In one of my recent posts, I discussed the cyclically adjusted P/E ratio or the CAPE ratio, which is the ratio of stock price to the average earnings over the past 10 years. This figure can be calculated for an individual stock or a broad index and gives you an idea of the current price versus the long term valuation of the company or the stock market. To make my case for the idea that the S&P 500 was becoming overvalued, I used the example of Robert Shiller’s chart below which graphs the CAPE ratio and long term interest rates over the entire life of the S&P 500.
One way to reduce risk of your equity investments is through diversification. Given the option through country ETFs to invest in almost any stock market in the world, I took a look at a chart complied by Star Capital which ranked world indices based on their CAPE ratio to see which markets may be worth looking more into at the moment.
Two countries stand out to me, Russia just in terms of price and Brazil due to pricing, my knowledge of the Brazilian economy and recent events there. I would like to take the time now to make the case for investing in Brazil and there are a number of factors for my reasoning.
Catching Up On Current Events
Before I make my case though, for those that aren’t very familiar with the Brazilian economy, it is worth reviewing why the valuation is at such a low figure and the developments of the past few years that have put it there.
Political Scandals – The most important of recent events has to be the political scandals which seem to be never ending. These are collectively known as Lava Jato or “Operation Car Wash”. The car wash scandal has taken down a president (Dilma Rousseff) and recently threatened to take down her replacement Michel Temer. Essentially, this was a widespread case of political corruption where construction companies bidding for contracts from state owned entities like the Brazilian oil company Petrobras, paid bribes to politicians and their parties to win the contracts. Since Dilma Rousseff was the Chairwoman of Petrobras at the time and funds were directed to her party to help finance campaigns, she was deemed to have a hand in this process and was impeached and removed from office in August 2016.
Recently, her center right replacement Michel Temer was caught on tape seeming to endorse bribes to a jailed politician. This sent the Brazilian stock market the BOVESPA, down once again as it introduced a new round of uncertainty into markets. Given that 24 senators and 39 lawmakers in the lower house of congress were also implicated and that dozens of politicians have already been convicted all the way up to the highest levels of government, the specter of more political instability is casting a shadow over markets at a time when it is least needed.
Recession – As if to add insult to injury, the political scandals tipped the economy into its worst recession ever. GDP contracted by 3.8% in 2015 and 3.6% in 2016. Investment fell 10.2% in 2016 as high interest rates discouraged investment across industries. The central bank had its rate as high as 14.25% as of October last year. These high rates were the consequence of the central bank trying to stave off inflation as the value of Brazil’s currency the real plummeted in the wake of the recession as seen below.
In addition, the recession has left nearly 13 million people unemployed and caused Brazil to lose its hard fought investment grade debt rating.
All this has left the economy in a rough state. Even for 2017, analysts were hoping to finally project a comeback for Brazil but the economy is only expected to grow by 0.5% this year. The good news being that inflation has come down to 6.3% in 2016 from 10.7% in 2015, giving the central bank more room to cut rates.
The Case for the Value
I see a lot of parallels here with a tough period in the American economy. In the late 70’s and early 80’s the US had a relatively young workforce, high inflation, was in the midst of a severe recession, had sky high interest rates and events like the Iran Hostage Crisis were taking its toll on the national psyche. Seemed like a bad time to be bullish on the stock market, but you would be wrong. As inflation was tamed, rates came down and taxes were cut, the stock market took off. Those that didn’t take the time to invest when times were bad were likely kicking themselves down the road for not taking a rosier view of things.
Interest rates came down from a high of 20% in April of 1980 and in the next 10 years, the stock market more than tripled in value.
This is the situation in Brazil right now. Despite a nice return in the BOVESPA of 63% in 2016 and a 21% appreciation of the currency, as can be seen below in USD terms, there is still room for growth in terms of earnings and currency appreciation. The iShares ETF EWZ, which tracks the Brazilian market, is still way below its all-time high of $99.55 and currently sits at $35.50 after reaching a low of $18.80 in early 2016.
Not Just Value but Macro Fundamentals
I am not bullish on Brazil just based on the expected currency and stock market appreciation alone. If that was the case I would be taking a closer look at Russia based on its CAPE figure. Rather, I believe there are other long term factors that play into Brazils favor, these are:
A Large and Relatively Young Population – The median age of the population is 31 years, compare this to 37.9 for the US and 46.8 for Germany. 43.8% of the population is of prime working age of 25-54 which represents approximately 90 million people out of a total population of 206 million. Compare this to the working age population of the US which numbers approximately 127 million. Although the median age makes Brazil no spring chicken like Nigeria (18 median age) it means the time is now in terms of its potential.
A Maturing Democracy – For the moment the scandals are an embarrassment for Brazilians but many in the private sector believe this points to a maturing of Brazilian democracy in the long run. There are now institutions strong enough to take on the ruling political class and the popular pressure on politicians will in the long run produce more honest politicians and a transparent system. The big question looming is how the political campaigns of the future will be financed, if they are explicitly capped with public funds (such as in Israel) or corruption is institutionalized (such as through lobbying in the US). There seems to be a general sense from many observers that this is short term pain for what is deemed a long term gain in terms of a better functioning political system.
World Class Companies – The scandals involving Petrobras apart, Brazil still has some world class companies, from the emerging banking titans of Itau Unibanco and Bradesco to the food giants AMBEV and JBS to cutting edge manufacturers like airplane maker Embraer, Brazil has proven that the country has long term winners that can compete on a global scale. With valuations still at the lower end of the historical spectrum, this is a great time to pick up some world class companies at reasonable prices.
How to Invest
In order to take advantage of this opportunity on a macro scale there are a number of broad indices you can invest in such as the large cap iShares MSCI Brazil Capped Index (EWZ) to the Global X Brazil Consumer ETF (BRAQ). EWZ is by far the most popular, this ETF intends to track the MSCI Brazil 25/50 and has $5.8 billion in assets making it the most liquid of any of the Brazilian ETFs out there. The underlying index is a free float-adjusted market capitalization-weighted index with a capping methodology so that no single issuer of a component exceeds 25% of the underlying index weight, and all issuers with weight above 5% do not cumulatively exceed 50% of the underlying index weight.
This prevents one single company from dominating the entire stock market and presenting concentration risk for investors who just want to capture the entire market. However, when we break down EWZ by sector, we still have concentration risk apparent in the exposure to the financial sector of Brazil.
I put the sector breakdown side by side against the S&P 500 to give you an idea of how the risk changes when trying to invest in EWZ. Investors should be aware that when trying to capture the Brazilian market by investing in EWZ this represents a higher allocation towards financial stocks so that will have implications on overall risk of a portfolio.
Despite this, I think an overvalued sector balanced market still does not beat out a sector lumpy undervalued one. Barring Petrobras, the top ten holdings of EWZ consist of world class companies that are essentially oligopolies in their home market such as AMBEV, Vale and Itau Unibanco. If you want to avoid the government owned public companies such as Banco do Brasil and Petrobras altogether, holding Itau Unibanco outright may not be a bad choice at all right now as long as you aren’t overweight in financials exposure.
As with all emerging markets investments, know that given their small size relative to the big developed market indices and the tendency of institutional investors to duck and run at the sign of any danger, emerging markets are inherently volatile. However if you can stand the bumpy ride, I believe the Brazilian market is on its way up for the foreseeable future.The information provided by www.cashchronicles.com is for informational purposes only. It should not be considered legal or financial advice. You should consult with an attorney or other professional to determine what may be best for your individual needs. www.cashchronicles.com does not make any guarantee or other promise as to any results that may be obtained from using our content. No one should make any tax or investment decision without first consulting his or her own financial advisor or accountant and conducting his or her own research and due diligence. To the maximum extent permitted by law, www.cashchronicles.com disclaims any and all liability in the event any information, commentary, analysis, opinions, advice and/or recommendations prove to be inaccurate, incomplete or unreliable, or result in any investment or other losses. Content contained on or made available through the website is not intended to and does not constitute legal advice or investment advice and no attorney-client relationship is formed. Your use of the information on the website or materials linked from the Web is at your own risk.