Investors Flip Flop on Opportunity in Brazil

Last month, Bloomberg reported that the company that makes Havaianas flip flops may end up for sale by its parent company J&F Investimentos SA. Their major shareholders are at the heart of a bribery scandal and the company is running the risk of requiring some serious liquidity should prosecutors win their case. As a result, Alpargatas, the company that produces the sandals, is trading at a mere 12x estimated earnings; meanwhile, most global competitors are trading at a multiple more than 50% higher.

Oddly enough, this is the second time Alpargatas has been caught in a controversy through no fault of its own. The company’s previous owner, Camargo Correa, had to sell them to J&F in 2015 after being caught-up in an antitrust investigation regarding unrelated business dealings.

This time, however, J&F’s controlling shareholders admitted to corruption charges, and released incriminatory recordings of Brazil’s President Michel Temer, throwing the country into turmoil less than a year after former President Dilma Rousseff’s impeachment scandal. As a result, the M&A market in Brazil, which was on fire to start the year, has screeched to a halt. And who can blame it? With corruption seemingly becoming an annual event for Brazilian politicians, is entering this market worth the risk?

Despite all the problems of the past two years, Brazil is still well primed for growth. Their GDP per capita has risen considerably over the past three decades, as shown in Figure 1.

Brazil GDP
Figure 1 – Brazilian GDP Per Capita (Source: World Bank)

Even with the recent dip, the implication is clear: Brazilian productivity is considerably higher than it was even 10 years ago and, as economic reforms are pushed through and a recovery in commodities continues, Brazilian productivity stands to improve even further, driving growth. As a result of increased productivity, Brazil’s middle class has grown considerably over the past two decades and this is poised to continue, adding fuel to the country’s economic engines.

Where Raw Data Meets the Rule of Law

Beyond raw fundamental data, Brazil also benefits from something many emerging markets lack: the strong Rule of Law. The corruption scandals, while damaging this ideal, also serve to strengthen it. That regulators are given powers over anti-trust competitive concerns, and corrupt politicians must face their day in court sends, a powerful message to those planning on doing business in Brazil – if you operate here, your rights will be respected and protected. The confidence this inspires far outweighs temporary negative sentiment from scandals, and drastically reduces the operating risk for companies in the country. When combined with the aforementioned growth outlook, this is the sort of environment that strongly encourages investment.

As a result of its past successes, Brazil’s investment community has been growing, both in size and sophistication, with the Brazilian stock market now regularly traded by investors across the globe and Brazilian companies expanding beyond the country’s borders at ever greater paces. Brazil’s strong investor presence is perhaps highlighted most clearly through Berkshire Hathaway’s willingness to regularly partner with Brazil-based 3G Capital. Warren Buffet is, after all, notoriously picky about who he’ll do business with, so his repeated joint ventures with 3G illustrate that Brazil is producing world-class investors.

Priced to Sell

With all these strengths, it’s easy to think that Brazil would be an expensive market to enter. However, its Cyclically Adjusted P/E ratio (CAPE) was sitting at 10.7, while the BRIC average is 12.9, and Emerging Markets as a whole are at 14.9, meaning that the country is actually very attractively priced relative to its peer group. Obviously, this is a result of the nerves that have been rattled over the corruption scandal, but this presents a significant opportunity. As M&A activity has dried up and valuations have dropped, Brazil, with all its benefits, represents fantastic value for those willing to take the risk and snap up local companies for a fraction of what they cost two years ago, and gain a foothold in a country with a very promising future.

It’s obvious that Brazil has undergone phenomenal growth over the past twenty years and, even though they’ve hit a bit of a rough patch, the foundations that have been laid for the future are solid. From excellent fundamentals to the rule of law to producing top-notch talent, it’s hard to see the country’s current woes as anything but temporary, and this is likely to ring true for dealmaking, as well. With all this in mind, it’s plain to see Brazil is likely to regain its status as an up and coming powerhouse with plenty of gas in the tank.

Kevan Hartford

Kevan Hartford is a Toronto-based finance professional working in asset management.