Brazilian equities: quick and dirty guide why and how to invest in Brazil

Brazil – beaches, samba, Rio de Janeiro. These are the widely known facts. For the more curious, Brazil is a BRICS`s B, a leading agricultural producer, and one of China`s main import partners. At the same time, Brazil suffers from all the typical problems of South America – corruption, inequality, and crime.

Despite these, Brazil is the region’s leading economic and political player. Together with Chile, it has the best image of any country in South America among American and European political elites. This puts it in an advantageous position vis-à-vis its South American neighbors. At the same time, Brazil is a member of BRICS. An alliance with an uncertain future, hazy goals, and achievements, but a factor on the geological chessboard.

Brazil is China’s second major supplier of raw materials. The first is Russia, from which the Chinese import energy raw materials. From Brazil, they import agricultural produce and metals. Brazil could not be described with a few words. In the next chapter, I will highlight its advantages.

Brazil at glance

Brazil is the world’s eighth (based on country GDP) economy and the first in South America. Its strength and potential rests on the following:

· A large population, of which 69% is of working age, i.e., 150 million of the total population;

· Brazil, the world’s fourth-largest country in terms of arable farmland, is in the top five in soybean production and first in coffee, orange juice, and sugar production;

· They have some of the largest Pre-salt reserves of gas and crude oil – relatively easy to extract, therefore cheap and high-quality oil;

· The election of Lula da Silva has stabilized Brazil politically – after the relative isolation of the Bolsonaro administration, the country is gradually returning to the geopolitical game;

· Abundant natural resources – Brazil ranks among the top five in the world for bauxite and iron ore; among the top ten for gold, crude oil, and natural gas.

Brazil and Argentina are some of the countries best positioned to benefit from global changes – secular inflation, capital transfer from the core to the periphery, and increasing geopolitical fragmentation. The movement of capital from the core to the periphery is once again linked to the new bull cycle in commodities and the rise of emerging markets.

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Core to periphery

Tangible assets and emerging markets (EM) will dominate the current decade. Most EMs are commodity exporters. Brazil is no exception.

China’s integration into the global economy drove the previous commodity super cycle. The current catalysts are a few:

· Capital cycle – decades of minimal or no investment in the commodities sector guaranteed to destroy present and future supply. In the coming years, the supply will not be able to satisfy demand. The deficit in many commodities will keep growing.

· Upgrading infrastructure in the US – over $1 trillion allocated. This undertaking will need colossal amounts of raw materials.

· The Green Deal Part 1- As ridiculous as the whole story and the people promoting it are, they achieve the opposite of what they aim for. Demand for fossil fuels and ores will grow even more. Without them, there is no way to produce all the necessary infrastructure for the green “transition.” The quantities of base metals, rare earths, and energy commodities needed make upgrading US infrastructure look like renovating a cottage.

· The Green Deal Part 2 – much of the “green metals” are mined and processed in China. Unless new deposits are developed, Europe and the US will depend on China. Decades ago, the Western world could afford dependence on OPEC countries because it had control over them in one way or another. Now times are different – political and economic fragmentation and polarisation reminiscent of the Cold War. That is why more and more investment will be directed towards friendly and neutral countries that possess such raw materials. Brazil is among them.

· India is climbing the GDP S curve – the GDP per capita curve is not a linear straight line. It has the shape of an S-curve. Crossing the $2,300-$3,300 GDP per capita means that a relatively large proportion of the population has escaped extreme poverty and is moving toward relative prosperity. This means one thing – increasing consumption, which requires more and more raw materials. China made this leap 20 years ago, which triggered the previous bull cycle in commodities.

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A weak dollar and rising commodity demand put Brazil in an advantageous position. The movement of capital from the core to the periphery will work for it as long as it allows. There are several other factors that I still need to describe. The ones I have mentioned are the long-term ones – they will affect the commodities market in the coming years in the same way as the tide lifts all boats.

Since the beginning of the year, we have started to see the action of the tide – the stock market in Brazil is among the leaders in year-to-date growth.

Brazilian stock market

I will show how undervalued the Brazilian equity market is today with a few charts. The first illustrates the primary Brazilian equity index IBOVESPA valued in price-to-sales ratio.

Crescat Capital

The graph shows the aggregated value for all companies included in IBOVESPA. The current low is comparable to the 2008 GFC (external shock) and the political crisis in Brazil (internal shock) in 2015.

Brazil is politically stable, and globally we are going through a “normal” turbulent period. However, the market is pricing Brazilian equities as if Brazil were going through a deep internal or external crisis.

The second chart shows the relationship between Brazilian stocks and commodity producer equities. There is a close correlation between the two because a large part of Brazil’s GDP is based on mineral extraction and agricultural production.

Crescat Capital

The top half shows Brazilian and commodity producer stocks as separate variables, and the bottom half shows their ratio. Brazilian stocks need to catch up to commodity producers.

Both charts show that Brazilian stocks are still deeply undervalued, even after a solid first half of 2023. The beginning of a bull market in Brazil directly correlates with the new commodities super cycle. The close correlation between commodities and the Brazilian economy makes investing in Brazil a venture that requires attention and commitment. In the next section, I will provide safety instructions on how NOT to invest in Brazil.

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Brazilian equities and their peculiarities

Money always moves from the impatient and unprepared to the patient and prepared. Brazil demands more of both. Investing in regions and markets we do not know is dangerous. The circle of competence works at the level of sectors and instruments but for world regions too.

The Brazilian economy and stock market closely follow the commodity cycle. That’s why the charts of IBOVESPA companies resemble those of a mining company – sharp declines followed by epic highs followed by new lows.

This feature is essential because by buying shares even in a Brazilian bank, we are taking a long position in bauxite, soya, iron ore, gold, and oil – commodities that Brazil has in abundance and whose price determines the state of its economy.

In addition, a considerable part of commodities exports is directed to China. This means that the Brazilian economy is a derivative of the Chinese economy. When China prospers, Brazil prospers, and vice versa. The following graph clearly illustrates Brazil’s dependence on China and commodity prices, in particular agricultural output:

Gavekal Research

The charts imply that the Brazilian stock market is a function of the Chinese economy and agricultural market.

Considering these features, buy and hold strategies, dollar cost average, and long-term positions for over a few years are not recommended. Brazil is not the US or Europe, where you can hold stocks for decades, realize capital gains, and receive regular dividends. Investments in Brazilian companies require a rigorous risk mitigation plan that includes active position management.

The risks inherent in Brazil are already calculated in the stock prices, and the risk-reward is perfect for building asymmetric positions with a 12-24 month horizon.

The industries I look at are linked to Brazil’s strengths – solid demographics and abundant natural resources. These include – banking, education, health care, mining, and heavy industry. They will generally benefit from the new market paradigm.

Companies operating in those industries show robust financial statements – growing free cash flows and solid balance sheets. Both are mandatory prerequisites for any company I consider investable. The reason is simple: they increase any company’s chance to survive and prosper.