking) make up about 24% of the index. I don't really need to go to Brazil for my large cap oil and mining exposure, and I'm not overly excited about Brazilian banks - for example Itau Unibanco trades for 2X book value - I'd rather own Wells Fargo at 1.5x book.
What I want out of my Brazilian investments is exposure to Brazil's massive domestic economy that has huge secular tailwinds for the medium to long term if the government of Dilma Rousseff can just get out of the way. Brazil has 200 million people with a median age of 30 years. 87% are urbanized, literacy is high at 89%, and the country spends 5.6% of GDP on education (the U.S. by comparison spends 5.4%). Unemployment is running at about 6%, and government finances are in relatively decent shape with a public debt/GDP ratio of about 66%. A quick snapshot by The Economist of the government's bumbling can be found here. Despite these self-inflicted wounds, Brazil's economy is still estimated to grow at a 2.5% clip in 2013 and a 3.2% rate in 2014 according to the IMF's most recent World Economic Outlook. Still quite healthy compared to the "advanced" economies at 1.2% and 2.1% respectively. Per capita income has continued to grow substantially as the chart below from the World Bank shows demonstrates (Gross National Income is now nearly USD $12,000 per person):
This isn't meant to be a comprehensive analysis of Brazil's economy (far from it). I only want to point out that the country has a lot going for it and the domestic side of its economy should do well over the long term. TD Economics recently published a good 5-page discussion of Brazil's economy that I encourage readers to check out. It can be found here and a few charts and quotes are below:
"Overall, we foresee the Brazilian economy growing at around 2.5% this year and accelerating further to 3.1% growth in 2014. Private consumption will likely keep rising at a solid pace, as low unemployment supports real wage gains."
- TD Economics
"Brazil has enormous economic potential to keep raising its income per capita. However, to crystallize that potential, it has to save more so it can raise its stock of both physical and human capital. To achieve this objective, it has to work on structural reforms and continue to promote macroeconomic and financial stability."
- TD Economics
A consistent prescription from economists is that Brazil needs to ramp up its fixed investment in order to return to higher growth. The government has now recognized this and is taking steps to encourage investment (it's the inverse of the Chinese problem of over-investment).
People are free to take a more pessimistic or optimistic view of Brazil. From my standpoint it is a place with enormous potential going through a soft patch. I can make one statement with virtual certainty: By the time everything looks rosy in Brazil, its stock market will be a lot more expensive than it is today. Justified or not, Brazil is on sale.
Picking individual Brazilian equities can be a bit daunting from North America, particularly smaller names. When the whole market has sold off so dramatically, it's sufficient (perhaps even preferable on a risk-adjusted basis) to buy a diversified basket. But choosing the basket matters. I've arbitrarily narrowed the field down to two options: the iShares MSCI Brazil Capped ETF as a proxy for larger caps, and the Market Vectors Brazil Small-Cap ETF as a proxy for small caps.
I'll cut to the chase - I prefer small caps as represented by BRF for two main reasons: 1) sector mix and 2) a selloff over the past couple of months that has dragged small-caps down as much as the commodity-oriented large cap index despite the favorable sector mix.
As the chart above shows - the small-cap index is heavily skewed toward consumer discretionary, industrials, and health care and has very limited exposure to energy and materials. In other words, it's full of what I want, without the heavy and distorting Vale and Petrobras anchors. Sure, if we get another commodities boom those sectors may outperform, but I don't consider them investments in the "real Brazil". Let's be honest, those names are basically pure play bets on Chinese growth. I have enough of those bets on outside Brazil (too many lately...).
These differences were not lost on the marketing folks at Market Vectors:
Source: Market Vectors
Below are some key portfolio characteristics as at June 30 (I would caution that the P/E at 17x might not seem "cheap" at first, but consider the earnings downturn noted previously, and the fact that these companies are generally growing quite rapidly):
For fun, let's take the fund's top holding, Anhanguera Educacional Participacoes SA (GM:ANGAF) at a 5.3% weighting. This company is a large private post-secondary education company with nearly half a million enrolled students. From the website:
(click to enlarge)
The financials look sold with gross margins of 56% and a stellar EBITDA margin of 26.9%, with decent growth:
Below is the revenue and EBITDA profile of the company for the past several years, including the consensus forecast for 2014:
It appears the company is merging with another private education player and has a 2013-2017 expected EPS CAGR in the 25-30% range. At about a 15x 2013 P/E that doesn't seem too bad.
Picking the bottom of the top 15 list, Brasil Pharma is basically the Walgreens of Brazil:
Brasil Pharma's revenue and EPS are forecast to grow at 19% and 68% from 2013 to 2014 , respectively. It has an EV/ 2014 EBITDA ratio of 9.5x.
Plucking from the middle of the list we have Diagnosticos da America which "specializes in diagnostic medicine and preventive health. The Company provides services to patients in the area of clinical analysis, specialized tests and image diagnosis. The Company maintains locations in the States of Sao Paulo, Rio de Janeiro and Parana, Brazil. " It is growing it's top line by 10% and EBITDA by 20%, and trades at 8.5x 2014 EBITDA.
I have not done a deep dive on any of these 77 companies, but rummaging through them (I encourage you to do the same) it looks like there are a lot of interesting names with exposure to healthy domestic growth at valuations that are far from stretched - especially when compared to overcooked small caps in the U.S. (disclosure: I am short IJR). Below is the YTD performance by sector for BRF:
The chart below shows that over the past few months BRF has been dragged down along with the large caps - not surprising given the outflows we've seen:
Now for the obligatory Buffett quote: "It's better to be approximately right than precisely wrong." It applies in this case. While there is certainly risk of further losses, domestically-oriented Brazilian companies offer compelling value. At some point (perhaps we are there?) I expect the toxic brew of depressed earnings (for some sectors), depressed multiples, declining currency, and capital flight to go into reverse.
Given a choice between good news and cheap stocks, I'll take the latter all day long. Time to take a deep breath and wade in.
"Be brave. Take risks. Nothing can substitute experience."
- Paulo Coelho, Brazilian novelist
Additional disclosure: This article reflects my personal views only. I have a long position in BRF. All data and calculations presented are accurate to the best of my knowledge but have not been vetted, checked, proofread, or independently verified. This article does not constitute investment or tax advice, and should not be relied upon for any purpose other than entertainment. I welcome comments and or corrections.