As the global financial sysAtem gives the first, albeit flimsy, signs of stabilisation, wise investors start looking for opportunities to take some of their assets out of those boring Treasury bonds. The most daring of them will focus again on the stockmarket; the really brave ones will get back to equities of companies based in emerging economies that, even at the best of times, offer the chance of juicy results as long as you are willing to take high risks. But those who turn their attention to Brazil may well find out that they had not acted so recklessly after all.
At first sight, putting money in equities of Brazilian companies today looks like something for the James Bonds of the financial world. Albeit belatedly, the global financial crisis has hit the country in the past few months with some force. This development has tested a thesis that has been gaining ground that, like other emerging economies, Brazil had managed to decouple itself from the economies of the developed world. Well managed, fiscally responsible and rich in natural resources, Brazil was one of the countries that was taking advantage of the commodities boom to diversify its economies and carve a place in the top echelons of the global economy. As a result, the argument went, it seemed capable of surviving the financial turmoil unscathed.
It has not always been like that: only recently Brazil has ditched its long-earned reputation for high inflation and economic mismanagement. After years of tough fiscal policies by the government, the productive sector picked up pace by the middle of this decade and began to deliver the rates of growth that Brazilians, as inhabitants of the proverbial “country of the future”, had always thought were right around the corner. Between 2003 and 2007 the country’s GDP increased at an average rate of 3.8% a year, which may not look too impressive compared with China or other Asian economies but is a far cry from the 2.1% achieved between 1981 and 2002. Equity markets responded in full, boosted by the strong interest from international investors and a wave of initial public offerings (IPOs) by companies that sought funds to expand their businesses. Five years of uninterrupted stockmarket growth ensued: if in 2003 the combined capital value of all companies listed at Bovespa, the São Paulo exchange, equalled 19% of Brazilian GDP, by the end of last year the ratio had reached 65%.
Perspectives looked even rosier last April, when the country was granted investment grade status by Fitch and Standard & Poor’s, opening the way for government and companies to have access to cheaper money. The stockmarket euphoria, also fuelled by the purchases of domestic pension funds and a growing army of private investors big and small, reached its zenith right afterwards. Ibovespa, Bovespa’s main index, breached the mark of 73,500 points – just for comparison, by the end of 2002 it was struggling to stay above 10,000. At the same time, America and Europe found themselves already in a mighty struggle to avert economic decline. All the signs were that the Amazon sloth would finally show itself to be an agile and fearless economic jaguar, with locally-based multinational companies making purchases in Europe and America as they stretched their newly found muscles.
But the decoupling thesis, as convincing as it may have sounded, was not to survive the sustained attack on investors’ confidence perpetrated by Fannie Mae, Freddie Mac, Lehman Brothers, AIG and all the rest. Looking for liquidity wherever they could find it, investors took billions of dollars out of emerging market equities, Brazil included, and Ibovespa fell to as low as 36,000 points in October. The economy has slowed down, as banks lost their willingness to lend, and the local currency, the real, devalued sharply against the dollar. A tumble that created the opportunity for an “I-told-you-so” moment by more conservative investors but which raises an interesting point: has the time arrived to start buying Brazilian equities again?Observers of the Brazilian economy say that it has. “There are lots of bargains in Brazil,” argues Urban Larson, the director of Emerging Equities at F&C investments. “It is an attractive market right now, and it is probably cheaper than it was back in 2002.” Luis Fernando Lopes, a partner at Pátria Investimentos. a São Paulo-based asset manager, agrees, but with a caveat. “There are interesting opportunities if you have an investment horizon of at least a two or three years,” he says. With a similar reasoning, BlackRock announced that it was increasing the weight of Brazil in its Latin American fund, claiming that the South American giant offers good prospects for medium and long-term investments. And Mark Mobius, the emerging markets guru at Templeton Asset Management, has also announced that Brazil is one of the places where he is on the lookout for bargains.
The case for Brazil rests on a few basic assumptions that the impact of the global credit crunch in the country has not been enough to have an impact so far. The most convincing of them is that the Brazilian economy is still doing well, with the prospect of posting healthy, if unspectacular, performances this year and the next. For all the problems created by the global crisis in Brazil, the International Monetary Fund (IMF) still forecasts that the economy will close 2008 5.2% larger than in 2007. “To a great extent, the Brazilian economy is disconnected from what is happening in thedeveloped world,” argues André Caminada, a portfolio manager at Victoire Finance Capital, a São Paulo-based asset manager. “The fact is that the fundamentals of the country remain very good.”
Brazilian economists are usually working with a worst-case scenario of a 2% GDP growth in 2009. That is if the lack of credit in the domestic market assumes dramatic proportions and that investment and consumption grow much more slowly than in 2008. More often than not, analysts expect that the economy will grow between 2.5% and 3%, with the most sanguine among them, including the IMF, betting on 3.5%. The Brazilian government, for its part, remains pretty bullish, forecasting between 3.8% and 4% of economic growth in 2009. “Although the Brazilian economy is slowing down a little, it is certainly not getting into a recession,” Larson says. “It is a normal cyclical slowdown.” A reduction of the pace of growth was widely expected anyway, despite the global financial crisis, as the Brazilian Central Bank had started to raise interest rates to hold off inflationary pressures.
Such numbers are the envy of policy-makers in more than one developed country, who can only hope that their economies will avoid a long recession in the next year. So, if the perspectives for the Brazilian economy are far from gloomy, why have its equity markets suffered such a battering in the past few months? Larson says that it has been the result of herd-like behaviour of investors who have lost much of their ability to think straight. “Markets have not been rational, they have all been about fear and returning to assets that have been historically safe,” he points out. “Investors are not stopping to think about where risks are. They are only going to go with investments they are familiar with.” The most chicken-hearted have been foreign investors who in the past few years were flocking to Bovespa in the search for higher returns: in the year to September, they had withdrawn R18 billion (£5 billion) out of the São Paulo exchange. “International investors are following a handbook whose sell-by date has expired a long time ago,” says Caminada.
The old image of Brazil is that of a country highly exposed to commodity markets, as it is a big exporter of soya-beans, coffee, sugar, iron ore and other staples. Once commodity prices go down, so does the Brazilian economy, according to this view. The country was usually prone to suffer more than others from international shocks owing to its mammoth foreign debt and lack of reserves in hard currency. But these are examples of the outdated knowledge mentioned by Caminada. One item that annoys him in particular is the supposed dependence on the exporting of commodities to keep the economy afloat. “Commodities amount to at best one third of our exports,” he says. In another difference with emerging economies in Asia, for instance, Brazil’s export sector plays a less determinant role in the health of the economy, representing a 13% slice of its GDP. Domestic demand is an important variable for the development of the country and has acquired a lot of strength of late.
The criticism of the high exposure to financial turmoil abroad does not convince Caminada either, particularly as the country has replaced its dollar-denominated debt with debt in the real. “Today Brazil is a creditor in dollars and not a debtor any more,” he says. “We even gain when the dollar goes up. And the country has piled a huge war chest in foreign currency reserves that gives the government tools to act decisively when the economic environment takes a turn for the worse and foreign investment dries up.”
Additionally, practices of corporate governance have progressed in many companies, and no significant part of the economy is dependent on subsidies, according to Caminada. “Without subsidies, there’s no time-bomb in store for the economy,” he says.
But some reminders sporadically pop up to remind investors that risks are always there. A domestic factor that has helped to deepen the stockmarket slump was the use by many firms of operations with currency derivatives to dilute costs by betting that the real would keep its valuation against an embattled dollar. The Brazilian currency, bolstered by a healthy fiscal position and the strong performance of exports, reached as high as 1.58 against its American counterpart earlier in the year.
But as investors flocked to American Treasury bonds to protect themselves from the meltdown of equity markets, the greenback made inroads against several currencies, including the real, which went back to more than R2 against the dollar.
As a result, options on derivative contracts were called in, and companies had to meet their commitments at a much higher rate than they had planned. Some, like Sadia, an agribusiness giant, Aracruz, a pulp and paper multinational, and the holding company of Grupo Votorantim, a mining and financial group, have already disclosed huge losses with such operations. Sadia lost R760m in the third quarter with currency derivatives; Aracruz reported a R1.9 billion loss; and Votorantim fared even worse with losses of R2.2 billion. Fears about the extent of the losses to be incurred by the thousands of firms that are known to have engaged in such operations have weighed on the heart of many an investor, Brazilians and foreigners alike. But Cetip, a São Paulo-based clearing house for over-the-counter operations, has announced that, at worst, total losses incurred by all companies that made such arrangements should reach no more than $3 billion (1.7 billion). The firm says that albeit not insignificant, this is not a catastrophic number, considering the large number of companies involved.
“I am shocked that some companies made such a mistake, they should have known better,” says Larson. Anyway, the credit derivatives fiasco provides a further argument for investors to keep their cool for a little longer before plunging into Brazilian equities. “The financial reports that will be released until the end of November will be the key,” explains Caminada. “They will give us a clearer view of what companies are faring well despite the squeeze in money markets and also of which have suffered most with currency derivatives.”
Another outcome of this episode, allied with pressures coming from the outside world, has been a partial shut-down of lending by Brazilianbanks. The accelerated growth of credit has been one of the main drivers of Brazil’s economic growth in the past few years. Thanks to lower interest rates, both companies and consumers discovered better options to fund their spending by borrowing freely from a banking market that for a long time had been loath to lend. In 2003, the total volume of loans in the country amounted to 22% of the GDP, while projections show that the ratio should reach 40% by the end of 2008.
But banks have tightened the corporate credit tap in the past few months, to some extent as a result of the global money crisis, but also, according to some analysts, reflecting concerns about the capacity of some companies to repay their loans. The government has promptly announced measures to try to unlock credit markets, including a temporary amnesty from compulsory deposits that banks have to make to the central bank. It will be some time before it becomes clear whether such efforts will pay dividends by making easy credit available to companies again. But Febraban, the Brazilian federation of banks, has already warned that, even if that is the case, firms should be prepared for a new reality where money will be more expensive than in the past few years.
So the prospect for the Brazilian economy is possibly of a steady, albeit unspectacular growth, with equity markets evolving accordingly. Investors looking to profit can start looking at the sectors and companies most likely to fare well in this new environment. Lopes suggests that investors should be wary of firms that need high levels of leverage to make their businesses work. “One thing that you need to consider is how dependent a company is on credit,” he says. “Take the property sector. Developers are very highly leveraged and have presented over-ambitious investment plans. They won”t have access to the money they need to carry forward those plans.”
Brazil faces nothing like the mortgage crisis that is hitting Britain, America or Spain, but the native property sector faces challenges of its own. In the past few years, property developers were among the brightest stars of the stockmarket, with many companies launching IPOs to fund their fast growth. A fledging mortgage market and an incipient market of securitisation of loans, allied to income gains made by Brazilians of all social classes, seemed to have created the conditions to make huge profits in both residential and commercial property.
But the credit crunch has cast a shadow of doubt over the sector as a whole. Caminada says that it is too soon to say that property developers will underperform because of the lack of credit, but that they look like a bet only for those who are not afraid to take risks.
Other mainly domestic sectors are likely to fare much better. Analysts like to highlight companies that are gaining with the change of consumption patterns of Brazilians as particularly interesting prospects. They include agribusiness outfits like meat producers and drink companies, where customers are migrating to higher-value items. Retail networks like the Pão de Açúcar supermarket chain, which do not depend too much on the availability of credit to clients to keep the business going strong, are also often mentioned as attractive propositions.
In the past few years, Brazil has tried to improve its infrastructure to unlock economic development. Investments in ports, roads, railways and other major works have been announced, although many have not necessarily materialised so far, and companies dealing in these areas are followed with interest too. Larson picks up transport companies as one of his favourite segments at the moment, as well as electricity providers, telecoms and other utilities that need to expand to meet Brazil’s growing hunger for energy. Cemig, an energy producer, is an example of what Lopes calls a “well managed company”.
For those who are really capable of isolating their views of Brazil from the rest of the world, some of the most attractive propositions can be found in the banking industry. Brazilian banks have been posting several years of record results and are used to navigating turbulent waters, a heritage from the country’s rocky years in the 1980s and 1990s. “Historically, times of volatility have been good to invest in Brazilian banks,” Larson says. “And they tend to do well in almost any environment.” Lopes agrees that the fundamentals of Brazil’s big banks are rock-solid, but warns that some of the smaller listed players present a different proposition. “Small and medium banks with an excessive focus on consumer lending will face a struggle,” he says. Market analysts have often selected the likes of Banco Itaú and Unibanco as examples of banks with good outlooks thanks to their sophisticated and diversified operations.
Some of the Brazilian blue chips could also present remarkable deals. Two of the most famous of them, Petrobras, an oil giant, which is state-controlled but partially listed, and Companhia Vale do Rio Doce, a mining multinational, have seen their shares drop dramatically as commodity markets softened in the past few months. But once again there are some factors that might indicate their devaluations have more to do with investor panic than sound analysis. “Petrobras is one of the few major oil companies in the world with a projected growth of production for the next decade,” stresses Larson.
In a recent interview, president Luiz Inácio Lula da Silva has said that Petrobras investment plans to explore its new huge offshore findings rely on a minimum oil price of $35 per barrel, which gives the company a huge margin to manoeuvre despite recent falls. Analysts have also pointed out that Vale’s current market value has already factored in up to a 50% drop in the quotation of iron ore. The fact that Vale has been buying its own shares has been interpreted as a signal that they are already cheap.
For all the positive signs, it is unlikely that foreign players will return to Brazil soon; as a result, the stockmarket is set to evolve at a less exuberant pace than in the past five years. Which could give some useful time for investors to think hard about the matter without missing the stockmarket train. “Volatility will stay high in the remainder of 2008, and everybody will still be a little on the defensive in 2009,” Caminada says. “So it could be the best time to build a good portfolio of Brazilian equities, as investors will be able to buy stakes at strategic companies at very low prices.”