By Jeffrey Willardson at Pensions & Investments
By now it is no secret that emerging market economies are growing faster than those of the developed world. But elevated growth has not necessarily led to superior equity market performance. In fact, it rarely does. Actually, emerging markets’ strong economic growth profiles have led to increasing worries of inflation and capital flow reversals that have stalled stock market performance.
Brazil is certainly not immune to these risks, but we believe common misperceptions exist that, when properly understood, can create opportunities for equity investors.
More than just a commodity play
Like many EM countries, Brazil is perceived to be a pure commodity or natural resource play. It is true that Brazil is the world’s largest exporter or producer of beef, coffee, ethanol, iron ore and sugar. Increasing the perception, 45% of Brazil’s stock market index — the Bovespa — consists of oil, mining and steel stocks. In reality, however, those same sectors make up just 8% of Brazil’s gross domestic product. The vast majority of Brazil’s growth engine is domestic consumption — Brazil’s services sector makes up nearly 70% of the country’s GDP. Indeed, Brazil is not a homogenous market and economy, as is commonly thought.
Today, Brazil’s domestic sectors are being fueled by significant and powerful forces: increased domestic consumption, high absolute and relative GDP growth, wage growth, low unemployment and continuing educational advances.
While we believe these factors provide long-term tail winds and local investment opportunities, more importantly, we think Brazil is ripe for sector and stock specific differentiation at a time when most developed equity markets battle high cross-sectional correlation.
Dispersion is alive and well
In 2010, the Bovespa was up just 6%, yet there was significant dispersion among sectors. Oil was down 19% while health care and beverages, both domestic-oriented sectors, were up 98% and 58%, respectively. Additionally, the Bovespa Small Cap index, dominated by companies that rely on consumer spending, jumped 23%. Analyzing emerging markets’ equity performance over time, large dispersion has been common — in the information technology sector for example, the 10-year compounded annual growth rate of the best-performing stock was 89% vs. -27% for the worst stock. We expect dispersion to continue to be pervasive in emerging markets, and in Brazil in particular, indicating that fundamental stock picking and the ability to tactically allocate long and short are attractive strategies to take advantage of investment opportunities. However, investors should be cautious that dispersion can lend itself to sector rotation, as we have seen so far in 2011. Therefore, those investing in Brazil should be macro-aware and nimble.
Local appetite for equities in Brazil is increasing
In many ways, the equity culture in Brazil is substantially underdeveloped. For the past 30 years, with interest rates hovering north of 20%, Brazil’s local market has been dominated by fixed income and cash. The appetite for risky assets (e.g., equities) has been very low and when market disruptions arise, like in 2008, local investors tend to sell equities and revert to the safety of fixed income. This trend is very evident when analyzing Brazilian pension funds, whose average exposure to equities is a mere 16%. But as interest rates have come down in the past five years to their current level below pension funds’ benchmark returns (the majority of plans actually guarantee such a return), local pension fund investors have been looking for alternatives to enhance performance. In September 2009, the regulatory authority — the National Monetary Council — passed a measure that allows pension funds to invest up to 70% of their assets in certain domestic equities (an increase from the prior limit of 50%). PAAMCO analysis indicates Brazilian pension funds alone, with nearly $250 billion, could allocate an additional $50 billion to local equities in the coming years. We believe this potential demand and shift in attitude toward equities could create additional support for local Brazilian shares as well as buffer the often more volatile external capital flows from global investors.
Despite the run, equities are still attractive
A common perception in Brazil is that equity investors have missed the run. Yes, Brazil has enjoyed significant stock market performance over the past decade, but scratching below the surface reveals some interesting points of consideration.
As previously mentioned, the Brazilian stock market is dominated by commodity exposure. The two largest index holdings are PetroBras (oil and gas) and Vale do Rio Doce (iron ore), which make up approximately 30% of the index. When these two names are stripped from the index, the performance of the Bovespa is still impressive, but the run-up is not nearly as severe. In our view the ex-commodity exposure in Brazil (i.e., domestic consumption) is often overlooked and still provides attractive opportunities.
Just as important as understanding the past is recognizing where we are today. Current valuations in Brazil are a very important determinate of the success and direction of a go-forward equity strategy. The MSCI Brazil is currently trading at a 10.3 times forward p/e ratio (12 months), which is a discount to the five-year average of 11.4 times. This is also cheaper than global, emerging markets and Latin American equities. Company-specific earnings growth is expected to be strong over the next few years, which suggests that a net long equity strategy in Brazil could be attractive.
Misperceptions aside, the risks are real
As the first quarter of 2011 ended, Brazil consumer prices rose through the official target range for the first time in six years (currently 6.5% year over year). As a result, the central bank raised short-term rates to 12%, which is the third increase this year. Credit growth also has been accelerating and the government has adopted several measures to curb the rapid appreciation of the real, including taxes on purchases from foreigners of local fixed income and equities. These evolving risks, along with potential outflows from Brazil by foreign investors and the proper integration of the new Brazilian president, are important considerations when implementing successful investment strategies in Brazil.
Jeffrey Willardson is a portfolio manager in the portfolio solutions group at Pacific Alternative Asset Management Co. LLC, Irvine, Calif.