Emerging Markets Equities

Brazil: Being disciplined on value

With a major political, economic and social crisis, perhaps Brazil is more reflective of the negative stereotype sometimes associated with emerging markets.
May 2018
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Brazil was once considered a paragon for the potential of emerging markets. Strong growth rates, stable political leadership and a confident consumer base, all of which supposedly heralded a new era of economic expansion and increased wealth. The nation waded through the global financial crisis relatively unscathed largely thanks to reduced interest rates, increased government spending and in particular, subsidized credit from the state development bank. While the good times did roll, it also corresponded to a booming commodity cycle.

In more recent times, having witnessed the oil price collapse and finding itself in the midst of a major political, economic and social crisis, perhaps Brazil is more reflective of the negative stereotype sometimes associated with emerging markets.


From boom to bust

The country has been in recession now for two years, shrinking the economy by nearly 10% with double-digit inflation and interest rates, a widening of the budget deficit (from 2% to 10%) and an unemployment rate of about 13%. Add to this political instability with the impeachment and imprisonment of recent presidents and of course the largest corruption scandal (“Lava Jato” – Operation “Car Wash” – being the ongoing criminal investigation) in the country’s history involving Brazil’s largest company, scores of businessmen and politicians across party lines, and it doesn’t really paint a pretty picture.

But herein lies the “Brazilian way” – to muddle through without revolution or coup. Michel Temer, who came to power following the impeachment of Dilma Rousseff, and who himself was later embroiled in a corruption scandal, managed to hang on and has been able to bring inflation somewhat under control, which has resulted in the lowering of interest rates. The most significant move from Mr Temer was to put a 20- year freeze on government spending.


Time to pull the pension?

While these are all nice to see, they are baby steps and the bigger reform that could actually impact Brazil’s massive debt is reform of the pension system. Needless to say, this is far more challenging and will take real political leadership to push through. Brazil currently spends more on pensions than education and infrastructure combined. The state pension accounts for about a tenth of Brazil’s GDP (or a third of government spending) – fairly excessive for a country with an average age of just 31 years. If not overhauled, pensions could snowball to a fifth of GDP by 2060.

Elections are fast approaching in October 2018, where these issues will dominate the agenda. However, at present there are no front-runners. Former President Lula is currently polling ahead but given he is serving a 12-year prison term for corruption, his participation is unlikely.


A hot stock market

Despite the clear challenges facing the country, the positive soundings around reforms (like freezing government spending, overhauling of labour laws) and a slow economic cyclical recovery has fed (probably excessive) optimism, resulting in a Brazilian stock market that has actually risen to near all-time highs in local currency terms.


Impressive operators

Brazil has some great companies and we met with several while on the ground on our recent trip in April. As investors, we like companies that are able to thrive when times are tough, which have sustainable moats protecting their business, can generate strong cash flows, and also, importantly, respect minority shareholders. In this regard, you cannot help but be impressed with many of the companies operating in Brazil.

A great example is Raia Drogasil (RADL), the market leading pharmacy retailer (though still having only around 12% market share) in what is a highly fragmented market. It has consistently demonstrated best-in-class execution, delivering EBITDA* margins of around 8-9% despite accelerated growth in the past few years (around a third of its new stores are less than three years old). Its focus has been on organic growth, rather than on acquisition, which for us is a great measure of its focus on creating value rather than creating an ‘empire’.

RADL was not the only top-class outfit we met. Alpargatas (mainly known for their Havaianas flip flops) was very interesting while Hypera Pharma, the largest pharmaceutical company and OdontoPrev, engaged in the provision of dental services, both really impressed us with their discipline, capital allocation decision making and management quality. A word should also be reserved for the banks we met and, in particular, Itau. Itau’s management team has consistently shown the discipline and foresight required to run a highly profitable organisation, delivering conservative but sustainable growth while also, something it is probably best in class at, cross-selling other financial services to its extensive customer base.

But at what price?

The price required to own most of these businesses is the real barrier to buying. Experience has taught us that often the best management teams and companies are found in unusually harsh environments, ‘diamonds in the rough’, if you will. There was a time (perhaps in 2015) when there were opportunities to buy some of these businesses, as no-one wanted to touch Brazilian equities. But it would appear that currently the market has become overly excited by the tepid signs of a possible recovery, pushing prices to a point where they are not attractive, even given the clear quality. This is frustrating but the beauty of being a long-term investor is having time on your side. We will wait patiently for the next opportunity.


Reform is needed

On departing Brazil, the overarching feeling one gets (as perceived from the companies and people we met) was one of “frustrated optimism”. There are areas of improvement and commodity prices have also recovered from their recent lows. It looks like growth is starting to pick up a little after two years of recession, inflation has cooled off, interest rates have also come down, and unemployment has at least stopped rising.

But reform is what’s needed and the new president taking office later in the year has a tough task in this regard.


Risk warning

The value of investments and any income derived from them can go down as well as up as a result of market or currency movements and investors may not get back the original amount invested.

Investing in emerging markets is generally considered to involve more risk than developed markets.


Our key takeaway

Impressive companies in a tough environment – but we won’t overpay for them.

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