Brazilian Research

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Brazilian Research

© Mike Hodges


I get sent all kinds of research and documents from all over Brazil.  I recently received this which was produced by BTG Pactual which you might find interesting:

Stick with the quality names, even if they aren’t a bargain.

Switch to cheap/out-of-favor plays or stick with good/expensive ones?

The dilemma most investors are facing now is whether to stick with the sectors supported by good macro fundamentals but that are no longer a bargain, or to risk switching to out-of-favoured sectors in the hope of better days ahead. Our portfolio is starting 2013 the same way it ended 2012: favouring sectors with good fundamentals.

We like Consumption, Education, Infra, Capital Goods and BRL plays

Although Brazil’s GDP growth may disappoint once again, some sectors could continue posting decent growth. We favour local consumption (BOV:CSAN3),(BOV:PCAR4), (BOV:BPHA3), (BOV: MGLU3), infrastructure (BOV:CCRO3), (BOV: STBP11), education (BOV:KROT3), (BOV:AEDU3) and capital goods (BOV:AUTM3). We also like some financial stocks (e.g. (BOV:BVMF3) and (BOV:BRIN3) and are keeping some defensive names in the portfolio (BOV:BRML3) and (BOV:CMIG4).

In addition, we would also retain some exposure to the weaker BRL (via Vale, Suzano, Embraer and food companies JBS and BR Foods). On the other hand, we would avoid Oil & Gas, banks, steel and, to a lesser extent, utilities and telecoms.

Ibovespa (BOV:IBOV) of 71,000 at YE13 (or 68,000 ex-Petro); Some upside, but not much based on our analysts’ forecasts (i.e. if the upside potential of all our TPs plays out), the Ibovespa (BOV:IBOV) should end 2013 at 71,000 points, offering upside of 18%. If we exclude Petro, our 2013 Ibovespa (BOV:IBOV) target falls to 68,000 (upside of 13%). Trading at 12.2x 12-month fwd P/E, the Ibovespa (BOV:IBOV)looks relatively cheap, but valuations of out-of-favour and preferred sectors differ strongly (9.6x for out-of-favour vs. 19.3x for preferred sectors).

2013 earnings to grow 15% (ex-Petro), thanks to easy 2012 comps

We are modelling for 2013 consolidated earnings growth of 25%, on the back of easy comps and the fact that Petrobras accounts for 38% of expected growth. Ex-Petro, we expect 2013 earnings to grow 15% (with risk skewed to the downside).

Investment thesis: Switch to cheap, out-of-favour plays or stick with good/expensive ones?

We prefer the latter.

The Ibovespa (BOV:IBOV) did poorly in 2012 (up 7.4%, less than an average Selic rate of 8.6%), especially considering its feeble performances in 2011 (-18.1%) and 2010 (+1.0%) and the performance of its peers (in 2012, the Ibovespa (BOV:IBOV) posted the weakest performance in USD among its Latin America peers, the S&P500 and the Dow).

However, the performance of the Ibovespa (BOV:IBOV) was dragged down by the poor performance of a few heavyweight sectors. While Oil & Gas (16% weight), Banks (12%), Telecom and Utilities underperformed the broad tape, the rest outperformed – although Mining (another heavyweight with 11%) only just beat the Ibovespa (BOV:IBOV). Some did much better. Education rose 115%, retailers 70%, pulp and paper 64%, capital goods 52%, etc (see chart 3). So, the dilemma most investors are facing is whether to stick with the sectors supported by good macro fundamentals but that are no longer a bargain or to risk switching to out-of-favoured sectors hoping for better days.

Looking for alternatives in sectors with good fundamentals

Our portfolio is starting 2013 the same way it ended 2012: favouring sectors with good fundamentals. There is no question that the fundamentals of the Brazilian economy have been deteriorating, with economic forecasts in the past months changing for the worse. GDP growth expectations, which were close to 4.0% in Nov/12, are now at 3.2% and further revisions should continue to be to the downside. At the same time, inflation forecasts are rising after recent data signalled higher inflation at the end of 2012 (consumer inflation, as measured by the IPCA index, ended 2012 at 5.84%, well above the 4.5% target midpoint). With inflation heading north (market consensus is now pointing to 5.65% in 2013, compared to 5.47% a month ago), the government may have fewer tools to revive the economy. To make matters worse, energy rationing (if confirmed) would further pressure inflation indices and reduce potential GDP growth. So, 2013 could be quite a challenging year for Brazilian companies.

That said, although overall GDP growth may disappoint once again, some sectors could continue to grow decently. Consumption-related sectors should continue to do well. Unemployment rates are at record low levels, the wage bill continues to trend higher, and the government has been trying to foster growth via a series of pro-consumption measures. Capital goods may also continue to benefit from the government’s stimulus measures. Another sector we expect to continue to do well is infrastructure. There are numerous opportunities to improve Brazil’s infrastructure and we believe the Brazilian government is willing to improve conditions for the private sector in order to boost the

latter’s participation (in fact, given how tight labour markets are, stimulating private sector investment in infrastructure is probably the best way to drive economic growth).  Education is gaining not only from Brazilians’ need to improve their (particularly low) education levels, but also from the government’s financing program (FIES), which has been moving credit risk away from companies and offering students a cheap financing alternative. The 2012 admission cycle was helped by this trend, which we expect to continue in 2013.

We remain bearish on Oil & Gas, Banks and, to a lesser extent, Utilities/Telcos

On the other hand, conditions remain extremely challenging for some sectors that already performed quite poorly in 2012. The prospects for investments in listed Oil & Gas companies in Brazil, mainly Petrobras (BOV:PETR4), are challenging. Petrobras (BOV:PETR4) production figures are uninspiring to say the least, and without a sizable gasoline and diesel price hike it will continue to post weak results. We believe there is a strong chance of gasoline and diesel prices being hiked in the short term, but we don’t expect the size of the hike to be enough to recover Petro’s (BOV:PETR4) losses in the sale of these products (a steeper price rise could have a major negative impact on consumer inflation – something the government is keen to avoid). For those expecting a relatively big price increase, at current levels Petrobras (BOV:PETR4) would be a good investment opportunity. We are more sceptical and would remain underweight the name.

We are still cautious on banks after the raft of government measures last year. With public banks aggressively providing credit at reduced spreads, private banks may continue to lose market share, i.e. top line growth may be timid. On the other hand, NPLs have stubbornly refused to come down much, preventing banks’ profitability from improving. A more sizable economic rebound could help bring NPLs down and serve as a trigger for the sector, but at this point macroeconomic and credit data don’t signal a stronger recovery. We would rather own mid-cap banks at this point and our preferred picks are Banrisul and Daycoval. At this point, we think Utilities’ stock prices have adjusted to the negative events that took place in 2012. That said, it remains unclear what will drive sector stocks back up, while we believe pending definitions to concession renewals and the threat of energy rationing may add volatility. We would be very selective in picking utility stocks, and Cemig is the name we like the most.

Among telecoms, the competitive environment (extremely tough in 2012) may get even worse in 2013, with the big players expanding their operations to regions where they are currently weak. In addition, M&A talks may turn relatively smaller players into larger, integrated competitors. At least the regulatory framework looks clearer after Anatel released important regulation at the end of 2012. We like home builders’ macro fundamentals, in the form of decent pent-up demand for housing in Brazil, credit availability and the government’s willingness to boost the sector via stimulus measures. The large cap names are relatively cheap, but should take longer to resolve their respective internal issues (e.g. down scaling operations, termination of sales, cost overruns, etc). We believe the best way to play housing is via smaller caps or real estate brokers – and although neither look particularly cheap, they are definitely better options than large caps. We are including Even in our portfolio.

Retaining some exposure to a weaker Real

Most of our pick are stocks exposed to Brazil’s domestic economy (despite the dire economic prospects of the Brazilian economy) as we still think that the prospects for the global economy aren’t much better, with Europe barely growing and the US growing but not much (with extra volatility from the seemingly endless fiscal crisis). China’s economy has been showing some signs of improvement (albeit marginally), but higher inflation may prevent a stronger rebound.

That said, we decided to expose part of our stock selection to a Real that has gotten weaker over the past year and to some sectors that may gain from specific improvements in the global economy. We have included companies like Vale (weaker Real + better prospects out of China), Suzano (weaker Real + deleveraging), Embraer (weaker Real + better cycle in 2013 + some government stimulus on personnel costs) and food companies BR Foods and JBS (weaker Real +synergies/deleveraging + stimulus on personnel costs). All-in, we continue to favour local consumption, education, capital goods and infrastructure sectors, and would also retain some exposure to the weaker Real (viamining, paper and pulp and food). Although we like the macro fundamentals of the housing sector, we would remain on the sidelines as we don’t see how to play it (micro issues aren’t helping). We would continue to avoid Oil & Gas (Petrobras(BOV:PETR4)), Banks, Steel and, to a lesser extent, Utilities and Telecoms.

And focus on stock picking…

Choosing the right sectors may not be enough to guarantee a good performance in 2013. Stock picking has been important in recent years, and may be even more crucial in 2013 as prices of good quality stocks have soared. Clearly, finding decently priced stocks among the sectors we like the most is a major challenge. On domestic consumption, we favour ethanol producer and fuels distributor Cosan, supermarket play Pao de Acucar, drugstore BR Pharma and retailer Magazines Luiza. We also like Lojas Americanas (which is among the top picks of our retail equity research team), but overly high valuations (30x 2013E P/E) prevent us from adding it to our recommended list. In infrastructure, we are sticking to CCR (which may benefit from Brazil’s urgent need to improve its overall infrastructure) and Santos Brasil (to play the solid prospects of Brazil’s container terminal segment). In capital goods, we like Autometal, which is relatively cheap, gains from government stimuli for auto production and has decent exposure to the promising Mexican market (40% of sales).

Sectors View

We are keeping our exposure to Education via Kroton and Anhanguera, and sticking with BVMF as our top pick among financials as we believe the company will continue to gain as investments shift from more traditional fixed-income instruments towards equities and derivatives. We also like the stock momentum of BR Insurance and the resilient and defensive BR Malls, as a protection against inflation. To complete our selection of stocks exposed to the domestic economy, we would add Cemig as a defensive, cheap stock and Even, our top pick among home builders.

As we mentioned earlier, our top picks among the names exposed to a weaker Real, leveraging and the global economy include mining giant Vale (BOV:VALE5), paper and pulp producer Suzano, food companies BR Foods and JBS and aircraft maker Embraer.

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