EWZS: Look For A Buying Opportunity Later In 2023
Summary
- Emerging Markets, in general, and Brazil, in particular, are trading at extremely low P/E multiples in the context of the last two decades.
- Brazilian stocks are cheap for many reasons; but this may not warrant such a large discount. It may lead to a bullish run like in the early 2000s.
- Poor sentiment is seeing Brazilian stocks likely in a bottoming-out pattern. Yet, later this year might present a better entry point, given the challenging outlook for commodities this year.
- The iShares MSCI Brazil Small-Cap ETF has less concentrated bets on commodities versus the MSCI Brazil Index. It may provide good risk/reward and diversification for one’s portfolio.
Edson Souza/iStock via Getty Images
iShares MSCI Brazil Small-Cap ETF overview
The iShares MSCI Brazil Small-Cap ETF (NASDAQ:EWZS) was launched in 2010, offering investors exposure to the MSCI Brazil Small Cap Index. It now has assets of approximately $90 million, and the expense ratio is 0.58%.
It currently consists of 98 holdings, with the largest weight representing no more than 5% of the fund. Sector wise, the largest weight is the industrials categorically at about 20%. It can offer more diversification compared with the main MSCI Brazil Index, which has circa 21% sector exposure to materials. Although there is more diversification with the EWSZ ETF in that respect, one must weigh up the riskier nature of the smaller capitalized stocks it holds.
Performance numbers up to April 30th are below, so keep in mind there have been some strong gains since then. Despite that though, the numbers will not paint a good picture since inception in 2010.
ishares.com MSCI Brazil Small-Cap ETF data as at April 30, 2023.
The same could be said for various other emerging markets where the 2010s were a decade to steer clear of that asset class.
Are Brazilian stocks cheap in 2023?
For those that prefer quantitative analysis, the graphic below (calculated from data since January 2000), indicates yes. We can see that many of the key Latin American emerging markets are driving a lot of the overall cheap value signal within EM. Note below Brazil is second from the left in terms of value.
Excludes UAE, Qatar, Saudi Arabia and Kuwait due to limited data history. 1The z-score is a measure of how far valuations are from historical mean, calculated since January 2000. (Schroders, Refinitiv Datastream, MSCI, IBES, Schroders Strategic Research Unit. Data as at 30 April 2023.)
Many will point out that Brazil is cheap for good reason. Common points made are the market’s large weight to commodities, political instability, higher inflation / interest rates etc. Yet it is important to realize that their market currently is not just at low outright P/E ratios. It is also at a relatively low point on such metrics compared to averages over the last 20 plus years. Yet are these typical reasons for Brazil stocks being cheap particularly more relevant today?
Surprisingly in this context, the last couple of years has seen a return to favor of global commodity equities, but Brazilian stocks remain relatively depressed. This is in contrast to when Brazilian equities performed strongly during the early 2000s commodities bull market.
Whilst there are many critics of leftist President Lula, at least the election is behind us now, given financial markets hate uncertainty. It is also interesting to note that Lula was the leader for the period of 2003-2010, which also spanned that good run in Brazilian stocks I just referred to from around 2003- 2008.
On the inflation / interest rate front, for sure Brazil has far higher interest rates than many developed countries. Encouragingly though they actually have positive real rates. That is a sign they have had in place monetary policy settings over the last couple of years that should drive down inflation.
Will emerging markets like Brazil ever outperform?
There is a tendency for investors to suffer from recency bias when the possibility of investing in emerging markets and / or Brazilian stocks are mentioned. As it often does, the timeframe chosen matters when drawing conclusions on historical data. Whilst in the last decade or so it feels like EM never performs, if you go back to data from a bit more than two decades back it suddenly looks different.
Morningstar direct via wasatchglobal.com
You may notice the above table breaks the categories into small and large caps, and uses the more broader Russell indices for the U.S.
As I am reviewing the small cap Brazil ETF in particular here, it is encouraging to see the small cap EM segment on top over the longer time period.
A key contributor to EM outperforming in the 2000s was in fact Brazil. Will we see the pattern repeat itself in this decade, with the political leadership recently replicating what was in place back then?
Bloomberg
The 2020s might share some similarities to the early 2000s when EM & Brazil stocks were in a bull market. Like back then, we are coming off a period of decade long underperformance in certain investment themes. For example, the 1990s were not good for EM, commodities, “value” compared to “growth”, precious metals, foreign stocks vs US.
Likewise in the 2010s, those investment themes were generally a terrible place to be. Last year though was characterized largely by a reversal of such themes, which perhaps mark the beginning of a long-term trend.
Will commodities continue to rise in the 2020s?
I am skeptical however about the prospects of commodities providing the same sort of tailwind to Brazilian stocks this time around, particularly in the short term. In President Lula’s previous terms, the backdrop was a major infrastructure boom in China and related commodities demand. It may have been more good luck than anything with that particular bull market.
Having said that the argument that the supply of commodities will disappoint in the years ahead due to a long period of under investment has some merit. In that respect there are some similarities to how things looked at the end of the 1990s.
At the present time global growth appears to be slowing thanks to the typical time lag of so many global central banks aggressively tightening monetary policy in the last 12- 18 months. For that reason, I am somewhat hesitant to step in right now and accumulate exposure to Brazilian stocks.
Brazil interest rate history a key factor resulting in low p/e ratios
Prospective investors in the Brazil stock market should rightly be concerned about the nation’s historical record on inflation. A trailing P/E ratio of circa 5 times in the last year for the whole market sounds cheap, but very high interest rates can mean that is not the case.
Likewise, a related issue for foreign investors is currency risk. Large potential gains in nominal terms may not be so attractive if accompanied by severe declines in the nation’s currency.
Once again whilst these are certainly issues to be very mindful of, I am not sure they present more of a risk to Brazilian stocks that has typically been there for the last couple of decades. That is, do these issues warrant Brazilian equities to be trading at the valuation low points of their typical range?
After all, they have already acted decisively to contain inflation. Inflation is also not dramatically different to what we have seen in developed nations in recent times.
Brazil central bank, national statistics agency, Bloomberg.
For sure inflation has been uncomfortably high, but what stands out on the above chart is that real interest rates are positive. Monetary policy is clearly restrictive, which at least should provide a bit of comfort to investors that they will win the battle with inflation.
It does, however, make one wonder if it spells trouble for the economy ahead in that they have tightened too much.
The above chart also in my mind makes the low P/E of the market less enticing. In the back of my mind are reasonably low P/Es in other frontier / emerging markets where the inflation / interest rate backdrop is more normal. A couple of markets that spring to mind I have previously discussed on Seeking Alpha. For example, Vietnam stocks where the forward P/E is at a historical low point, and South Korea where P/Es are typically low and corporate governance appears to be on the improve.
Brazil economic outlook 2023
Although I have highlighted the concerning inflation history of Brazil, the country does have a few things going for it in terms of fundamental strength. If they will not benefit as much from the commodity story led by China infrastructure spending like in the early 2000s, they still have agriculture as another potential tailwind.
They are currently enjoying a strong trade surplus that is improving and agriculture is playing a significant role in that. This remains a structural growth story that is still in place today.
USDA, Economic Research Service using data from U.S. Department of Commerce, Bureau of the Census, via urs.usda.gov. 
Should Brazil be successful in bringing interest rates down soon from current levels, that would bode well for bringing down their fiscal deficits and winning back confidence from global investors.
I have highlighted how over a long period of time agricultural exports are now making up a much larger share of overall exports. There is no escaping, however, that other commodities such as iron ore still play a major role. In regard to this I see some risks there and am cautious about acquiring Brazilian equities over the next few months.
Are Brazil and China ditching the US dollar?
There has been plenty of publicity over whether the likes of Brazil and China will move away from the US dollar, however, there simply seems to be a lack of creditable alternatives in the foreseeable future. If this issue itself is not seen as a major influence on markets in the short term, well it is possible that Brazil strengthening ties with China might be unnerving some global investors. As much as investors may not like such developments, everything has its price and Brazilian stocks are at extremely cheap valuations. They therefore could represent an attractive non-correlated bet to other risk assets.
For instance, for those investors that have concerns over the US dollar, and geopolitical risks generally in the world, a small position in Brazilian stocks may have some merit. They offer exposure to hard assets, very cheap banking sector, and perhaps can manage to remain relatively neutral if we get escalating geopolitical tension in the world. Another way to think of it is a potentially uncorrelated bet in an “all-weather” type portfolio.
Ironically, even before last year’s election and uncertainty, there were articles discussing Brazil as a safe haven of sorts. That may sound like a stretch to many, but a key point is it gives exposure to different attributes. A country with higher real interest rates, trade surpluses, attractive valuations and more neutral “official” foreign policy can appeal to many global investors.
Brazilian small caps vs large caps
I don’t want this article to overemphasize too much why I am focusing on the Brazil small-cap ETF versus the larger iShares MSCI Brazil Capped ETF (EWZ); however, it is important to note key differences. I primarily refer to the MSCI Brazil ETF having approximately 21% exposures to materials, and in particular about a 15% weight in Vale S.A. (VALE).
In contrast you can see the more modest largest stock weights and sector bets of the Brazil small cap ETF below.
ishares.com MSCI Brazil Small-Cap ETF data as at May 19, 2023.
Personally, I prefer not taking such concentrated bets. I do concede though the extra risk in the sense of gaining exposure to an ETF with much smaller companies. The 20-year data I included earlier that had EM small caps ahead of large caps might offer some encouragement. The small cap ETF in this case offers more exposure to the consumer sector if that interests you more. Despite the Brazil stock market’s recent bounce, you can see below the valuations here still look tempting.
ishares.com MSCI Brazil Small-Cap ETF data as at May 18, 2023.
Conclusion
When Brazilian stocks are mentioned as an investment idea almost instantly the well-known risks are sighted. High inflation, political instability, budget deficits, social unrest have all made the headlines with Brazil over the last year or two in particular. Issues that are well known to flare up for emerging markets investors generally but are also lurking in developed economies to some extent.
At least with the Brazil stock market it is priced at such levels where it could be in the process of forming a major longer-term low. It is interesting to observe the solid YTD performance amidst such negative headlines, which can often occur when a market is bottoming out.
That being said I would be cautious about jumping in right now due to the cyclical nature of Brazil’s economy. Some of the fallout of their interest rate hikes, and also that of their trading partners, may still be ahead of us this year. The last couple of months the Brazil stock market looks a little over bought in that context. I see therefore the Brazil small-cap ETF as more of a potential buy on any weakness seen later this year.
This article was written by
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