Brazil fears appear overblown; opportunities beckon
Jonas Krumplys, CFA
Ivy Asset Strategy New Opportunities Fund
Ivy Asset Strategy New Opportunities Fund – September 2011
Commodities stocks have been among the most negatively affected by the recent declining market sentiment, with many driven their lowest valuations of the year. Commodity-rich Brazil, the world’s eighth-largest economy and a major exporter of hard and soft commodities ranging from iron ore to soy, is shaping up to be one of 2011’s worst-performing equity markets. But Jonas Krumplys, portfolio manager of the Ivy Asset Strategy New Opportunities Fund, still sees pockets of potential opportunity in Brazil.
The concerns surrounding Brazil’s economy and markets are not without merit. After surging 85 percent in 2009 - 2010, the Bovespa stock index entered a bear market on July 27 after declining 20 percent from its November 2010 bull-market peak. The pullback caused some companies to postpone initial public offerings or discount them significantly.
The industrial sector represents a significant component of Brazil’s gross domestic product (GDP) at approximately 25 percent (proportionally the second-largest in the Americas), and agriculture is roughly 4 percent. Brazil’s No.1 export partner is China. We believe the greatest concern now is that China’s economy, which has grown too rapidly for too long, is overdue for a hard landing. While that appears to bode poorly for Brazil, it’s important to recognize how and what Brazil exports to accurately assess the potential impact of China’s slowdown.
Currently, Brazil’s total exports are only 12 percent of GDP; half of those exports are commodity based, and half of those commodity exports are agricultural. To break that down more specifically, Brazil is the world’s first or second largest exporter of coffee, sugar, soy products, orange juice, poultry and beef — commodities the world is not about to do without. This is a significant distinction, as we think prices for these commodities are not likely to collapse. We believe that the wealth of its natural resources and the stability of its export commodities mean Brazil is inherently more stable than the recent equity market decline would suggest.
Inflation fears overdone
There are economic issues in Brazil, including concerns that the loan growth rate is too high, consumers are carrying too much debt and the country has credit difficulties. But these issues are true of all underdeveloped emerging markets when it comes to mortgages, credit cards or small- and medium- enterprise (SME) loans. The fact that Brazil’s annual loan growth rate has been roughly more than 20 percent since 2004, and is not slowing, is not unusual or alarming, in our view.
Inflation, which has run above the Brazilian central bank’s annualized target range of 4.5 to 6.5 percent since April, also has investors’ attention. In an effort to slow the pace of inflation, policy makers have raised the benchmark interest rate five times this year. There was a fear among some investors that Brazil would have to raise rates above 14 percent. But in fact, on August 31, policymakers cut Brazil’s benchmark Selic rate by 50 basis points to 12 percent, bringing its tightening cycle to an end. The government also has cut spending this year by 50 billion reals ($31.46 billion) to help dampen demand and reduce inflation.
We think inflation will become less of a concern once the interest rate cycle turns around, which is likely to happen late this year, and if the government continues to watch spending. Brazil’s fiscal debts are coming down (with a current debt-to-GDP of 60.8 percent) and we believe its economic growth rates are sustainable: The economy is forecast to grow by approximately 4 percent this year after expanding 7.5 percent in 2010.
Such a backdrop has created what we see as a favorable buying environment in equities, despite recent ominous headlines. With respect to price-to-earnings (P/E) and price-to-book ratios, the Bovespa is in line with similarly developing economies. Its price-to-book ratio of 1.37 times, is 6 percent below the low of 1.47 seen in 2008-2009. Brazilian companies are trading now at 1.5 times book value with a P/E of around 10. Average debt-to-equity of Bovespa companies is near 90 percent, compared with 145 percent for the S&P 500.
Opportunities in real estate
While Brazil’s lending rate is high by U.S. standards, it’s important to recognize that real estate lending rates in Brazil are tied to a government program rather than to the central bank rates. Financed by the government-owned Caixa Bank, the Minha Casa Minha vida (My House My Life) program, launched in 2009 with a goal to build and sell 3 million homes by the end of 2014, is one of the world’s most ambitious social housing programs. The total market value of outstanding mortgages represents less than 5 percent of Brazil’s GDP vs. a range of 50 to 100 percent of GDP in the U.S. or Western European economies.
The Fund’s current exposure to Brazilian real estate is about 9 percent of total assets, with 4.5 percent in residential developers and 3.5 percent in commercial projects, including offices and shopping malls. Despite a population base of nearly 200 million people, Brazil has only about 400 shopping malls (compared with approximately 105,000 in the U.S.). But there is demand for a great many more. This is one of the most under-penetrated markets in the world — despite Brazil being the world’s eighth-largest economy. Inflation rates of over 1,000 percent less than two decades ago means that commercial mortgages are a relatively new phenomenon The existing malls primarily were built by wealthy individuals who had made their money in industry, agriculture or mining and were looking for an inflation hedge. The occupancy rate in Brazil’s malls is near 100 percent and sales per square meter are growing very rapidly.
Despite challenges, future appears promising
Recent events have not significantly changed our outlook for Brazil. Its economy has slowed on the industrial side because the Brazilian currency has appreciated so dramatically. That appreciation has hurt the profitability of companies making machinery, buses and cars, for example, which is an issue because Brazil is also a major auto exporter. Brazil is trying various tactics to temper its currency’s exchange rate, including charging taxes on foreign investors buying Brazilian stocks and bonds. It recently began taxing currency speculators at a rate of 1 to 25 percent in order to manage capital inflows into the country.
There is no doubt that the industrial side of Brazil’s economy has slowed, but we think it was growing too fast last year. The Brazilian economy should not grow faster than 4.5 percent per year because its infrastructure is so poor. This is a country the size of the continental U.S. but it has fewer paved highways than the U.K. — a far smaller country. Less than 10 percent of the roads in Brazil are paved, it has almost no passenger rail system and there are not enough freight railways. There are only three freight railway companies and two of them are controlled by iron ore companies. Brazil needs more airports and larger, more efficient ocean ports to accommodate the growth it is envisioning.
We see this need to build infrastructure as an investment opportunity. Petrobras, a Brazil-based leader in development of advanced technology for deep-water and ultra-deep-water oil production, plans to increase oil production from its current pace of 2 million barrels per day to 4 million by 2020. Petrobras will need 28 drill ships to accomplish its plans, and it must build three major refineries and an enormous amount of pipeline. The Fund is investing in this expansion by owning a couple of engineering and construction firms. One is a French firm, Technip-Coflexip1, which is one of three companies in the world that can operate a flexible riser that can reach the bottom of the ocean. It’s currently building a factory and research center in Brazil to supply floating production, storage and offloading systems to Petrobras. Another is Petrofac Limited2, a U.K.based company that provides facilities solutions to the oil and gas production and processing industry.
The Fund also owns Cosan3, with businesses in energy, food, logistics, infrastructure and agriculture property management. It’s also the largest private producer of ethanol, a commodity Brazil will need to fuel its infrastructure expansion. Cosan just completed a multibillion-dollar joint venture with Shell to produce low-carbon biofuel — ethanol made from sugarcane, an abundant crop in Brazil. Shell is combining its extensive retail experience, global network and research in advanced biofuels with Cosan’s technical knowledge of large-scale biofuel production. The joint venture aims to produce more than 520 million gallons of ethanol annually to support Brazil’s burgeoning demand.
An additional holding is Brasil Foods4, the world’s 10th-largest food company and Brazil’s second-largest in revenue. The company is 60 percent domestic and sells a wide range of products, including poultry, pork, processed meats, frozen foods, and dairy products.
Tactical shifts, outlook
To manage short-term volatility, we have trimmed equity holdings in the Fund, including Brasil Foods (which nonetheless remains among the Fund’s top 10 holdings). Stocks tied to economies thought to be export-related have taken it on the chin in recent weeks, as have commodities. And we think that the markets will continue to be volatile in the near term on the negative sentiment surrounding the European banks and European sovereign debt.
Historically, Brazil is wary of inflation and tends to keep rates
high; however, as conditions change, it has room to again notch rates down to spur growth. It also has a sovereign wealth fund, hundreds of millions of dollars in foreign reserves, healthy banks with high tier-one capital and a government surplus. So we’re going to ride out the volatility and headline risk about Brazil, which we think is overdone.
1. Technip-Coflexip represented 1.27% of investments as of June 30, 2011.
2. Petrofac Limited represented 1.375 of investments as of June 30, 2011.
3. Cosan represented 1.13% of investments as of June 30, 2011.
4. Brasil Foods represented 2.40% of investments as of June 30, 2011. The Bovespa is a Sao Paulo-based stock and futures exchange. It tracks around 50 stocks traded on the São Paulo Stock, Mercantile & Futures Exchange. The Standard & Poor’s 500 Index is an unmanaged index of common stocks. Neither index is an investment product available for purchase.
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