No matter what happens in Brazil politically, we believe that, from an economic standpoint, 2016 is likely to be a tough year, as the market is anticipating -3.7% GDP growth on the back of last year’s -3.8% output.1
This is Brazil’s worst recession in decades – so why was the MSCI Brazil Index up 28% in U.S.-dollar terms over the first quarter of 2016?2 Why the disconnect?
In our view, President Dilma Rousseff has effectively lost control. She has lost the confidence of the people, and with that lack of support, her coalition has disbanded and an impeachment process is currently ongoing. (At the time of writing, Brazil’s senate just voted to put President Rousseff on trial for allegedly illegally manipulating fiscal accounts.)
If President Rousseff’s impeachment is approved by Brazilian lawmakers, she would have to step down from office for 180 days to defend herself in a trial. During that time, Vice President Michel Temer will likely serve as acting president. We believe Temer will return to a more orthodox economic policy that reins in inflation, focuses on reforms and, hopefully, returns the country to growth. This belief is what has spurred the market.
Opportunities in Brazil
Despite the political uncertainty, our strategy, as always, is to focus on company fundamentals – particularly earnings, quality and valuation (EQV). With that in mind, I would like to highlight one promising company we own in Brazil – the stock exchange BM&F Bovespa S.A. (BM&F) (1.47% of Invesco International Growth Class and 1.37% of Invesco Global Growth Class as at March 31, 2016), which has near-monopoly status in its most important businesses. The company’s EBITDA margin is close to 70%3, with a free-cash-flow yield in the high single digits and a balance sheet that is net cash. The company is also in the process of acquiring Cetip S.A. – Mercados Organizados, another high-quality Brazilian non-bank financial institution, which has a virtual monopoly in securities registration.
With the acquisition, we believe BM&F’s revenues may become more resilient, and earnings visibility could lead to further re-rating. With high barriers to entry for competitors and strong cash-flow generation, BM&F could be a stronger company after the acquisition, benefiting from the opportunity to serve Brazil’s population, which is still largely underserved in financial services. Additionally, with a new government administration and a better macro outlook, BM&F has been stronger these past few months, gaining 57% year-to-date through to the end of April 2016 in Brazilian real terms.1 Despite the recent political movements, we believe the company it is still undervalued from a longer-term perspective.
Outlook for Brazil
The Brazilian stock market underwent a massive sell-off last year, but has been a top performer year-to-date. Overall, the Brazilian market is trading at 12 times forward earnings,4 which seems expensive to us, considering that its five-year average price-to-earnings ratio is 10 times.4 However, we believe earnings are depressed and do not fully reflect the long-term potential of the market. Although the market was up strongly in the first quarter of 2016, long-term valuations in some cases are still attractive if we assume reversion to average profitability.