In retrospect, it was a clear sign of a market top…
A few years ago, I was waiting to speak as an energy specialist was wrapping up his presentation. He closed with a recommendation of Brazil’s energy giant Petrobras (PBR), boldly predicting that its market value could reach more than a trillion dollars.
While Petrobras stock reached $71 in 2007, it now trades under $5.
And just last month, Brazil itself lost the coveted investment grade status it earned in 2008.
We’re likely close to the bottom, as well as what Sir John Templeton famously referred to as the point of maximum pessimism.
Does this mean we should count Brazil out? On the contrary. Despite the country’s troubles, Brazil represents an undervalued emerging market opportunity.
Trouble in Paradise
So what’s wrong with Brazil? Where to begin…
Brazil is a giant commodity play and, from oil to iron ore, prices have been in a free fall. President Dilma Rousseff is embroiled in a scandal amidst charges of corruption and mismanagement. Brazil’s bloated government has 39 ministries and a widening fiscal deficit.
Inflation is soaring and its currency, the real, has lost 36% of its value against the U.S. dollar in the last year. Brazil’s stock market is reeling. The Brazil iShares ETF (EWZ) is down 49.8% in the last year and small caps are down 63%.This brings the market back to levels last seen in 2009 during the global financial crisis.
State-owned Petrobras is down 70% this year alone and is weighed down by $107 billion of debt – $80 billion of which is denominated in U.S. dollars. (ExxonMobil (XOM) has a market value 10 times that of Petrobras.)
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This is the way it is with some emerging markets. It’s a rollercoaster ride as stocks swing from euphoria to despair. Investors need to manage risk by waiting for a sharp selloff and then scooping up distressed deep-value assets.
In other words, during a downward movement like this, you’ll need to adjust your approach to investing in emerging markets in two ways:
- Ignore the common advice of financial advisors to have a 10% or 20% allocation in your portfolio to emerging markets. This “buy and hold” strategy is a real loser.
- Shift your focus from markets that are doing well to those that are out of favor – even hated.
Which brings us back to Brazil.
This month, I’m leading a group of hedge funds to Brazil to evaluate opportunities. Here’s what we’ll be looking for:
- Quality companies with solid earnings and low debt trading well below book or fair value.
- Companies and assets that are in terrible shape, but are trading at distressed prices so cheap that the upside potential is well worth the downside risk.
Despite its present challenges, Brazil has some tremendous advantages.
The country has a youthful population with a giant consumer market. It’s the world’s largest producer of iron ore, coffee, and sugar cane, and the largest exporter of coffee, sugar, soy, meat, and chicken. Brazil is self-sufficient in energy, and hydro supplies 40% of its electricity needs.
It may take a change in political leadership and more pain to right Brazil’s ship, but Brazil will be back.
So keep an eye on the Brazil iShares ETF, and if you’re a more conservative investor, wait for an uptrend before building a position. If you’re more speculative, consider the call options that go out to next year.