Steve Rubens'  Instablog

The consensus among many investment advisors is that the economic paradigm that will define the next decade will be characterized by inflation, currency devaluation, commodity appreciation and slow real growth.  Marc Faber accuses the Federal Reserve and other central banks of reckless money printing, Jim Rogers emphasizes that the dollar is a flawed currency, and Michael Pento warns that the U.S. economy has all the elements of a banana republic. 

Most citizens of the developed world derive their salaries from and have their primary residences in their home countries.  They are therefore heavily exposed to weaknesses in their local currencies and economies and must seriously consider the benefits of investing beyond their borders.  A review of the key trends of the new economic paradigm suggests that Brazil offers a valid hedge to potential instability in the developed world:

·         Stagnant Growth in Real Terms: Consumption represents 70% of the U.S. economy and reduced access to credit will continue to curtail the U.S. consumer’s spending habits.  Wall Street may enjoy stock market rallies fueled by low interest rates, but Main Street is unlikely to find a catalyst for growth in real terms.  By contrast, Brazil has a growing internal market with a diversified economy.  Unlike other developing countries, Brazil is not heavily dependent on exports nor are its exports concentrated in a single industry.  Although Brazil is viewed primarily as a commodities producer, commodities represent less than 30% of the Brazilian economy. 

·         U.S. Inflation and Dollar Weakness: Increasing public debt, low interest rates and a rise in the money supply create a threat of inflation in the U.S. and a weak dollar.  Deterred by fears of repeating the 1937 recession, Ben Bernanke has indicated that no change in the Fed’s position is forthcoming.  Meanwhile, Brazil’s difficult past with inflation has created a hawkish central bank which maintains relatively high interest rates.  Though rates have been cut to a historic low of 8.75%, analysts and traders expect rate hikes in 2010.  Such action would not cause panic and cessation of investment as would occur in the U.S. since Brazilians are not conditioned to expect uninterrupted low interest rates.  Brazil is also a net creditor and has a debt to GDP ratio around 40% as compared to above 60% in the U.S.  A look at key statistics of these two major countries of the western hemisphere supports the idea that today’s U.S. is appearing more like yesterday’s Brazil, and vice-versa.   

·         Rising Commodity Prices: An imbalance between supply and demand is leading to higher commodity prices which could exacerbate inflationary pressure in the developed world.  The crisis resulted in the suspension of new projects which will be greatly needed in a few years when demand from the developing world increases.  As an important commodity producer, Brazil should benefit while developed countries suffer from the consequences of rising prices. 

·         Demographic Shift:  The developing world now accounts for 80% of GDP growth as a share of the world total (compared to approximately 40% ten years ago).  Persons over the age of 65 make up over 20% of the population of developed countries (and this is expected to rise to a third of the population by 2050).  The ageing population will dampen growth in developed countries and weigh heavily on fiscal deficits.  In the developing world, persons over 65 make up less than 10% of the population and Brazil’s over-60 population by 2025 is still expected to be below 15%.   

·         Alternative Energy and Carbon Credits: Environmental concerns and the slowing discovery of new oil fields is increasing interest in alternative energy.  Some investors, including George Soros, have argued that this area may produce the next wave of innovation that can reinvigorate the economy.  Moreover, cap and trade systems are spurring investment in carbon offset projects.  The developed world is playing catch-up in the area of alternative energy while Brazil has a fully integrated ethanol program and is a popular location of many carbon offset projects.

In the new economic paradigm, investors should allocate a larger share to emerging markets than in the past.  Among developing countries, those with large internal markets offer the best hedge since they can decouple more successfully than those that are primarily export driven.  Of the few candidates with large internal markets, Brazil offers unique features such as a democratic system, low exposure to international conflicts, a mature free market economy and a history of private property rights. 

Brazil has reached this position of stability by slaying the demons that have traditionally haunted it including dictatorship, inflation, high interest rates, and excessive debt denominated in foreign currencies.  The fact that these ailments are less than a generation old and still fresh in the country’s collective memory have actually immunized Brazil against the current epidemic. 

BRIC markets were once viewed as risky investments but in today’s environment it would be risky not to participate in those developing countries with large and stable internal markets.  There will be fluctuations in the economies and currencies of the developing world and any pull back should be used to gain more exposure.  Jim Rogers frequently suggests that in order to prepare children for the 21^st century they should be learning Mandarin.  Portuguese is easier for most Americans and Europeans and may well offer as much opportunity. 

This year Brazil has outperformed the United States both in financial markets and on the soccer field with a victory in the final of the Confederations Cup.  To understand the future of Brazil’s soccer team you have to look beyond the big names currently playing and study the roster of the under-20 team where up and comers with great potential exhibit their skills.  Likewise, to see where Brazilian markets are going investors should evaluate the country’s private equity and venture capital markets which will produce the market leaders and IPOs of the future.  This is especially true in Brazil where only 500 of the country’s 12 million companies are publicly traded, leaving a large pool of potential stars in the antechamber to public markets. 

Brazilian financial markets have been in the spotlight this year and the enthusiasm is equally strong in the country’s private equity and venture capital markets.  The Emerging Markets Private Equity Association (EMPEA) conducts an annual survey on the plans and opinions of Limited Partners regarding emerging markets.  In the 2009 survey, Brazil was only surpassed by China in attractiveness for investment over the next 12 months.  This represents a move up of two positions from the 2008 survey where Brazil was in fourth position behind China, India and Eastern/Central Europe.  The survey also indicates that Brazil will see the largest increase in net investors over the next 1 to 2 years.  Seventeen percent of current investors in emerging markets private equity plan to increase their stake in Brazil and another 11% plan to enter the market for the first time. 

This positive momentum has occurred as the global economy is suffering one of the greatest crises of the past half-century.  Brazil has been able to weather this economic storm thanks to prudently capitalized banks, large foreign currency reserves, low dependence on exports and a growing internal market.  Luiz Eugenio Figueiredo, President of ABVCAP (the Brazilian Private Equity and Venture Capital Association) and a Partner at Rio Bravo Investimentos, notes that the crisis has had less of an impact on private equity in Brazil because of the reduced role of leverage in the Brazilian market.  He also adds that there remains a large base of institutional investors which still do not have significant participation in private equity.  On average, Brazilian pensions funds currently allocate 2% of their capital to private equity as opposed to the international average of 8 to 10%.  

A beneficial side effect of the economic downturn has been a significant reduction in Brazil’s interest rates which have recently come down to a historic low of 9.25%.  Of the R$1.2 trillion in Brazilian investment funds, 78% is invested in fixed income assets.  The drop in interest rates should now motivate investors to look to alternative assets that can offer a higher rate of return.

The rise in appeal of Brazilian private equity can be attributed to two powerful forces which more than mitigate any negative effect the crisis might create.  The first is an increasingly favorable regulatory and business environment and the second is a diversity and abundance of investment opportunities appropriate for private financing.

Álvaro Gonçalves, Managing Partner of the Stratus Group and former President of ABVCAP, explains that the increase in interest in Brazilian private equity is not a result of a sudden development but rather a consequence of an evolution over the last 10 to 15 years.  Private equity in Brazil began in earnest in 1994 as hyperinflation was brought under control and the industry became regulated by the Comissão de Valores Mobiliários (Securities and Exchange Commission of Brazil) with the introduction of Instruction 209 (focused on Venture Capital) which was later followed by Instruction 391 (regulating Private Equity funds).  The initial years of this newly regulated industry would be fraught with difficulties as contagion from the 1997 Asian flu and wild currency fluctuations hampered growth.  Inexperience and undue aggressiveness in privatization investments also resulted in additional setbacks.  Only recently has macroeconomic stability coincided with regulation and professionalism to allow funds to realize their true potential.

A major step forward was the introduction at the beginning of the decade of a more rigorous public listing standard known as the Novo Mercado.  Companies listed under the Novo Mercado must adhere to strict corporate governance practices, a higher level of transparency, minority shareholder safeguards and GAAP or IFRS accounting rules.  More recently a similar listing standard for smaller companies called Bovespa Mais has been introduced.  These initiatives have reinforced confidence in Brazilian public markets thereby invigorating the IPO market and creating a favorable exit strategy for private equity investments. 

Another legal development is the legitimacy of arbitration as an effective form of dispute resolution in Brazil.  Eduardo Buarque de Almeida, a Managing Director at the Brazilian private equity firm TMG, explains that his firm’s first fund only held majority interests in its investments.  In its newer fund, TMG is more willing to enter a minority position since they trust that they can resolve potential disputes within three to six months, as opposed to being bogged down in the court system.   

Enforcement of financial regulations has also been more prevalent as three corporate executives have recently been accused of insider trading.  Yet, it is not just the threat of sanctions that are resulting in the acceptance of tougher regulations.  The success of companies listed on the Novo Mercado is proving that strict standards result in higher valuations.  Simon Olson, a Partner at the Brazilian venture capital firm DFJ FIR Capital, explains that a “culture war” is at hand between the old way of doing business, based on cronyism and opacity, and the contemporary standards driven by the rule of law.  The high correlation between increasing returns and strict corporate governance is putting into question the antiquated way of doing business.  Of all the BRIC nations, Brazil’s market is now likely the most transparent and regulated, which places the country in a privileged position among private equity in emerging markets.

An attractive legal and business environment is of little value without investment opportunities. 

Many investors erroneously tend to view Brazil as a one-dimensional economy based on commodities.  In fact, commodities represent less than 30% of GDP and there are many other areas where the country excels.  Because of the diversity of industries and the size of the consumer class, many investment possibilities are appropriate for private equity and venture capital funds.

Traditionally early-stage financing is attracted to innovation sectors, such as technology and biotech, which offer significant returns.  However, Olson notes that large emerging markets such as Brazil also offer potential in “low tech” sectors where a high degree of fragmentation can lead to growth through consolidation.  As an example, he offers the Brazilian auto leasing industry which is composed of over 1,000 companies, the largest of which holds only a 12% market share.  Typically, these auto leasing companies purchase a number of vehicles from the manufacturer at a discount, lease them for a period to customers, and then sell them for an amount greater than the initial purchase price.  Since this model benefits tremendously from economies of scale, consolidation can offer impressive returns.

Almeida also sees consolidation as a success story in Brazil.  The first fund of TMG sought to benefit from fragmentation in the area of dental care insurance.  Initially, there were over 700 small dental care providers, none holding more than 3% of the market.  TMG acquired a company with 2% market share that they believed had the best management team.  Through organic growth and acquisitions, the company obtained 30% of the market and completed a successful IPO on the Novo Mercado.

This model can be replicated in countless Brazilian industries including the enormous food and beverage industry.  Although big players such as Unilever, Proctor and Gamble and Sadia are already dominant in the Brazilian market, there remains over 2000 family owned companies with over $100 million in revenue.       

Brazil also offers a number of investment opportunities in growth sectors that are based on innovation.  The country has established a solid reputation as a leader in renewable energy with the most successful biofuel program in the world and huge potential in hydropower and thermal energy.  This has garnered attention from global investors including renowned venture capitalist Vinod Khosla.  

Less well publicized, but also very advantageous, is Brazil’s position as a technology player.  Brazilians have a reputation as early adopters, which explains why the country has among the highest average internet-use time and one of the largest markets for cellular phones.  Brazil also has a remarkably efficient electronic voting system, with 98% of the population voting this way, and the high percentage of internet tax filings (annual federal tax applications also have a close to 100% adoption of the internet as the preferred mean by more than 40 million applicants).  Private financing have deep resources to identify similar technological developments through a base of over 400 incubators throughout the country.        

In an economy as large as Brazil’s, the list of potential investments is endless.  For instance, real estate is also attractive as the government has initiated aggressive funding programs in this area.  Figueiredo notes that in the near-term the sectors with the most potential include sectors that are minimally impacted by the crisis (such as food and beverage), sectors that are not capital intensive (services) and sectors that are traditionally attractive to private equity such as technology and infrastructure. 

There is ample evidence that Brazilian private equity offers promise, particularly at a time when many other countries are more seriously afflicted by the economic crisis.  The difficult question is deciding how to participate in this market and choosing among the numerous investment options.  Currently, over 80% of the available private equity capital is directed toward a small group of 3000 companies with over 1000 employees and over $200 million in sales.  Gonçalves notes that this may create the appearance that too much capital is chasing too few deals.  However, he proposes that a look further down the ladder reveals that less than 15% of private equity capital is targeting middle-market companies with 250 to 1000 employees and $20 million to $200 million in sales.  This imbalance is even greater with respect to capital targeting smaller companies, indicating that the landscape for private equity and especially venture capital is ripe to flourish.  Brazilian private equity may well encounter more challenges ahead but it is clear that the training wheels are off and the industry has sufficient maturity and depth to be relevant on a global scale.

Disclosure: BBD, CZZ, GFA

Brazil’s infrastructure improvement program, Programa de Aceleração do Crescimento (PAC), has plans to fund many projects including a high-speed train between Sao Paulo and Rio de Janeiro.  The Brazilian stock market and the Brazilian Real appear to have caught a ride on this train as they outpace many other indices and currencies.  Whereas, the Dow Jones and S&P 500 are returning to breakeven for the year, the Bovespa is up nearly 37% (and over 75% off its 52-week low) and the Real has rebounded over 12% against the Dollar (the second best performing currency in 2009).  Last month, Dollar inflows exceeded outflows by $1.4 billion.  This is a sharp contrast to last November when $7 billion fled Brazil. 

Part of this relative strength derives from the growing conviction that Brazil is one of the best positioned markets in this crisis (an opinion put forth in my earlier articles as well).  Brazil’s economy has two powerful engines: a growing internal market and a large base of natural resources.  The recent wave of earnings reports has confirmed that the consumer base engine can continue to be strong despite weakness in the export-dependent natural resources engine.  Last week, steelmaker Gerdau announced a drop in revenues of 22% from a year earlier and mining company Companhia Vale Rio Doce reported a 33% drop.  Meanwhile, beverage manufacturer AmBev saw an 11% gain in revenues and Vivo, the cellular phone company, increased revenues by 9%.

Over the long-term the Bovespa and the Real should continue to strengthen against the Dollar, especially when inflationary forces take hold of the US economy and provide commodities with higher values.  However, investors need not worry that the high-speed train has yet left the station.  More weakening events are on the horizon that should provide new dips for interested investors to jump on this long-term opportunity.  Here are some factors that could bring back some turbulence to the Brazilian Real’s rocketing performance:

Central Bank Action

During the last run of the Brazilian Real in 2007 and 2008, the Brazilian Central Bank (BCB) made some attempts to restrain the precipitous rise of the currency but was ultimately unable to rein it in.  This past week, the BCB bought dollars in the foreign exchange market for the first time since last September.  This time their efforts may be more successful as the factors below assist them in achieving their goal. 

Return of Risk Aversion

Since the crisis landed on Brazil’s shores there has been a correlation between weakness in US markets and weakness of the Brazilian Real.  The same fear and uncertainty which brought down US markets resulted in forced liquidation and a re-assessment of risk which dissuaded investors from emerging markets and caused a retreat to Dollar denominated assets.  The current decrease in risk aversion which is raising US markets is the same sentiment behind the flow of funds to Brazil and other emerging markets. 

This may be the first rally since the crisis began that is resulting in panic buying instead of an opportunity to unload bad positions.  This panic buying may continue for some time as it has not yet reached a crescendo but its sustainability is unlikely.  Though there is debate on whether the March lows will be retested, there is a general belief among analysts that more corrections are inevitable as further negative surprises await both the US and Brazilian markets.  The forecast of Brazilian GDP for 2009 by private sector economists has fallen from a retraction of 0.3% to 0.39%.  A return of fear will undoubtedly result in a retreat to the US dollar once again, though over time these retreats should be mitigated by the growing threat of inflation.   &nbs...

Election and Spending

As mentioned in my previous article, the upcoming election may dissuade some foreign investment until a clearer vision of future policy is revealed.  At the end of April more uncertainty was added to the election as Dilma Rousseff, the likely candidate of President Lula’s party, announced that she is battling cancer.  As the election approaches and Lula’s presidency ends, there are many who anticipate that he will conclude his mandate with a wave of increased spending.  The aforementioned PAC infrastructure program, which kicked off in 2007, has recently been joined by new spending initiatives motivated by the crisis, including the low-income housing stimulus package and tax cuts on automobiles and construction material.  An increase in inefficiently managed public spending could negatively impact the Real’s forward movement.

Regional Time Bomb

In a recent World Cup qualifying match, the Argentinean national team suffered a humiliating 6-1 loss to Bolivia, their worst result in over 60 years.  The disaster on the soccer field may soon repeat itself in the country’s economy.  Though the Brazilian economic landscape is far different than that of its neighbor’s, a powerful seismic event in Argentina will inevitably be felt by its major regional trading partner. 

As the global crisis reached a nadir last year, Argentina appeared destined for a repeat performance of its debt-default earlier in the decade.  President Christina Kirchner’s administration was able to avert disaster by selling bonds to national agencies, including the state pension which is now flush with cash following last October’s desperate measure of nationalizing the private pension fund.   

This delay tactic should allow Argentina to cover its $20B in debt and service charges owed in 2009.  The ability to cover 2010 debt is more questionable and beyond that the probability of default increases significantly.  The current $150 billion of government debt exceeds the amount at stake in 2002, exports have been halved and foreign currency reserves are rapidly depleting.  The situation is further aggravated by increased spending anticipated ahead of the mid-term June elections. 

Argentina is following the US’s strategy of taking desperate measures to avoid disasters today without worrying about the consequences in a few years.  This “pay it later” approach is likely to result in inflation for the US in a few years and debt default for Argentina.

A failure of one developing country tends to cause distrust of the entire emerging markets sector even though other developing countries do not share the same economic attributes as the failed economy.  Hence, a debt default in Argentina would certainly have a psychological effect on foreign investment in other countries in the region including Brazil.

Investors should not fight the current positive trend, but, likewise, they should not succumb to the psychology of panic buying, keeping in mind that there are a number of factors waiting to throw a wrench into the current euphoria.  These moments of weakness will provide good buying opportunities to benefit from Brazil’s long-term favorable story.

Disclosure: No Positions