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Buying cheap Brazilian equities

16 Jul 2015 by Jim Fickett.

Inflated markets never last forever, even with central bank support, and bargains are once again beginning to appear. At least platinum, coal, and some global equities are cheap. This post is about Brazilian stocks.

There is ample bad news out of Brazil. Corruption has caught up with current leadership. A drought is hitting hydroelectric plants and residents of the largest cities. The cost of the many apparent freebies handed out by Lula, the previous president, have begun to significantly impact the federal budget. The two biggest props under the previous expansion – the global commodity boom and a huge expansion of domestic consumer credit – have both gone bust. And so sentiment is very poor as, for the short term, it should be.

However there is little reason to think Brazil will not recover from this downturn, as it has recovered from others. There are two possible caveats to that statement. The first is inflation, currently running at 9%, and still rising. Brazil had a bout of hyperinflation in the 1980s and 90s. If that were to return all bets would be off on the value of any equities. That is a real risk, but the government seems realistic about trimming the budget and keeping interest rates high, even though it is causing a recession. Second, Brazil has abysmal infrastructure. Recent data confirm that the summary on this topic that I wrote in 2012 (Brazil infrastructure) still provides a reasonably accurate picture. On the one hand, I don't believe sustained high growth will be possible unless the country finds a way to tackle this problem. On the other hand, businesses have always found a way to function despite the terrible roads and ports, and will continue to do so.

All in all, I think it is not clear to what extent the country will experience extraordinary growth again, but it would be surprising if the economic cycle were not to bring at least a normal recovery in due time.

Research Affiliates reports that CAPE for the MSCI Brazil index is currently at 9.2, compared to an historical median value of 16.3. The EPS record only goes back to 1994, so the CAPE record only goes back to 2004. Still, 9.2 is low enough, on an absolute scale, to provide a reasonable margin of safety. The nominal dollar price of EWZ, the iShares MSCI capped ETF, is approximately at a 10-year low. This is partly due to the behavior of the Brazilian domestic market (cf. the performance of DBBR, a dollar-hedged fund), and partly due to the fact that the dollar is approximately at a 10-year high against the real. Thus both the economic cycle and the long-term cyclicality of exchange rates are in favor of a current buy.

There are a number of ETFs focusing on Brazilian stocks but only one two, EWZ and DBBR, follow the broad market. I prefer NOT to hedge the exchange risk; I will put 2% of the portfolio in EWZ tomorrow.