Almost five years ago, I visited Brazil and met with over a dozen companies. My timing wasn’t very good from an immediate investment opportunity perspective. While I was able to establish what would become strong relationships with several management teams, decade-low interest rates and record interest among foreign investors made it very difficult to find great businesses at prices that were materially below their intrinsic value. Well what a difference five years makes! The Brazilian stock market is off more than 30% in local currency (70% in U.S. dollars) over that five- year period and foreign interest in Brazil is at or near a decade low. The chart below shows the EWZ, the iShares MSCI Brazil Capped ETF that tracks Bovespa. It has seen its share count fall by 50% which when coupled with the 70% decline in the stock market in U.S. dollars means that over $10 billion of the $12 billion has been pulled from the Brazil ETF in less than five years.
During the dog days of August, Brandon and I decided to go back and revisit a lot of the same companies, in addition to several new ones. I wanted to share our thoughts on the outlook for the country and provide a case for how we believe patience and readiness pay off over the long term.
The issues Brazil faces today are twofold: political and economic
On the political front, there is a lot of uncertainty with President Dilma Rousseff’s approval rating at 7% (below inflation at 9%!) and no strong opposition. Historically, politicians tend to stay close to the centre. So while people are upset with Ms. Rousseff for breaking her campaign promises, there was never strong opposition to her policies. (They were very popular after all). This creates uncertainty for the future leadership which worries the markets.
It’s clear that the new Finance Minister Joaquim Levy is currently making the decisions, and people view the President as incapable. Mr. Levy so far has proven quite market-oriented and pragmatic about running the government, both on taxes and spending, so we don’t expect the political environment to get worse from here. However, we do need clarity for foreign investors to come back.
On the economic front, Brazil is going through a difficult transition with inflation increasing financing costs, political uncertainty slowing investment and a corruption scandal involving Petrobras hurting industrial growth.
Importantly, large price adjustments have been made in the energy and utility spaces over the past year, where the government was using publically-traded but government controlled companies to manage inflation, (Petrobras lost R$60B from 2011-2014 due to the fuel price being fixed by the former Finance Minister who was Chairman of the Board). These adjustments have added about 250-300 basis points to inflation (now 9%), which in turn has led to high policy rates of just over 14%. Most financing is linked to the policy rate, so we have seen significantly increased cost of capital for corporates and consumers. Low end consumer spending, which depends more on instalment purchases, has been impacted the most. The good news here is that just lapping these price increases should see inflation get closer to the central bank’s target of 6% next year and rates should start coming down.
However, if all else is held equal, we should see some resolution within the next 12-18 months. By the middle of next year, we should have interest rates starting to fall, corruption settlements (already begun) and some form of political certainty. Growth should stabilize, at a lower but positive level, bringing foreign investors back. Huge risks remain, of course – we haven’t seen the bottom in activity and there is risk to further downgrades of federal government debt over the next six months.
Patience and readiness
A consistent belief here at Cambridge has always been to have your shopping list ready as volatility creates opportunity and you never know when you’re going to find the businesses you want to own at the price you want to pay. That requires patience to wait for the fat pitch opportunities when they arise.
A lot of the companies we met with expressed similar thoughts: focus on reducing/minimizing controllable costs; spend money wisely and only when the return justifies the risk; and most importantly always act in long-term shareholders best interests. These same attributes drive successful organizations and profitable investment opportunities here in Canada, the U.S., and in just about any other investable country in the world. Our surprise was in how consistent this message was communicated by numerous companies, reminding us that opportunities are abound in Brazil. What better time to do the work than when the cover of the newspaper says “Recession?”