Small Cap Bargains in Brazil

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It has been exactly 1 year since I wrote our first bullish piece on Brazil.

The thesis is working out well so far.

The Brazilian ETF we like (EWZ) is up 54% over the past 12 months.

And in January, Brazil got a huge endorsement from hedge fund legend Stanley Druckenmiller. Via Yahoo Finance:

Billionaire investor Stanley Druckenmiller’s investment firm built a substantial position in Brazilian stocks just before a major market rally in January.

Duquesne Family Office acquired approximately 3.5 million shares of the $9.1 billion iShares MSCI Brazil ETF during the fourth quarter of 2023, according to regulatory filings. The firm also purchased call options on the fund.

Assuming Druckenmiller got into EWZ around $32, that’s a $112 million position, plus the call options. That’s sizable, even for a billionaire like Druck. Having him on board is great news.

Today we’re going to explain why Brazilian stocks still have major upside, and why small caps might be the next big mover.

Room to Run

I recently found a Morgan Stanley report titled LatAm Spring. The emerging market team at MS is apparently very bullish on Latin America, and especially Brazil.

The report is a 268-page monster, filled with great charts. I read it all, and will share some of the more interesting findings.

The chart below is fascinating. It shows what a “rule of thumb” portfolio looks like (60% stocks, 40% bonds), compared to the average portfolio in Latin America and Brazil.

Source: Morgan Stanley Research

In Brazil, investors only have 9% exposure to stocks! They maintain a shocking 91% exposure to fixed income (bonds, CDs, annuities).

Why do they hold so few stocks in Brazil? Because for the past 15 years, Brazilian stocks have been getting crushed. Foreign investment dried up, because for a long time, commodities were out of favor. And Brazil’s a commodity-heavy economy. Oil, iron ore, copper, precious metals, and more.

And after the COVID pandemic, inflation in Brazil reached 10%. As a result, the central bank jacked up interest rates to 15%.

Why own stocks when you can get paid 10%+ in fixed income (bonds and similar securities)?

But now, Brazil is entering a rate-cutting cycle. In March, interest rates are expected to begin easing.

This should make stocks far more attractive to local investors. And foreign money is already flooding into the country over the past year.

As investors switch from fixed income back into stocks, share prices will naturally rise.

It’s a beautiful setup. I haven’t sold a single Brazilian investment, and have no plans to anytime soon. I want to let these dividends compound and valuations grow for years to come.

Growth Returns

Here’s another interesting chart from the Morgan Stanley report. It shows how earnings are expected to grow in a “spring” (bullish) scenario in various LatAm countries.

Brazilian companies could see EPS growth of 11% per year, all the way out to 2035! That would generate impressive returns over the next decade.

If this bullish earnings forecast comes to pass, I believe it will re-rate Brazilian valuations to much higher levels.

(side note – Morgan Stanley thinks Argentina could grow even faster than Brazil. I haven’t studied Argentina as much, but will over the coming weeks. Look for coverage on that soon.)

Small Caps Next to Run?

So far, most of the attention on Brazil has been on the large cap stocks. Giants like Vale (VALE), the iron ore miner we like, which is up 74%. Petrobras (PBR and PBR.A), our favorite oil play, which is up about 30% since we highlighted it. And Nubank (NU), Brazil’s fast-growing digital bank, which is up 49%.

Those are still rock-solid, and I haven’t sold a share.

But I recently found a Brazilian small cap ETF that looks great too. The ticker is EWZS, and it’s managed by iShares, a division of BlackRock.

EWZS owns 70 smaller companies in Brazil, and they are trading at seriously cheap levels. The average P/E ratio is just 9, and the price/book ratio is only 1.1.

For comparison, the Russell 2000 American small cap index trades at a P/E of 34 and a price/book of 2.4. The S&P 500, meanwhile, trades at a P/E of 29 and a price/book of over 5.

EWZS gives you exposure to smaller miners, consumer companies, utilities, construction, oil and gas, and banks. If the Brazilian economy continues to rebound, it’ll do very well.

The fund is a nice vehicle to get exposure to smaller companies in Brazil. I own it and plan to buy more in retirement funds throughout the year.

For more than a decade Brazilian stocks have dramatically underperformed. So there’s still plenty of room to run.

Investors are increasingly interested in gaining exposure to hard assets, higher yields, and cheap stocks. Brazil fits the bill nicely.

And with interest rates set to fall, Brazilian investors will once again be looking to stocks for growth. And small caps are an excellent way to play that trend.

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