Even though Brazil is in a severe recession and its government is mired in endless political scandals, its stock market, as reflected in the Sao Paulo BOVESPA Index, is in positive territory and up about 15% year-to-date in local terms. In the view of emerging-markets specialist Gerardo Zamorano, at San Diego-based Brandes Investment Partners, that underscores why value investing works.
"If you look at 2015, it was a horrible year for Brazil," says Zamorano, director of the investments group, who has been involved in asset management since 1999 when he earned an MBA at the Kellogg School of Business at Northwestern University. "It's not just that Brazil's GDP growth is around minus 4%. What we have so far is that this is Brazil's worst period since the early 1900s. In fact, it is much worse than in the 2008 financial crisis, when Brazil rebounded pretty quickly. Business confidence is at the lowest level ever."
How to explain the market rebound that is sandwiched between two years of negative 4% GDP growth years, on top of the political quagmire and the ongoing PetroBras scandal? All told, it's a complex and dispiriting background.
However, Zamorano takes a different perspective. He and the five-person team that manages the $216- million Brandes Emerging Markets Value prefer to focus on individual Brazilian companies that offer attractive upside potential.
And it's something that the eight research teams at Brandes seem to agree on. "We don't just focus on Brazil. But all of the research groups are flagging Brazilian ideas that are trading very cheaply relative to their long-term worth," says Zamorano, who is the head of the telecom and media research team.
"In fact, at the end of 2015, Brazil was the largest country in the EM portfolio at close to 20%," says Zamorano, a Mexican native who also earned a B.Sc. in economics at The Wharton School, University of Pennsylvania, and previously worked for the World Bank's International Finance Corp.
The fund holds a cross-section of Brazilian utilities, banks, telecom companies, industrials and food retailers. "We got to a point where all these factors -- the weak economy and corruption scandals -- created a perfect cocktail of negative news," says Zamorano, noting that Brandes started taking an interest in Brazil in 2014. "That influences the way the market prices companies -- which tends to have a shorter-term focus than we do."
As a rule, Brandes takes a long-term view and estimates what a company may be worth over a multi-year period. "We are not concerned with the next two or three quarters," says Zambrano. "Instead we are concerned with what the business fundamentals present over the next three to five years."
Typically, Zamorano notes, equity analysts have put extremely low multiples on many Brazilian stocks, based on 2016 earnings. "But there is no way that 2016 is a normal year for a Brazilian business. After two years of very negative fundamentals for the country as a whole, it's not fair to value those companies on current earnings. We are patient enough to evaluate these opportunities based on a three- to five-year potential. That's why our portfolio reached close to 20% in Brazil, versus 7% for the benchmark MSCI Emerging Markets Index."
One of the companies that Brandes favours is Embraer SA, a leading manufacturer of airplanes and competitor to Canada's Bombardier Inc. "The market is negative on the firm," admits Zamorano. "Because of the budget crisis in Brazil -- revenues are down significantly -- the government has cut its defence budget significantly. As part of that move, it has postponed many defence programs, which the market has looked at in a negative light."
However, Brandes expects that the domestic slowdown will soon end and a new large transport airplane for offshore markets will yield results in 2017-18. Still, the life cycle of some regional jets is at the tail end, which often results in heavy discounting. "The market is seeing smaller margins. But we believe that over the next couple of years as they launch a new generation of regional jets, margins will come back up to a higher level, more consistent with the history of the company."
Another favourite is Marfrig Global Foods SA, which exports Brazilian beef to overseas markets and supplies beef to McDonald's restaurants in Asia. "We believe we will see an improvement in the pricing of beef. It's on the up cycle now," says Zamorano. "The industry is more rational as it's in the hands of three players. Through consolidation, the industry is more orderly."
At the same time, the once closed U.S. market has been opened to Brazilian beef imports. "That presents a significant opportunity," says Zamorano, noting that other countries, such as Japan, are likely to follow the U.S. development. "There is a growing demand for beef, globally speaking."
While many Brazilian stocks are attractive, there is currency risk, Zamorano admits. "When we look at exchange risk, we look at it company by company," he says, adding that the team becomes concerned if a company generates most of its revenues in local currency but carries a lot of unhedged debt in U.S. dollars.
Currency movements can hurt emerging-markets funds and 2015 proved to be a challenging year, adds Zamorano. But currency effects can work both ways. "Part of the return this year has come from appreciation in the Brazilian real."
