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Valuations reflect Brazil's reality, says EM boutique star

Valuations reflect Brazil's reality, says EM boutique star

Recent economic and political events in Brazil including the Petrobras scandal have made some investors cautious about the region, but Citywire A-rated Matt Linsey is now positive on the country.

In an investor update, the founder of boutique North of South Capital, who also runs the GAM Star North of South EM Equity fund on mandate, said the country was facing a lack of growth and political uncertainty and this is visible in the price of Brazilian equities.

'From a macro perspective Brazil has rarely looked worse than it does today,' he said. ‘Over the last ten years we have generally been cautious on the outlook for Brazilian equities given that valuations relative to the domestic fixed income were not attractive, with real rates averaging between three and six percent.'

‘With current five year interest rates of 15.6% those selling Brazilian equities are facing a very difficult task. It is precisely for this reason that we are becoming more positive on Brazil as valuations now reflect this reality unlike in the past.'

‘Taking the five year rate of 15.6% as our risk free rate and adding on equity risk premiums ranging from six to ten percent we still see upside to current share prices for a number of stocks,’ he said.

Linsey currently has an allocation of 9.75% to Brazil, which is up from the first quarter of the year, where he reduced his exposure to 7.59%. He listed the recent S&P downgrade to junk status and the arrest of the chairman of Latin America’s largest investment bank BTG Pactual as contributing factors to Brazil’s economic situation.

‘The economy should contract by approximately 3.5% this year. Market consensus is for a further decline of 2.3% in economic activity in 2016, with some brokers now calling for a contraction in 2017. Even if the economy were to begin to stabilise today, this will still rank as the worst economic contraction for Brazil since the 1930’s.’

‘In fact, the only one we can think of is a mark improvement in the current account deficit due to falling demand for imports, which in turn has helped to stabilise the real,’ Linsey said.

Distressed stocks

Linsey named electronic retailer Via Varejo as a stock which offered opportunities in the long term as it is trading at a distressed valuation. Elsewhere, he predicts property developer Ez Tech will decline to 14.5% next year before recovering to reach a sustainable level of 22.5% in 2020.

‘The company has also increased its payout ratio from 25% to 34% this year to support its return on equity. Cash currently accounts for 11 % of market capitalisation. They are on course to complete the EZ Tower B in Sao Paulo this year.'

‘Given these assumptions and an equity risk premium of 6.6% we arrive at a cost of equity of 22.2%. Surprisingly, this still gives us an upside of 15% on the stock,’ Linsey said.

The GAM Star North of South EM Equity fund lost 10.5% in US dollar terms over the three years to the end of November 2015. This compares to a fall of 12.15 by its Citywire-assigned benchmark, the MSCI EM (Emerging Markets) TR USD, over the same period. 

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