Brazilian Value: The Trade of the Decade

Value investing is often described as running towards the fire or seeking out disaster. Often, outstanding returns can be had as the market reverts from total capitulation, to merely bad. In the case of Brazil today, an investor is paying capitulation pricing for prospects that are already better than merely bad.

I believe Brazilian value equities (most of the market) represent one of the best opportunities I have seen in my 15 years of investing.

Background

With the IBOVESPA index trading for 6x earnings, with an 8.5% yield, even the bears acknowledge Brazilian companies are very cheap. Sadly, they will also give a long list of reasons to avoid them and label the country uninvestable- music to contrarian ears.

Since the election of Lula last year, markets have feared a return of corruption on a mass scale and even seizure of assets. This ignores that, despite his strong win in the presidential vote, Lula and his Workers’ Party (PT) allies control only 141 of 519 seats in the lower house. Clearly, any legislation will require working with significant chunks of the centre and right wing parties.

While I don’t want to go too deep on Lula, as the man has been very well documented by many smarter and better informed than me, I am hopeful that his Car Wash history, association with scandal and redemption are more likely to steer his governance in a positive direction.

Further, while many claim to invest with a long-term view, few seem to practice it. I am prepared for my ownership of Brazilian companies to outlast Lula’s presidency, although stocks did extremely well under his previous leadership, ironically.

The above chart (from Crescat Capital) is a breath of fresh air, when considered against the frothy valuations on offer in the US, which currently makes up 65% of the global MSCI index.

Advantages

Like much of Latin America, Brazil has healthy demographics working in its favour. Its current median age of 33.5 years places it well below much of the western world and will ensure a solid, productive capacity for the coming decades.

The country’s geographic isolation and political neutrality are also strong attributes, when the current state of geopolitics is considered. In an increasingly strained global trade network, the ability to deal amicably with all parties is enviable, as is geographic distance from tense borders.

A further economic positive, Brazilian YoY inflation came in at 3.16% in June, after surging to over 10% in the post-Covid environment. A great result for the Central Bankers, who were quick to jack rates up to their current level of 13.75% and wore accusations they were stifling the economy.

Cuts now look set to commence in August, spurring a wave of investment that has been held back for much of the last/lost decade. This would come at a time with commodity exports picking up, a dirt cheap currency and foreign capital almost non-existent.

There is another reason why Brazil’s market should roar this decade, and it is very close to my heart. The Ibovespa is essentially a value index and is priced to do well in the comeback of the “old economy”. The index’s four largest issuers are banks and commodity producers (Vale, Petrobras, Itau and Bradesco) and make up 36% of the composite.

I certainly acknowledge that this industry mix means the Ibovespa will never reach the multiples of other countries containing a large tech component. However, the explosive earnings recovery, that I believe will take place over the next 5-7 years, should more than compensate.

The following quote from Rajiv Jain, of GQG Partners, sums up my views nicely:

“There is a lot of political noise, but just look at the fundamentals: The banking system in Brazil is solid, earnings growth is strong, valuations very attractive. We feel Brazil is a much better way to play China than China directly. Are you bullish on China? Then buy Brazil! You get less corporate governance issues, you receive boatloads of dividends, good growth, very under owned assets.”

The Brazil Value Portfolio

Today I want to propose a equal-weighted portfolio of unusually cheap equities that I intend to track and report on over the next several years. Any suggestions of names I have missed are very welcome. These are all NYSE traded companies, as IBKR doesn’t have access to the local market and I am quite jealous of those that do.

Ultrapar Participaçoes (NYSE:UGP) is one of three large players in the Brazilian fuel distribution industry. The company was mismanaged under previous management, but margins are now on the improve. The company trades at 11x earnings, that should revert meaningfully higher over the cycle, and pays a 3.5% yield.

Despegar (NYSE:DESP) is a busted IPO, having fallen 75% since its 2017 listing. The company is the leading Online Travel Agency in Latin America and would be an ideal acquisition target for a large, western competitor. DESP has, lately, used its significant net cash to buy competitors at distressed prices and trades for 4x projected ‘23 EBITDA.

Vale (NYSE:VALE) is a metals and mining giant and the largest producer of iron ore and nickel in the world. It will be a natural beneficiary of the emerging, global middle class. Capital allocation is a shareholder’s dream, with debt at very modest levels (.4x EBITDA) and a ‘22 shareholder yield of 20%. Vale has bought back over 15% of its outstanding shares since April 2021 and trades for <4x earnings.

Embraer (ERJ:NYSE) is a complex situation. The business scraped through Covid by the skin of its teeth, but is now making meaningful progress out the other side. Embraer manufactures aircraft, with a backlog of $17.5b of work, half of which is commercial aviation. Like so many Brazilian companies, it has fallen over 60% in price in the last decade, since the Real and commodities hit their last peak. ERJ sells for 6.5x projected ‘23 EBITDA and could be a huge winner from foreign capital returning to Brazil.

Assaí (NYSE:ASAI) is a wholesale, self-service supermarket chain that was spun out of Companhia Brasiliera de Distribucao in 2021. The company should continue to benefit from seperation from the troubled GPA franchise. It offers great value to its customers and is growing at +15% pa, justifying a 15x PE.

Companhia Energética Minas Gerais (NYSE:CIG) is a power generation and distribution company with operations across 24 states. Its impossible-to-replace infrastructure and ongoing growth allow it to achieve ROEs of close to 20%. The company is only modestly leveraged and its prefs sell for a bargain 7x earnings and 5x EV/EBITDA, with a 6% yield.

Petrobras (NYSE:PBR) trades for 3x earnings and has paid monster dividends, since recovering from Covid, which hasn’t changed under Lula thus far. The company has vast, low-cost reserves and has voraciously paid down debt in recent years. Readers will know I’ve held PBR for over two years and believe returns will continue to be excellent.

While a special situation with its main asset in Colombia, Companhia Brasiliera de Distribuição (NYSE:CBD) has been underappreciated by the market due to its lacklustre Brazilian GPA operations. Recent interest from private buyers has woken the market from its slumber and started to see CBD move closer to a reasonable fair value. I wrote the company up here in April and see a conservative, fair value at least 50% above current levels.

Telefônica Brasil (NYSE:VIV) remains ignored by the market, trading at 3.5x EBITDA with a 10% yield. The company is net cash and has started buying back some stock, hopefully they do a lot more of this.

Conclusion

In 1982, the S&P 500 traded as low as 8x cyclically depressed earnings. It turned out to be the buying opportunity of a lifetime.

Today, Brazil has all the attributes of a similar investment, with bargain valuations, washed-out sentiment and a battered currency. The country has been in a funk for so long, that the CAPE ratio is mostly irrelevant, with the last decade only comprised of declining profits and economic upheaval.

The returns will likely be worth the wait, for those with the stomach and staying power.

Thanks for reading, I apologise this was a long time coming after promising it in my last post.

Guy

I own shares in Petrobas, CBD and Telefônica Brasil.

As always, this isn’t investment advice. Please do your own due diligence and seek professional advice if you’re unsure about your finances.