It’s shaping up to be a lousy year in Brazil. Social strife is rising, the central bank is raising rates to stave off resurgent inflation, and the country’s leading export market—China—is pulling in fewer imports. No surprise that investors are heading for the exits, with Brazil’s Bovespa stock market index down roughly 25 percent in 2013.
The sharp drop in Brazilian stocks is starting to catch the eye of value investors. “We had been cautious on emerging markets in general, and Brazil in particular,” says Alec Young, S&P Capital IQ’s global equity strategist. “But with better valuations in place, we’re becoming much more constructive.”
Brazilian stocks weren’t especially pricey when the year began, and the subsequent plunge has opened a widening gap in terms of relative valuation. Analysts at JP Morgan note that Brazilian stocks trade at 8.6 times projected 2014 profits, compared a multiple of 14 in the U.S. and 16 in Mexico, Latin America’s other major economy.
The Mexico analogy is apt. Ed Kuczma, an investment analyst who follows emerging markets for Van Eck Global, believes that over the long term “you’ll see higher growth in Brazil over Mexico, in part because consumer spending forces in Brazil will be more powerful.”
But the outlook for 2013 remains challenging as Brazil deals with a stubbornly high 6.5 percent inflation rate. A hike in interest rates is the only readily available tool to curb inflation, but rate hikes are actually a positive for many investors. “Higher rates give credibility in the inflation fight, which is important for global confidence,” Young says.
Also of concern for investors is the government’s heavy hand when it comes to taxation of resource-focused multinationals. Oil giant Petrobras, for example, has proved to be a poor investment in recent years in part due to periodic massive tax levies that caught investors off-guard. Petrobras may also be facing a further $3 billion tax bill to resolve a dispute regarding asset sales that took place a decade ago. (The company recently obtained an injunction to allow for further judicial review).
In the power generation sector, leading Brazilian utilities such as Companhia Energética de Minas Gerais S.A saw their share prices plunge last summer when the government mandated deep price cuts in power prices.
Two Brazils
It’s crucial to distinguish between the two pillars of the Brazilian economy: commodity exports and domestic consumption. While Brazil retains its role as one of the most dynamic global producers of natural resources, slumping commodity prices imply a down year for many major exporters such as Vale. “Until China rebounds, Brazilian exports are likely to remain under pressure,” says Van Eck’s Kuczma.
Investors need to pay attention to the domestic economy, which remains a solid long-term growth story. “There has been an ongoing trend towards wealth creation across all social classes,” says Bruno del Ama, chief executive officer at Global X Funds. “The purchasing power keeps on expanding, which is generating very positive long-term dynamics.”
The still-robust Brazilian consumer explains why Brazilian companies are expected to boost profits at a double-digit pace in both 2013 and 2014, according to JP Morgan.
There are a handful of ETFs squarely focused on Brazil’s rising middle class, eschewing the drag associated with export headwinds. Todd Rosenbluth, director of ETF research at S&P Capital IQ, is a fan of the iShares MSCI Brazil Small Cap Index (EWZS). “It’s a more direct way of profiting from the domestic consumer growth,” he says. The ETF sports a 0.60 percent expense ratio and has roughly two-thirds of its portfolio in Brazilian consumer cyclical firms, real estate firms, and consumer defensive firms.
The fund was launched in September 2010 and has had a somewhat rocky history, slumping by more than 20 percent in 2011 and again in 2013, but rising more than 20 percent in 2012. Since inception, this fund has fallen 22 percent, compared to a 52 percent gain for the SPDR S&P MidCap 400 ETF (MDY), a proxy for a similarly-focused U.S. portfolio.
But Brazilian stocks are now so much less expensive than U.S. stocks. The 3.9 percent average dividend yield on the Bovespa, for example, is nearly twice as high as the yield on the S&P 500.
Equally important, Brazil may be poised for an economic rebound. A recent Reuters survey of economists found expectations for 3.5 percent GDP growth in Brazil next year, compared to 2.9 percent projected GDP growth this year.
“Consensus forecasts are looking for a re-acceleration in profit growth in 2014,” notes S&P’s Young. Brazil is expected to benefit from a drop in inflation back below 6 percent, which may enable the central bank to reverse recent rate hikes.
To capitalize on the long-term growth trends in Brazil, Global X launched three targeted ETFs in 2010: The Global X Brazil Consumer ETF (BRAQ), Global X Brazil Financials ETF (BRAF) and Global X Brazil Mid Cap ETF (BRAZ). The first two carry 0.77 percent expense ratios while the latter has a 0.69 percent expense ratio.
As is the case with all Brazilian funds, and all emerging market funds for that matter, these ETFs have badly lagged U.S.-focused funds in recent years. Yet it’s important to remember that over longer-time horizons, investing in Brazil, Latin America and other emerging markets have been quite lucrative. For example, since the start of 2001, the MSCI Brazil Capped Index (EWZ) has more than doubled in value, compared to flat results for the S&P 500. EWZ comprises larger companies, with a strong tilt toward financials and commodities exporters.
In keeping with the notion that domestically-focused Brazilian funds hold greater near-term appeal, investors may want to check out the Global X Brazil Consumer ETF, which has one-third of its assets in consumer cyclical stocks and the rest in consumer defensive stocks. The Global X Brazil Mid Cap ETF brings greater exposure to electric utilities, financial services and energy producers. The Global X Brazil Financials ETF (BRAF) doesn’t hold much appeal right now due to rising interest rates and compressed net interest margins.
Investors looking to own stakes in Brazil’s smaller, though often-faster growing companies, might look to the Market Vectors Brazil Small-Cap ETF (BRF). This fund was launched in May 2009 and surged from $25 to above $60 by the end of 2010. But Brazil’s recent challenges have pushed this ETF 50 percent lower from that peak to a recent $31.50. More than 60 percent of the portfolio is invested in consumer discretionary and financial services stocks, as reflected by the fund’s underlying index, the Market Vectors Brazil Small-Cap Index, which is cap-weighted and float-adjusted. The 0.60 percent expense ratio is near the lower end of the peer group.
An economy with robust long-term growth prospects and depressed valuations should always get your attention. Though 2013 may prove to be challenging for Latin America’s largest economy, investors need to look past Brazil’s recent underperformance and focus on the economic re-acceleration that is expected to take root in 2014 and beyond.