EWZ: Brazilian Equities Are Undervalued
Summary
- Brazilian equities might be undervalued; in any case, high returns are on offer.
- A key risk is the USD/BRL exchange rate, which is likely to worsen (i.e., appreciate), given Brazil's poor current account.
- Nevertheless, provided Brazilian corporates are able to deliver real earnings growth as projected, EWZ should be able to perform better into the future.
- Even a mild, unexciting scenario, EWZ's returns could firmly exceed 15%, with returns of over 20% per annum also possible if/as inflationary pressures begin to subside over the next few years.
Erich Sacco/iStock via Getty Images
iShares MSCI Brazil Capped ETF (NYSEARCA:NYSEARCA:EWZ) is an exchange-traded fund that is designed to track its benchmark index, the MSCI Brazil 25/50 Index. EWZ offers exposure to mid- and large-sized Brazilian stocks.
As of January 3, 2022, EWZ had net assets under management of $4.68 billion, with an expense ratio of 0.57% (not cheap, but roughly in line with other country-specific funds, especially funds geared towards less developed markets like Brazil). As at the same date, EWZ had 50 holdings, and the top 10 holdings represented about 58% of the fund as of recent.
(Data from iShares)
In terms of sector exposures, Brazilian stocks are naturally over-weight Materials, Financials, Energy, and Consumer Staples (these together making up about 75% of the fund at the start of 2022).
(iShares)
You could argue Financials stocks are a broader (albeit lower return on equity) bet on the wider Brazilian economy. Materials and Energy are both pro-cyclical and are both likely to remain subject to global commodity demand and price volatility. Consumer Staples are a local, safer, but also less exciting bet on the Brazilian consumer. Staples stocks are traditionally viewed as "defensive", not growth-oriented or economically sensitive.
I was neutral on EWZ in January 2021, and to date, EWZ has fallen over 20%, although the total return is not so bad, with a negative return of about -15%. The S&P 500 (excluding dividends) has increased by 24.53% over the same time horizon according to Seeking Alpha. So, I was right to be at least neutral, but I thought it would be worth revisiting. On a trailing one-year basis, flows into EWZ have been negative, but as we can see, more recently flows are positive as investor interest is picking up in EWZ.
EWZ tracks an index that is based on a 25/50 framework, which is to say that no single issuer should represent over 25% of the fund, and all 5% weightings should together not exceed 50%. Since there is a lack of data on the 25/50 version of the MSCI Brazil Index, we will use the regular factsheet for forward data; the two indices are quite close in any case, by their constituents and weights. MSCI Brazil Index reported a trailing price/earnings ratio of 5.63x as of November 30, 2021, a forward price/earnings ratio of 6.97x, and a price/book ratio of 1.72x.
Dividing price/book into forward price/earnings, we get an implied forward return on equity of 24.68%, which is very strong. However, bear in mind that Brazil's local annual inflation rate is currently running at well over 10%; we will capture this risk when calculating the cost of equity next (inflation will be accounted for under local "risk-free" rates, i.e., the 10-year government bond yield in this analysis).
Professor Damodaran's current recommendation for the mature market equity risk premium is 4.77%. As of July 2021, Damodaran also offered a country risk premium of about 2.50%. Adding the two figures, we find a local equity risk premium of 7.27%. The current Brazilian 10-year yield is currently running at about 10.855%, similar to current annual CPI (the inflation rate above, of 10.74% in November 2021).
So, our cost of equity is quite high, hence why the price/earnings ratios are very low for Brazilian stocks (per the MSCI index figures offered earlier). Our cost of equity is 18.125%.
For earnings growth rates beyond year one (i.e., beyond forward results implied by our forward price/earnings ratio), three- to five-year earnings growth rates are estimated at 20.66%. Even if local CPI keeps running at a high rate of over 10%, this still implies strong real earnings growth rates. I arrive at the short-term valuation gauge below by assuming 20% earnings growth after year one, but falling to 10% by year five (i.e., I am trying to assume a normalization of inflation and thus the real earnings growth rate).
(Author's Calculations)
In this case, EWZ looks undervalued, with 30% upside potential. As a sanity check, I used Morningstar's alternative forward price/earnings ratio for EWZ specifically of 7.28x (as of December 30, 2021) and assumed only 5% earnings growth from year two onwards (i.e., a rapid normalization of inflation, as well as effectively close-to-zero real earnings growth by implication; Brazilian CPI has in the past coasted at 5% per annum in any case). In this unexciting scenario, downside is projected at about -10% (on valuation).
But, I think the answer lies somewhere in the middle, between -10% downside and 30% upside. What this really means, is that the implied cost of equity is somewhere between 16.50% and 22.8% (according to my calculations; to solve for the valuation in these different scenarios). While 16.50% might be below our base cost of equity estimate of 18.13%, it is still high. Meanwhile, a cost of equity of 22.80% would entail a surprisingly good outcome. But regardless, the implied returns are high, and so I would say EWZ looks attractive.
Of course, there is risk in the exchange rate. USD/BRL has appreciated since my last article, which has helped to depress the price of EWZ.
(TradingView)
However, using The Economist's PPP-adjusted Big Mac Index, the Brazilian real is possibly still overvalued.
Also, it is worth noting that the Brazilian current account has been back into a deficit recently, which suggests that the currency would need to depreciate further in order to restore balance (or for the country to achieve a surplus).
On the other hand, Brazil has managed to achieve current account surpluses in some months since the emergence of the pandemic. It is possible that USD/BRL will remain underneath the recent ceiling of just under 6.00 (above the current market price of about 5.70). So, there is a good chance that forward depreciation will not exceed 5% on a 6- to 12-month basis. And that is safely underneath our implied cost of equity in our valuation estimates.
I am however seeing expert forecasts for Brazilian inflation to settle quite quickly, down to even below 5% over the next few years.
(National Institute of Economic and Social Research)
There is every chance that Brazil's real earnings growth rates, even at the currently high fair cost of equity for Brazil, will justify EWZ's valuation, and support a firmer USD/BRL exchange rate going forward. I would still err on a stronger USD/BRL rate (i.e., a weaker real, owing to the poor current account deficit). However, I do think there is a good chance that further USD/BRL appreciation will be limited, and thus not bad enough to hurt EWZ shares.
While investing in Brazilian equities might be risky, I am cautiously optimistic and, due to the high returns implied at this juncture, bullish. However, because of the risks involved, I would not recommend a high allocation to Brazil.
What's Changed
Since my last article, what's primarily changed is the price, relative to forward earnings as projected by consensus analyst estimates. Before, the forward price/earnings ratio was 12.55x; according to the same data provider in this case (Morningstar) the forward price/earnings ratio is 7.52x. Meanwhile, with inflationary pressures having heated up, sentiment is poor, which has led to front-loaded ETF outflows (which probably helped to depress the price).
Admittedly, the Brazilian 10-year yield is also higher, at about 11% today as compared to around 8% in my last article, yet this still gets factored into our cost of equity. Given earnings are expected to grow at a strong clip even after high inflation rates, EWZ can justify its valuation. Without significant further depreciation in the exchange rate (I have argued further depreciation is probably bounded), implied returns could be in the region of 16% to 23% as noted earlier.
This article was written by
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