Brazil, state-sponsored companies, and food

5 Nov 2012 by Jim Fickett.

I am, in general, looking for more global diversification. A good place to look for an opportunity is in Brazilian agriculture.

I am worried about the long-term health of both the dollar and the rule of law in the U.S., and am looking to diversify globally a bit more. Canada, Europe, Mexico and Brazil are at the top of my list for foreign investing destinations.

Brazil's major strengths include:

Weaknesses there are, of course; among the worst:

The problems are serious enough that it is hard for me to get excited about an ETF covering the whole Brazilian stock market, but the strengths are such that I would like to find a way to invest. Looking one level down, from the nation to sectors, some of the most common recommended areas are banks, commodities, and agriculture.

The banking sector might be a reasonable place to invest, as banks in Brazil have phenomenal interest margins. However the government, aware that the credit boom which has driven much of Brazil's recent growth is in some danger, is strongly pressuring the banks to reduce interest margins. In addition, of the three sectors this is the one least favored by major global trends.

Commodities are, of course, attractive in general, given high levels of debt worldwide and central banks testing the limits of paper currencies. However Brazil's commodities sector is particularly dependent on rapid growth in China, and I am somewhat skeptical that China's boom is a long-term one.

The agricultural sector is where I will look first. Barring a truly horrendous pandemic, the world population will continue to grow, and the general consensus is that it is going to be challenging to feed everyone. Brazil has some of the better farmland in the world (of all the farmland in the world receiving a meter or more of rain per year, one-fourth is in Brazil), and is a major exporter of food. In addition, the government has established top-notch agricultural research and education and, as a result, farm productivity has been increasing steadily.

Many companies in Brazil are closely tied to the government. My natural inclination is to avoid companies whose management is seen as a national rather than private matter (and I have been reluctant to look into Petrobras, the oil company, for that reason). However a few months ago I ran across an interesting article on national champions, suggesting that special favors from the government often outweigh the poor management that political connections bring:

That state-linked, listed companies should trade at a discount is almost an article of faith for many investors, who say these groups are frequently run as appendages of the state, rather than for the benefit of shareholders. …

Yet the shares of state-controlled emerging market companies have as a whole markedly outperformed private counterparts, both in the shorter and longer run.

Morgan Stanley has identified 122 companies in the MSCI Emerging Markets index that have a 30 per cent or higher state ownership. Collectively they have outperformed the benchmark index by a cumulative 260 per cent since January 2001, and by a third since the trough in October 2008.

“Co-investing with the state has historically been a winning proposition,” concludes Jonathan Garner, head of emerging market research at Morgan Stanley.

Mr Garner suggests several reasons for why these state-controlled companies have fared so well. Many are “national champions” that can benefit from state guaranteed loans or implicit support that lifts ratings and caps borrowing costs. Access to natural resources, specific budgetary allocations, tax benefits and regulatory exemptions also help.

Moreover, the reporting standards are often better than at smaller, private sector companies, and the trailing dividend yield – and the capital to cover these payments – is higher on average, Mr Garner points out.

Despite these advantages, the 122 government-related entities trade at a trailing price-to-earnings ratio of 7.9 times, a 31 per cent discount to the MSCI Emerging Markets index PE ratio, according to Morgan Stanley’s calculations. “This suggests significant relative value currently for the state-controlled group,” Mr Garner says. …

State ownership appears particularly beneficial in some sectors. By market capitalisation, almost two-thirds of the 122 state-controlled companies identified by Morgan Stanley are energy companies.

In this industry, government links can be advantageous, Mr Davies says. “Integrated oil companies sometimes struggle to make headway in some countries, while national oil companies enjoy the backing of their state, so in this case investors may benefit from aligning with the government.” …

But not everyone is convinced that state-controlled companies are a winning bet.

Michael Wang, a strategist at Amiya Capital, an emerging markets-focused hedge fund, points out that a few big companies that have performed particularly strongly have boosted the overall performance.

“If you get your stock-picking right you could have made a lot of money, but there have been an equal number of state-controlled companies where you wouldn’t have made any money over the same period,” he says.

My take is that one should neither especially favor nor reject an investment candidate based on involvement of the state, but just do your homework as usual.

So, bottom line, I am looking for an investment in Brazilian agriculture. I doubt it makes sense for a foreigner to try to own land directly, so I am looking for shares in a farming or farming supply company – preferably one not overly impacted by poor infrastructure.