A Scandalous Opportunity In Brazil

By Eric Fry

The chart below shows what “crisis investing” looks like… Take a close look.

It superimposes the current trajectory of the Brazilian stock market over the trajectory of the U.S. stock market during the Watergate era. As you can see, the two are remarkably similar.

Therefore, if we are to trust the implied message of this chart, Brazilian stocks are a buy… just like U.S. stocks were in 1974 at the depths of the Watergate crisis.

The broader message of this chart is that crisis creates opportunity. That’s because a crisis causes selling panics that push share prices down to deeply depressed levels.

The opposite is also true. During times of peace and prosperity, stocks can become fat and happy, rising to levels that greatly exceed any fundamental rationale. At these levels, stocks typically offer a much greater possibility of capital loss than of capital gain.

To illustrate these opposing phenomena, let’s briefly compare today’s U.S. stocks to Brazilian stocks. The S&P 500 Index has notched 30 new all-time highs this year. The Brazilian stock market has not. In fact, it is trading more than 50% below the all-time high it hit six years ago.

As a result of these divergent trends, the S&P 500 Index commands a valuation that is nearly double the valuation of Brazilian stocks – based on price-to-EBITDA ratios, price-to-sales ratios or price-to-book ratios.

Let’s take a closer look.

From Bad to… Less Bad

Brazil’s stocks and currency are depressed for several reasons. During the five-year stretch from 2011 to 2016, commodity prices plummeted, which caused the growth of this resource-powered economy to shift into reverse.

Meanwhile, a massive multi-billion dollar fraud scheme rocked Petrobras (NYSE:PBR), the national oil giant that accounts for about 10% of the country’s GDP. The fraud, dubbed “Operation Car Wash,” was a massive kickback scheme that lined the pockets of dozens of Petrobras executives and highly placed Brazilian politicians.

To top off Brazil’s toxic economic brew, Dilma Rousseff, the country’s president from 2011 to 2016, was impeached one year ago.

As a result of these economic and political stresses, Brazil’s benchmark Ibovespa Brasil Sao Paulo Stock Exchange Index tumbled nearly 80% (in U.S. dollar terms) from its 2011 high to its 2016 low. The value of Brazil’s currency, the real, also dropped sharply.

But the negative trends that buffeted the Brazilian economy for five long years have begun to reverse.

The prices of many commodities have been trending higher for more than a year, which has contributed to an improving economic climate. At the same time, the country’s chaotic political situation has become less chaotic. Dilma Rousseff’s successor, Michel Temer, has established a period of relative stability.

Thanks to these “less bad” economic and political conditions in Brazil, its stocks have been trending higher for more than a year. But the benchmark Ibovespa Stock Index is still 50% below its 2011 highs (in dollars). And on most valuation measures, the Ibovespa is trading well below its 10-year average levels.

So, there is ample opportunity to achieve large capital gains from the current price level. And the depressed Brazilian currency could amplify those gains greatly. Whenever a country’s stock market and currency rally simultaneously, profits can pile up quickly. The currency gains deliver a “slingshot effect” to the stock market gains.

Real Big Gains From the Real

One truly remarkable aspect of this effect is that it does not simply add currency gains to stock market gains; it compounds the combination of the two to produce an even larger total return!

Here’s an example, using a fictitious currency called a “meckla.” Let’s say $100 buys 100 mecklas on the day you decide to invest in the Mecklandia stock market. You exchange your $100 for 100 mecklas and invest all those funds in the stock market.

After one year, the Mecklandia stock market has doubled and the meckla’s value has doubled against the dollar, such that each meckla is now worth $2 rather than $1. In this scenario, your gain is not the sum of your 100% stock market gain and your 100% currency gain – i.e., 200%. Instead, your gain is 300%!

Here’s why: The 100 mecklas worth of stock you purchased would be worth 200 mecklas, and 200 mecklas would now be worth $400 – or a 300% return on the original $100 you invested.

The chart below shows a real-world example of the slingshot effect’s power.

In 2004, the Brazilian currency was just as depressed as it is today – about 3.1 reals per dollar. Brazilian stocks were similarly depressed. But over the next four years, Brazilian stocks rebounded, and the real rebounded as well.

Thanks to this slingshot effect, the Brazilian stock market gained 622% (in dollars) between May 2004 and May 2008. Less than half of that gain – 271% – came from the stock market’s performance in the local currency. All of the rest came from compounding the real’s appreciation against the dollar.

Today, Brazilian stocks are offering a similar opportunity to benefit from the slingshot effect. They possess enormous potential to reward investors. But this market still faces some serious bumps in the road.

First, even though commodity prices have bounced a bit, this bounce may not “have legs.” Commodity prices could remain in the doldrums for a long time. Iron ore and crude oil are two of the commodities that are still languishing near multi-year lows. And these two commodities play large roles in the Brazilian economy.

On the other hand, the slightest economic improvement, coupled with the slightest political stability, could cause Brazil’s stock market and currency to move substantially higher. We saw the same thing in the second half of the ’70s here in the U.S. Amidst the political turmoil of 1973 and early 1974, the S&P 500 Index slumped more than 40%. But shortly after President Nixon resigned in August of 1974, the stock market recovered and started moving higher.

Measured from the exact date of Nixon’s resignation, the S&P 500 delivered a total return of 12% after one year and 28% after two years. Perhaps more importantly, the lows of 1974 provided one of the greatest investment opportunities of the generation – $100,000 worth of the S&P 500 in 1974 grew to $266,000 by 1984, $637,000 by 1994 and $1.4 million by 2004.

Obviously, the Brazilian stock market might not replicate the S&P 500’s dazzling post-Watergate performance. But one thing is certain: Crisis creates opportunity.

Good investing,

Eric

Disclosure: We expressly forbid our writers from having a financial interest in their own securities recommendations to readers. All of our employees and agents must wait 24 hours after online publication or 72 hours after the mailing of printed-only publication prior to following an initial recommendation. Any investments recommended by Investment U should be made only after consulting with your investment advisor and only after reviewing the prospectus or financial statements of the company.

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