Is Brazil an Investing Opportunity?

The political situation is corrupted but the country shows growth potential.
From a long term perspective, the market is undervalued and currency effects can bring to gains of 80%.
Brazil is still a developing economy with a young population and huge potential.

Introduction

On Sunday the Brazilian congress voted for the impeachment of president Dilma Rousseff. When the senate, likely in the next few weeks, confirms the vote, the Workers party will temporarily be replaced by a center-right administration government. The move from left to right creates hopes for investors as they look for a more investing friendly environment. Before analyzing investment opportunities, a further note on the political environment is necessary. Of the 513 deputies in the Brazilian congress more than 150 deputies are involved in crimes but are protected by their parliamentarian status and in total 303 deputies face charges or are being investigated for serious crimes, therefore any investment in Brazil has to be discounted for corruption issues that are widespread in Brazil. As the figure below shows Brazil is highly corrupt.

Figure 1: Corruption perceptions index 2015. Source: Transparency International.

This means that the rule of law is weak and some logical investment decisions or expected results might be completely turned around by corruption issues.

Brazilian Economy

On the other hand, the Brazilian economy is the 7^th World economy with a GDP per capita of $15,153, thus with still lots of room to grow in order to reach the developed levels. In addition, it has a young population with 40% of the population being younger than 25 (US – 33%, Germany – 23%). Also Brazil is rich in natural resources ranging from iron ore to agricultural products. All these positive circumstances strongly influenced Brazil’s economic growth in the last 25 years.

Figure 2: Brazil’s GDP annual growth rate. Source: Trading Economics.

Except for the 2009 crisis and some minor recessions in the past Brazil has seen high levels of growth in the past. The question now is: Is the current recession a temporary and natural halt to the growth cycle or there are deeper structural reasons that will disable Brazil’s future growth? With the current political situation it will for sure take a while before things return to the previous growth levels but for those investors that stick to the “Be greedy when others are fearful and be fearful when others are greedy” Brazil might be the place to look at.

Investment Perspective

All this political turmoil and economic recession resulted in the fact that Brazil is among the cheapest markets by the Cyclically adjusted price earnings ratio (uses 10-year average earnings for PE ratio calculation).

Figure 3: Brazil’s CAPE ratio. Source: Star Capital.

The average normal PE ratio for Brazil is high at 42 but that is logical due to the current recession and high interest rates. Any improvement in Brazil could quickly bring the CAPE valuation to a more appropriate one for such a young, rich in natural resources and still developing country.

Another potential catalyst is the Brazilian currency. From a stable range of R$1.5 to R$2 Brazilian Reals for one US dollar the Real had depreciated to R$4 for a dollar in 2015 and currently the exchange is R$3.61 for a dollar.

Figure 4: BRL per 1 USD. Source: XE.

Any indication of a political stabilization and a positive economic outlook would quickly improve the exchange rate and create currency gains for foreign investors. The current base interest rate in Brazil is 14.5% which implies that there will be strong demand for the currency if the investment environment stabilizes. A return to the exchange levels prior to the current economic crisis of R$2 for $1 would create returns of 80% just from currency benefits.

Another positive for Brazilian companies is their surprisingly high level of financial transparency. The financial statements are easily accessible on most of their investor relations web pages and also translated into English.

How to Invest

The easiest way to invest in Brazil for foreigners is through American depositary receipts (ADR) of Brazilian companies traded on the US stock exchanges. Below is the list of the 25 Brazilian ADRs traded on the US stock exchanges.

Figure 5: Brazilian ADRs. Source: TopForeignStocks.

Another option is to invest thorough Brazilian ETFs. Some of the most popular are the iShares MSCI Brazil Capped ETF (EWZ) that tracks the MSCI Brazil 25/50 Index and the Market Vectors Brazil Small-Cap ETF (BRF) that tracks Brazilian small-caps.

Current Situation

The current market situation shows that the bottom in the Brazilian market was reached in January 2016 with a low of 37,497. Since then it has grown to the current 52,894 or 40% influenced by the expectation that a new government will improve the situation and the 15% appreciation of the Brazilian currency.

Figure 6: Brazilian stock index BOVESPA 1-year chart. Source: Bloomberg.

The latest 40% surge creates an uneasy feeling of being late to the party but positive economic news and political catalysts could further improve the situation.

Conclusion

Investing in Brazil should be considered high risk because as the market grew 40% in the last few months, so it can quickly decline. On the other hand, the risk/reward is very tempting. Signs of economic strength or a positive outlook would quickly strengthen the currency and bring to immediate gains. Consequently, a lower base interest rate would bring to a much needed relief for Brazilian businesses. The average CAPE of 8.2 further increases the upside potential. South Africa, a country that can be compared to Brazil, has a CAPE ratio of 19.1. A similar CAPE ratio for Brazil would mean a 100% gain on top of the potential currency gain. But, the risks are also very big. A continuation of the current political turmoil does not help a country in economic trouble. New political scandals like the Petrobras scandal where 100 people, including senators and top executives have been arrested, could happen in almost any company in Brazil. An example of how high the corruption goes in Brazil is that the president Dilma Rousseff was a chair at Petrobras when the money laundering activities started back in 2004. Further political instability could further destabilize Brazil, weaken its currency and quickly reverse the above mentioned potential gains. Investor must be aware that although Brazil has a potential for 100% returns, it also has the potential of huge losses.