Investing in Brazil: After the Hot Flashes

Brazil has been a hot item for a few years now. Normally it is internal issues that produce setbacks in the market. These are issues over elections more often than not.

A perpetual bugbear, ironically enough, was the fear that Lula would get elected. Then he finally gets elected and it is like there is “nothing to fear but fear itself”. Well, not quite, as the thing to fear appears to be hot foreign money. The two pullbacks (we dare not call them corrections) in recent times have both been externally generated and both have at their root the mechanisms of the yen carry-trade. In both instances hot international flows usually attributed the bogeyman hedge funds have retreated in a rush and sent the Bovespa into a tailspin. Neither of these corrections have been lasting. It is not clear if the same money rushes back in when the coast is clear or it is “bargain hunters” exploiting the situation.

This issue has its importance because the bargain hunters may be locals, or at least dedicated LatAm investors at the international level, and they will always be there while if the yen carry-trade finally expires its last (after many false alarms) then some of the fat, dumb (and hot) money that has larded the price of the region’s mega-caps may be gone for good. For the phenomenon of recent years has been one of mega-caps ruling thEarth. The hot money can’t be bothered getting down and dirty on analysis of value stories when the trade is all of the spread between the yen borrowing rate and either the capital appreciation of Petrobras or the frequency (and juiciness) of its dividends. The process is reinforced by ETFs (like EWZ), the emerging market indices and then the ETFs on the emerging market indices.

This self-feeding process vindicates investment in a handful of mega-caps irrespective of their individual growth or earnings virtues. While Argentina and Peru have been the leading growth economies in the region this decade, one would never know it from the indices or ETFs.

S&P Latin 40 – chicken or egg of investor interest

Who needs measures against hot money, like those in Argentina, when one can just escape its evil influence by falling out of favour (or out of sight) of the compilers of global indices? These good people are the gatekeepers who send money cascading the way of the markets and stocks” deemed” worthy of consideration. They would probably argue that their indices follow the money but increasingly in Latin America it looks like these faceless number-crunchers arrange the beauty contest, ogle the contestants and then plant the crown on the head of the fortunate elect.

Much has been made of the hot hedge fund money pouring into Latam. We decided to do a little study and found that dedicated Latin American funds held a mere $1.7bn (about the same size as Fidelity’s old LatAm mutual fund in its early 1990s heyday) and yet the ETF that tracks the S&P Latin 40 Index (ILF) has over $1.5bn in it. Maybe there is other hedge fund money swishing (swilling??) into Petrobras and America Movil but we can be fairly sure this money has never touched ground in Volcan in Peru or San Miguel in Argentina. The Kirchnerite loathing for hot money means that Tenaris is really the only "Argentine” name that can be deemed to have attracted any of this hot money.

We recently had cause to look in more depth at the S&P Latin 40 and its tracking ETF. Maybe some of the investors who dabble in it to the tune of $1.5bn should do the same. Supposedly it tracks forty stocks… a better wording would be 40 series of securities…. for the index is big into double counting. At least in the current version of the ETF, CVRD is two of the 39 securities and Petrobras is four of the 39, so much for Latin 40! Then we have the curious weightings. America Movil is nearly 11% of the index. When one adds in CVRD and Petrobras the three megacaps make up 30% of the Index. What’s the point? These three companies don’t make up 30% of Latin economies; they don’t even make up 30% of their own economies. CVRD and Tenaris (3.3%) are less and less Latin everyday. Repsol is not in the list, when we could make a very good case for it being more Latin than Tenaris.

So anyone tracking this index is going to get themselves, not only a overly large dose of Brazil and Mexico (in the mistaken belief that they are buying a diversified Latin exposure), but also are getting a rather narrow focus on banks in Chile, utilities and State-controlled/directed companies in Brazil with only the Mexican stocks giving some sort of representative exposure to consumers. Then there is mining. If mining is one of the motors of the resurgence in LatAm in the last five years, then all the exposure is in CVRD (RIO), which is zero gold, zero copper and zero silver.

Back to basics – local markets standing on their own legs

So are investors doomed to underperform if they don’t hold the index-dictated megacaps? We think not. The indices and ETFs have made their bed and they can lie in it, but if growth is elsewhere, serious investors do not have to forsake the process. Clearly Brazil’s megacaps, like Petrobras and CVRD, are under the spell of the hot money crowd, but the hundreds of other listed stocks that give exposure to Brazil’s economy will not necessarily languish if foreign money retreats in the wake of the unwinding of carry-trades or other liquidity bubbles that are externally generated. Latin American growth is now not dependent on hot money flows. In the 1990s a dam would not be built or a power transmission line would remain on the drawing board without the foreign flows. In the current decade the money washing into the region has not funded anything but stockbroker’s lunches with clients and houses in the Hamptons and Fairfield County. The money goes, the froth is blown off the beer of some big names. Does CVRD have to languish? No. CVRD can now move, as it should, in lockstep with the price of its underlying commodities. Each retreat from the market by foreigners also reinforces to the longer-term investors that they can trade against the hot money types. It’s pretty easy to see when they are selling with a gun against their head of a rising yen or similar. So you take their stock from them and sell it back to them when they rush back in later. At least that has been the way of “taking candy from babies” in recent years. Eventually the pumps and dumps in markets like Brazil (like those in the London copper market) clear out the feckless. How many times can they lose money before they learn the lesson? One day it will be deemed “too hard” a way to make a buck and the money will be left to another group.

It’s interesting to speculate what this new scenario will look like. If the few megacaps in the region are doomed to fall from favour then by inference the indices that are overweight in these names should underperform the general markets in the region. This is the trend for which we are looking going forward. This makes the recent “no-brainer” investment style, of buying the top five names in the region approach, an anachronism.

Outperformance will go to those investors who go beyond the blatantly obvious. This is virgin territory for many foreign investors as the old value-seeking portfolio managers of the 1990s who ran around the region have been relegated to greener pastures. There was an “ethnic-cleansing” of the Latin portfolio managers at the end of the 1990s which left the field open for the hedge fund players for whom the region was previously little more than exotic palm tree-lined beaches they had seen in the Sunday newspaper travel supplements. Local investors know the sectors where the economic action is.

Though it may appear that most of the action (and money being made) is in chasing the foreigners chasing megacaps, once this distraction is out of the way then the focus turns to real values. As the Argentine market in its splendid isolation post-2001 showed the locals gravitate to quite different names in the market when the game of second-guessing the foreigners investment tastes is no longer a money-earner. How about “growth” and “value” as novel new concepts? So is it possible to outsmart the hot money and find a gem or two in the Brazil market to beat the funds with over the long term? We believe so, even in the hot money world of the Bovespa index, and the way forward is to focus on growth stocks rather than grabbing at today’s market champions.

While having nothing as such against Petrobras, CVRD and the like, options go far beyond the “no brainer” choices of the Brazil market. Embraer (EMBR3.SA), just upgraded by S+P to a “five star buy”, is one that springs out of the pack. The aircraft maker has been reaping the profits from good growth and an increasing reputation for high quality products. Though low on many people’s radar, it is in fact the world 4th biggest aircraft manufacturer with a market cap of over U$8bn and a firm order backlog for their jets that totals U$1.4bn.

Though highly unlikely as a buyout target (due to its status as a “national champion”), further growth seems guaranteed thanks to the rapid expansion of air travel in its native continent as well as expanding into untapped markets currently dominated by Airbus, Boeing and Fokker amongst others. Recently, Embraer has a secured a five firm orders plus five option orders from Italy. The dividend yield of 4.5% adds gravy to an already attractive proposition. Another Brazil play that appeals is petrochemicals and plastics maker Braskem (BAK). Having suffered through the oil price spikes of 2006, the company has adopted an aggressive growth strategy in 2007.

They have signed contracts with both Bolivia and Venezuela to build new plant in the respective countries, have started a wide-reaching (and long overdue) internal campaign to improve quality and efficiency and has recently set out on the acquisition trail, having moved to buy the last independent Brazilian oil producer Ipiranga in a U$4bn deal shared with Petrobras and oil player Ultrapar (UPR) The deal will give Braskem control of Ipiranga’s petrochemical works. Although some analysts such as Merrill Lynch’s Frank McGann are concerned about the medium-term profitability of the petrochemical sector as a whole, we believe that buying BAK at its current low price would be a wise play as BAK are looking to grow 80% in the next three years. As part of a wider portfolio, BAK could be a useful counterweight position to large exposure in the energy sector. A recent upgrade from Bear Stearns also adds weight to the change in BAK’s appeal.

Another sector, another attraction. Oi (ticker TMAR5.SA) means “Hi” in Portuguese and is a telephony business holding its own against regional giants Telefonica and América Movil. Originally known as Telemar, Oi was re-branded on March 1st 2007 to revamp its image and target the youth market in the booming Brazilian cellular sector.

With 15.2 million landlines in service, 5.7 million wireless costumers and 400,000 broadband internet customers, there is a lot of room for growth in this company that covers 65% of Brazil and all major population centres.

Profits that turn around Rs270M (U$130m) per quarter are acceptable, and we would expect Oi to make a big promotional push on the back of their new branding policy to grab further market share. The share performance in recent years has not been stellar by any means, largely missing out on the hot money entering Brazil. With the recent spate of mergers and acquisitions in Brazil, coupled with Carlos Slim’s seemingly insatiable appetite for cellular market share in the whole of Latin America, we feel that Oi is a potential buyout play that will bring all the usual benefits to shareholders.

Decoupling from the unwashed masses

There is more to Brazil than blindly plowing hot money into ETF funds. The 3-month chart below clearly shows the “decoupling” of our examples Embraer and Braskem from the benchmarks of the Bovespa index and Petrobras (PBR). While the cases are certainly different, we would point to the resilience of Embraer through the recent “carry trade correction” and the way that BAK has rebound in far better style than its peers since the jitters of late February. They are by no means the only vehicles we would recommend as good ways to play the continued expansion in the country and region as a whole, rather just two examples of what can be found with a little diligence.

Conclusion

We may have been hypercritical of investment styles in the region in the 1990s but at least there was some semblance of legwork by institutional investors in those far-off glory days. The tendency in the current decade has been “dumb and dumber” with a shopping basket full of megacaps financed by the yen carry-trade. This becomes its own self-fulfilling prophecy both on the way up and the way down. The mutual fund managers that strode the region a decade ago came to a deserved end for not being nimble and for gulping “hook line and sinker” the stuff they were fed at glitzy Cancun conferences that passed for exploratory missions to the “region”.

The new breed doesn’t even cross the Fairfield County line in their hunt for the next play. With that as a strategy, savvy investors should be able to dash under their legs and snaffle value while avoiding the names that are subject to the ramp and dump tendencies that Brazil (and Mexico to a lesser extent) have seen in the last two years.