Investors in Brazil have had the dubious pleasure of undergoing one of the more stomach-churning rides in 2014. In U.S.-dollar terms, Brazilian equities rallied roughly 40% from their spring lows through early September, before surrendering all of those gains following a disappointing election outcome. Although the sell-off of the past few months has pummeled valuations, bargain investors might be better off looking elsewhere for a more promising emerging-market opportunity. Here are the reasons why:
Brazilian equities currently appear undervalued, but they have been cheaper before. The market is recently trading at about 10x price-to-earnings ratio and 1.20x price-to-book value, making valuations low, but we have seen lower prices in early 2003. On a relative basis, while Brazilian equities now trade at a 15% discount to other emerging markets, this is still above their long-term trend. Over the past 15 years, the discount was typically around 22% and swelled to 35% in the summer of 2013.
Bad fundamentals. Even with inexpensive equity valuations, I believe fundamentals don’t support a value play. Corporate profitability for Brazilian companies is below its long-term average and that of other emerging market companies (return on equity of 8% vs. 12% for the broader EM universe). Equally problematic, Brazil’s economy is struggling under the double weight of sluggish growth and relatively high inflation. Growth for 2015 is expected to be around 1% (growth peaked at over 7.5% in 2010), while inflation is expected to remain stubbornly high at 6.3%, just below the upper-end of the central bank’s target. The problem: Brazil suffers from a combination of poor infrastructure and declining demand for commodities.
Mediocre prospects for reform. The equity market rally in the spring and summer was predicated on investor optimism for a change in government. Hopes of policy changes were shed when President Dilma Rousseff was re-elected in late October. Adding to the gloom: the delay on the nomination of the next finance minister (signaling difficulties in attracting reputable figures) and a significant corruption scandal surrounding the state-controlled oil producer Petrobras.
Negative momentum and sentiment. From a top-down perspective, momentum continues to look negative going into 2015. Global investors are favoring other parts of the EM space, notably Asia, and local investors prefer bonds as short -term interest rates are over 11%, some of the highest rates in the world.