Brazilian stock prices have fallen by 35% in U.S. dollar terms since February, extending a decade long bear market. As shown in the chart below, Brazilian stocks (MSCI Brazil) have provided total investor returns of negative 40% over the past ten years. This compares to positive 27% for the broad MSCI Emerging Markets Index and 181% of the S&P 500 Index.
Much of this abysmal performance can be attributed to mean reversion, in the sense that Brazil has simply given back the high relative returns it enjoyed during the 2001-2011 period. In fact, over the past 18 years total stock market returns in Brazil (including dividends) have surpassed those of the U.S. market and are only slightly inferior to those of MSCI EM. This is shown in the next chart.
Brazil’s boom-to-bust tale is easily explained. Ample global liquidity and cheap capital, high commodity prices and a weak dollar fueled a credit and consumption boom until 2012. Since then a strengthening dollar, tighter liquidity and falling commodity prices have taken the air out of Brazilian asset prices and weakened the Brazilian real (BRL). The deteriorating global backdrop has been made much worse by Brazil’s own problems: debilitating corruption scandals, out-of-control government spending and a draconian monetary policy. Today, on the eve of a critical presidential election, the country faces the prospects of a severe deterioration in its solvency and an extended period of low GDP growth unless profound reforms can be implemented. The solvency problem is very real and the result of enormous fiscal deficits and growing entitlement spending. The chart below shows the growth of public debt and its expected further deterioration, according to IMF estimates.
Brazil is at a crossroads, facing a binary event with the upcoming election. If either one of the two reformist candidates (Jair Bolsonaro and Geraldo Alckmin) win the upcoming election the market is likely to applaud their ambitious free-market agendas. Successful reforms (privatization, deregulation, social security reform) could unleash “animal spirits” and propel the economy to a higher growth rate. However, the result of the election is unpredictable, and even if a reformist candidate wins it will be a battle to push legislation through a Congress captured by special interests.
Given the political uncertainty, how should the investor evaluate the potential upside from investing in Brazil? We should start with a view on the economy and where we are in the business cycle. We also need to have an opinion on the Brazilian currency’s valuation relative to the dollar. This will provide us an idea of how much earnings can increase over the next 3-4 years. Finally, we should understand where valuations are today and a view on how they might evolve in the future.
What is Brazil’s long term potential GDP growth and where are we in the business cycle?
The base case for the conservative investors should be for Brazil to maintain its long-standing GDP growth path of 2-2.5% per year over a full business cycle. This low growth path has existed for three decades now, the result of a very bloated and ineffective government. Governance in Brazil is very poor, marred by extreme corruption and very powerful interest groups that oppose reforms.
However, Brazil is early in its business cycle, a period characterized by a large output gap and ample idle capacity. This provides the opportunity for the economy to grow above potential for several years as the output gap is closed, perhaps at a rate of 3-4% per year. The following chart shows the long-term trajectory of Brazilian GDP and where we stand today relative to trend (dotted line). In the wake of the 2014-2017 recession, we are clearly below trend, but not nearly as much as in 2002 when the previous bull market for stocks started.
The main reason that the output gap is much smaller than 2002 is because the BRL has been relatively stable. This is because of the war-chest in foreign reserves built up over the past decade and the Central Bank’s willingness to use them to stabilize the currency. The following chart, from the IMF, shows Brazil’s real effective exchange rate for the past 30 years. Even after the recent weakness, the BRL is less than 10% undervalued, much less than it was in 1988, 2002 or 2016.
Earnings
If we assume that the economy continues on the path of recovery, the prospects for earnings and the stock market are relatively healthy. As shown below, earnings for the stock market (MSCI Brazil) –though they have rebounded from the trough of the recession — remain very depressed, at about the level of ten years ago. This is hown in the chart below.
As the economy recovers, firms will boost margins and return on capital will rise, so that we could see earnings grow significantly. At the same time the BRL could at least return to its REER trend, about 10% above today’s level. The result could easily be a 50-60% increase in dollar earnings from today’s depressed level over the next 2-3 years.
Historically, corporate earnings growth is very closely tied to GDP growth. Looking at the data in the chart above, between 1986 and 2018 USD nominal earnings grew by 5.8% , which can be decomposed into 2.5% real GDP growth, 2.5% inflation and 0.8% currency appreciation. This is a logical relationship premised on the corporate sector retaining a relatively constant share of GDP. This link between earnings and GDP leads to the “Buffett Indicator,” a concept which famed investor Warren Buffett has cited as the best measure for valuing the stock market. The Buffett Indicator looks at the value of the stock market relative to GDP over time. Since earnings and GDP maintain a relatively constant relationship, any difference in the value of the stock market relative to GDP can be attributed to valuation (the multiple of earnings implied by the value of the stock market). The Buffett Indicator for Brazil is shown below. The graph shows the relationship between the stock market (Bovespa) and GDP for the past 50 years. Periods where the stock market has been well below GDP are those where valuation multiples have been very low, creating opportunities for investors. We can see that that was the case in 2016 but not so much today. What we do have today is a GDP line which lies well below the trend line (red dotted line). This brings us back to the output gap, and the potential market appreciation based on economic recovery.
Multiples
The price that the market is willing to pay for earnings can vary enormously over time. We look at both the price-to-earnings (PE) multiple on the earnings of the past 12 months and the Cyclically Adjusted Price Earnings multiple (CAPE), which is a ratio made popular by value investor Ben Graham in the 1950s and most recently by Yale professor Robert Schiller. The CAPE smooths out earnings by taking an average of the past ten years of earnings adjusted for inflation. The chart below looks at both PE and CAPE in Brazil for the past 30 years. The CAPE ratio is clearly the better indicator in Brazil, having nicely pointed out the high valuation of the market in 1996 and 2008 and the low valuation in 2002 and 2014-16.
As the table below shows, the CAPE ratio of 9.6 is low compared to the historical average (1987-2018) and also the average of the past 15 years. However, it has been much lower in the past, ranging from 5.1 to 32.1. Assuming a positive business cycle in Brazil for the next five years, one might expect the CAPE ratio to eventually rise above historical averages.
We can also compare multiples to those of other markets, such as the United States. The table below looks at the sectorial composition of both the MSCI Brazil and the S&P 500, and the multiples by sector for the U.S. market. The U.S. market currently trades at a forward PE multiple of 17.2 times expected earnings for the next 12 months, compared to 10.2 times for Brazil. If we adjust the sector composition of the S&P 500 to make it the same as Brazil’s then the U.S. multiple falls to 15.1. In the case of the CAPE ratio, the S&P 500 currently stands at 33.3 (29.2 adjusted for Brazil’s sector composition) compared to 9.6 in Brazil.
Market Upside
The potential upside for the Brazilian market is good, though not as high as at the bottom of previous corrections in 1982, 1987, 1990 and 2002. The combination of multiple expansion (from a CAPE of 9.6 to 15) and earnings growth (+60% over the next 3 years) could easily result in a doubling or tripling of the stock market.
However, this doesn’t mean that investing in Brazil today is a simple proposition. The market has been much cheaper in the past because of a combination of lower multiples and a very depreciated BRL. The global environment is deteriorating right now for countries like Brazil with fragile economies. At the same time, if the election results in more “social populism” and Brazil’s finance deteriorate further, the BRL and the stock market may still need more time to find a bottom.
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