A reader recently wrote to me with some great questions concerning the interplay of Brazil's politics, economy, and investing environment. I want to share that letter and my reply with you.
Richard: Bom Dia(that's my best Portuguese). just read your Brazil "stimulus " article in SA and learned you live in Brazil. Would you mind if I ask you a question? PBR is looking very cheap at current prices and I'm thinking of purchasing some ADR's..., but I, along with many others, am troubled with Dilma Rouseff's socialist agenda. I suspect that this agenda plus some recent actions on her part are the cause of many of Brazil's finest companies selling so cheap. With those issues in mind..., what's your advice?
Well, those are excellent questions. I'm a stuffy old capitalist myself but I have no objection to taking socialist benefits like free medical, and free transportation now that I'm a senior, just so long as its not my money being spent! Many people (socialists) decry me for living this hypocritical life. But it is not hypocritical at all. Socialism could be very nice if it weren't for the fact that most people are just like me and prefer to take from the system than to pay into it so others may take from us. This is the fundamental reason it either fails completely or suppresses productivity and creates a culture of under performance.
Brazil, as much of the world and certainly all of S. America, has been moderately to highly socialistic for a long time. Part of this derives from their old European Latino, Colonial, and Catholic cultures. Government and the church have long provided for the basic needs of the people here. In fact, government and the church are so close that it is sometimes hard to find where one ends and the other begins. It is property tax month here in Brazil. The "pagamento de carne" - literally translating to "payment of the meat". This is an interesting idiom which probably goes back to colonial days when Brazil's main function was supplying meat and hides to Portugal and tax probably was literally paid in meat. My tax bill comes with a breakdown of where the funds go. About 30% of my taxes go directly to the Catholic church. I am not sure if that's because its the official religion of the nation or if its because the church originally owned the land here on which my home is located (our church is 351 years old and probably owned all the land it could see from the rocky outcrop it sits high upon).
Anyway, to get back to modern times ...
Because the government owns the mineral wealth, they get huge royalties from the oil, gas, iron, phosphates, gold/silver, etc. This funds much of the socialist program without them having to resort to class warfare taxes on business and people. That's not to say taxes don't exist. Remember though, the United States has one of the highest corporate tax rates in the world at 35%. Its effective rates of 23% to 28% place the U.S. second only to Japan as the highest taxes on the globe. Brazil has a corporate tax rate 34% with an effective tax rate at 24% (matching the lowest end of effective U.S. rates). Tax revenues together with the nation's natural resources income from royalties and carried working interests amply fund the country's cradle to grave medical; primary education; university; trade schools; infrastructure projects; security police; and military. These socialist foundations, taken together with work rules, price subsidies and price regulation for some domestic services such as electricity and fuel, create an environment that has lower wage demands. Overall the complex interrelationships of the culture, political, tax, workplace, and social regulations make head on head comparative costs between Brazil and the United States difficult. Brazil is cheaper to live in and has a larger middle class percentage. That middle class controls a greater fraction of the national wealth than its U.S. counterpart and is growing in size and disposal income rapidly. Conversely, the U.S. counterpart is shrinking and seeing their wealth gap widen.
Corporate Tax Rate
|Statutory % Effective Local Multinational|
|Sweden||28 % 10 % 18 %|
|Switzerland||21 % 17 % 19 %|
|Canada||36 % 14 % 21 %|
|China||25 % 22 % 22 %|
|Australia||30 % 22 % 22 %|
|France||35 % 25 % 23 %|
|Germany||37 % 16 % 24 %|
|United Kingdom||20 % 20 % 24 %|
|United States||35 % 23 % 28 %|
|Japan||40 % 37 % 38%|
Petrobras is if anything stimulated to work all the harder since the government is both a part owner and the royalty holder for its domestic production. In that regard, socialist spending does not get in its way, it is the engine that makes the socialism possible.
Brazil's economy is highly protectionist. There is basically a 100% import duty on any goods imported. Many key goods are not even allowed to be imported - cars and boats for instance. This results in offshore industry having to manufacturer in country - creating jobs and a secure industry. For example, Brazil in fact is a global car and small commercial aircraft exporter.
The government is also still highly bureaucratic (part of the Latino/old Europe/colonial culture. This adds to the business environment being complicated and non-standard, as much captive to the whim of the bureaucrat you are dealing with on a given day as it is to the complex, overlapping, contradictory, and often ignored laws. These factors all work to greater and lesser degree to suppress business productivity and its relative valuation metrics compared to more American and Pacific rim standards.
Currency "wars" is another major issue in the performance of Brazil's markets the past several years. Brazil is a creditor nation and also attracts far more foreign investment capital than is healthy. In fact, the government for several years has had a program to tax the important of foreign investment capital. This program is suspended right now as the economy as softened and they are able to control inflation (well controlled but always the fear in the closet after the nation's history of hyper-inflation a couple of decades ago). At its height, the tax on foreign capital was a full 2% ! Even now in the softer economy, interest rates are used by the government to hold down inflation and guide economic growth. Those borrowing rates typically are in the double digits, often upwards of 20%. These measures are not government's effort to squeeze another dime out of business. Rather, they are efforts to manage and limit the overly rapid growth of the economy. It is a nice problem to have. One the USA has not experienced for over a generation now.
Currency wars are a big issue for Brazil. The US has historically been its largest trading partner. Only recently replaced by China, the US still represents a very major trade partner for both imports and exports. Both China and the US have pursued policies of keeping their own currency weak for over a decade now and the US continues to follow weak dollar policies (expansion of money supply, monetarization of debt, low interest rates, etc). These policies have several negative economic effects on other nations in general and Brazil in particular. Such use of monetary policy distorts true exchange rates based on supply and demand parity relationships and simultaneously makes U.S. exported goods and services artificially cheap due to the weak dollar exchange rates while conversely making the exchange rate price adjusted Brazil goods and services more costly in the U.S. and thus suppressing U.S. demand for them. Effects of the monetary policy have a secondary follow-on effect also. Low U.S. interest rates make the higher rates of Brazil an attractive place to park cash. Brazil's bank interest rates of for deposits is currently in the 6% to 12% annual yield range. These rates arise in part from government policy targeted to controlling inflation. They have a contrary effect however of making the nation an attractive place to park capital for its high bank yields and thus fueling inflation. The foreign capital import restrictions and tax is part of how this dichotomy is addressed. As you can see, currency policies and issues can quickly become very complex and are subject to unintended consequences. Another way currency exchange rates have a subtle effect is in stock market performance metrics. When Brazil's currency appreciates 70% against the U.S. dollar, as it did in the late 2008 through mid 2011 period, even a flat performance domestically in Brazilian Reals shows a 70% growth performance when measured in U.S. Dollars. Conversely, falling exchange rates create the opposite effect.
As to specifics for Brazil, its a long term investment, and a bumpy ride. I personally like the electric utilities. They pay some very nice dividends. The dividends are a bit erratic in their size and growth, largely due to the currency exchange rate fluctuations, but overall on a strong up trend. Utilities are growing with expanding areas served, density of population, upward economic trends of the population and its living standard, and very favorable trends in long term currency exchange rates vs. the USD. Government does directly and indirectly limit the utility prices in some ways, but still has allowed for a stronger growth environment than most nations, including the USA.
I will work on an article about the business environment and investing ideas for Brazil once I plan out a way to do so with a set of clear and actionable opportunities that naturally fit into it. SA editors are very insistence that every article be focused on actionable recommendations. In fact, my Brazil tax stimulus article was forced through 4 major rewrites to meet that demand.
These observations just touch the surface of a very complex set of issues. I hope they give you an idea of some of the factors an investor must consider when assessing the enviroment of a foreign based business investment.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.