Brazil Scandal Not Expected to Impact the Long Term
The Brazilian equity market sold off strongly last week following the claim by a major newspaper that it had obtained a recording of the new Brazilian President, Michel Temer, discussing corrupt practices with a powerful businessman. With another period of political uncertainty ahead and potential for a second impeachment, we outline a summary of our current views in this note.
We have exposure to six Brazilian listed companies in our Emerging Markets strategy, with a combined weight of 11% at week ended May 19, 2017. At this time, none of our Brazilian holdings are banks. As bottom-up stock pickers with a quality growth style, our Brazilian investments have been selected due to their individual franchise strength and potential to deliver stable, less cyclical, and predictable growth over the long term. We have not sold any of our Brazilian holdings, nor have we had a change of view on the fundamental value of any of our holdings due to last week’s events.
As long-term investors in emerging markets for more than 20 years, we have seen many political upsets. We recognize that macro change, if drastic enough, can cause damage and act as an “off switch” for our investments. We look for red flags such as the potential for sharp changes in regulation or tax structures, as these can damage the long-term profit growth of even the best operator. However, we do not see anything to suggest this might be the direction Brazil is heading towards at this moment.
The political situation in Brazil returned to crisis mode, following the publication of a damning article on May 17, in O Globo one of the country’s leading newspapers. The article tied President Michel Temer to a conversation involving corruption that he appeared to endorse. The potential fallout from this revelation led the Bovespa stock market index to sell off 10% over the two-day period May 16-18, which combined with a sharp fall in the real against the dollar, left the index off 18% in U.S. dollar terms. The sell-off was led by the banks, in part as they are the largest sector in the MSCI Brazil index, but also due to their sensitivity to a macro recovery. On Friday May 19, the market and currency recovered some of the lost ground as the government held its coalition together and rebutted the accusations, leaving the market still up 5%, in U.S. dollar terms, year to date.
The O Globo article refers to a recording made between Mr. Temer and Joesley Batista, the Chairman of JBS, a large Brazil-based multinational meat processing company with 235,000 employees. According to the paper, the discussion included Joesley Batista outlining some of the ways he has dodged legal pressure from the huge Operation Carwash anti-corruption case through ‘cooptação’ (winning over) judges and prosecutors and the use of payments, to which the president replied “optimo, optimo” (fine, fine). This may not constitute a crime by the president, but it implies at the least he is comfortable with it. As a result, the Attorney General has requested the opening of an investigation. The government in response has admitted Temer met Batista, but disagreed that there was anything said in their conversation that implicated the president. The president stated he will not resign.
So, what does this mean?
First, it implies there is an active dragnet to try and catch high-level political corruption. According to O Globo, the Batista brothers had reached a plea bargain agreement to not only provide a list of bribes they paid to politicians going back 10 years, but to wear wiretaps to incriminate corrupt politicians. Fundamentally, breaking the back of high level corruption is hard to see as anything except good for the future.
However….secondly, without political cohesion in Brazil, much needed economic reforms could languish. The irony is that Temer has been doing a surprisingly good job getting the reforms pushed ahead. It is this second point that is causing the nervousness in the markets. Brazil is in a tenuous economic recovery following two years of deep recession and needs to pass certain economic reforms to keep the government finances sustainable.
In 2016, the Temer government passed a major amendment to the constitution bringing in a ceiling for federal (non-interest) spending in real terms over the next 20 years. This will be difficult to manage without subsequent reforms, in particular pulling back the cost of pensions. Brazil’s spend on pensions relative to GDP is one of the highest in the world at 11%, with pensions and other benefits accounting for nearly half of federal non-interest spending. A structural issue Brazil faces is the rapid increase in retirement age population, with the proportion of those age 60 or above set to rise from 10% of the population in 2010 to 20% by 2035 according to figures from the World Health Organization. Without reform, the International Monetary Fund (IMF) estimates pension spending will rise to 18% of GDP by 2030 and continue rising. With a cap in place and rising pensions, other spending would have to be cut. Problems with the pension system include low average retirement age and high average pension relative to income earned. With so many vested interests, the planned reforms have been contentious and therefore appear to us to require political cohesion to get passed.
How does the economy look?
Following two years of deep recession, the country is set to hold stable in 2017, with the IMF forecasting GDP growth of +0.2%, followed by +1.7% in 2018. The economy has been helped by a number of factors including: a bumper soybean crop, recovery in iron ore prices, falling inflation, eight months of falling interest rates, and a positive outlook for reforms with a new president following a long period of uncertainty leading to the impeachment of Dilma Rousseff. Most of these are one-offs and we believe the economy would benefit from investment into its infrastructure that would both create new jobs and relieve transportation bottlenecks. Temer launched R$45bn (U.S.$14.4bn) of infrastructure concessions in March aimed at building roads, ports, railways, and power transmission lines. There is a chance political instability could postpone the tender process and, in turn, slow the country’s recovery.
What is the outlook for our holdings?
Each of our six Brazilian holdings is driven by different factors with a long runway of growth forecast ahead. Our largest exposures are to Ambev (beer and bottling), Ultrapar Participacoes (speciality chemicals and distribution), and Cielo (merchant acquirer – credit and debit cards). We have not held a Brazilian bank since 2015 due to our unease holding banks through recessions, when we are unsure of the stability of the economy. Banks are leveraged by structure, and through recessions, losses can accumulate, while at the same time fresh equity can become very expensive. We are content to patiently wait and watch for economic predictability and a solid banking environment.
Ambev: 62% owned by A.B. InBev the world’s largest brewer controlled by 3G. Ambev is the dominant Brazilian brewer, but also has significant operations in Canada, Central America, and much of Spanish speaking South America. The structural drivers behind the demand for Ambev’s products include growth in the legal drinking age population, which is forecast to grow around 1.4% annually over the coming five years, alongside rising disposable income, and new drinking traditions as the middle class develops. The company controls Labatts in Canada where the Labatt brand alone had a volume market share of 43% in 2016 according to the company. Other 2016 market share positions in beer include: Brazil 66%, Argentina 75%, Paraguay 76%, Uruguay 95%, and Bolivia 96%. We see the company’s long-term potential driven by structural changes across its markets from both population growth and the increasing middle income consumers. We do not believe political volatility is likely to alter the intrinsic value of the company.
Ultrapar Participacoes: a Brazilian fuel and chemical storage and distribution company with five main business lines. Its primary businesses are its gasoline distribution business that delivers to approximately 7,500 gas stations in the country, and its LPG distribution business with a 24% market share by volume in Brazil, delivering to around 11 million households through a network of 5,800 independent retailers. Its other businesses include: Oxiteno, one of the largest producers of ethylene oxide and its derivatives in Latin America; Ultracargo, a bulk liquids storage company; and Extrafarma, one of the top 10 drugstore chains with 315 stores that levers its relationships with gas stations for new locations. We believe Ultrapar’s management has a strong track record of capital allocation through disciplined acquisitions, the overall business manages a return on equity in the high teens and generates substantial positive cash flow.
Cielo: the largest provider of payment card services and processing and settlement of credit and debit card transactions in Brazil, with 47% market share by transaction value. Through the company’s two major shareholders, Banco do Brasil and Bradesco (approximately 8,400 branches), as well as partnerships with other banks, the company has a broad distribution platform that feeds a business with recurring fees based on transactions and terminals in force and without credit exposure to the end users. Cielo has invested heavily in new payment channels including mobile and e-commerce products. In Brazil, over the last 10 years, card volume as a proportion of personal consumption expense has risen from 16% in 2007 to 28% in 2016 (source: IBGE, ABECS). We see the long-term growth being driven by the structural market share shift from cash and checks to cards and e-commerce payments, alongside the long-term growth in spending as the number and wealth of middle income households rise.
In summary, there is always the chance something significant might happen in an economy, and as bottom-up investors we are aware that macro level developments have the potential to damage any top or bottom line if the situation is dire enough. Macro can act as on “off switch.” However, we never view a macro call as enough on its own to justify a buy. We always need delivery of EPS growth to be generated by a business we believe, after deep analysis, can power itself through weak economic times. It is this quality of earnings we rely on to drive returns over long-term holding periods for our investors – and over long holding periods rarely, if ever, does the economy always look attractive. In Brazil, despite the recent political surprise, we do not see anything at this point that we believe might damage the long-term growth prospects, or the market positioning, of the companies we hold. As a result, we maintain our exposure to these well managed and market leading franchises at this time.
May 19, 2017
Past performance is not a guarantee of future results.
Virtus Investment Partners provides this communication as a matter of general information. The opinions stated herein are those of the author and not necessarily the opinions of Virtus, its affiliates or its subadvisers. Portfolio managers at Virtus make investment decisions in accordance with specific client guidelines and restrictions. As a result, client accounts may differ in strategy and composition from the information presented herein. Any facts and statistics quoted are from sources believed to be reliable, but they may be incomplete or condensed and we do not guarantee their accuracy. This communication is not an offer or solicitation to purchase or sell any security, and it is not a research report. Individuals should consult with a qualified financial professional before making any investment decisions.