Reckless fools or intrepid bargain hunters?
Only time will tell how best to describe fund managers scooping up Brazilian stocks in the midst of the country's economic crisis. One thing is clear: These managers are carrying out one of the biggest gambles of their careers. Brazil is not out of the woods by any means.
In dollar terms, the Brazilian market is down 14.1% in the year to date, after a 44% decline for 1998 as a whole, according to the
Morgan Stanley Capital International Brazil Index
. On Jan. 13, Brazil devalued the real, which has since sunk 33%. The crisis could get still worse if the government were to
default on its domestic debt or let inflation slip out of control, still a real possibility, according to some analysts.
But worries like this aren't keeping away Mark Mobius, manager of
Developing Markets Trust. He's been buying heavily as the market has slid. "We've taken losses in Brazil, but we see great opportunity," he says.
Mobius, whose fund returned 2% from Jan. 14 to Feb. 3, according to
, doesn't think Brazil is heading for default. "We've seen the worst in Brazil," he says.
detailed how Mobius made strong returns from buying bombed-out Asian stocks in 1997 and 1998.
In Brazil, Mobius' buying targets have included
, the long-distance telephone operator. Mobius likes the company over some of the other telcos because it has strong dollar revenues from its international business. Embratel has lost 1% since the devaluation.
Indeed, any company that has substantial dollar revenues has been bid up. Since the devaluation, Warren Howe, manager of the
Latin American fund, has been adding to positions in
, a paper and pulp company, and
Companhia Vale do Rio Doce
, the huge iron-ore-focused mining conglomerate. Aracruz is up 37% since the devaluation, and CVRD is up 22%.
Howe's fund actually produced a matchless 29% return since the day after the devaluation because it presciently hedged its real-based exposure.
Cheap Is Good
The reason managers say they are buying is simple: Companies look so cheap that they have supposedly "priced in" the potential risks of being in Brazil at a time of crisis.
Howe is attracted to the brewers
, whose ADRs have slipped 6.6% since the devaluation. At Thursday's open of 7 15/16, it trades at only 6.8 times forecast 1999 earnings, according to
Morgan Stanley Dean Witter
. "This company has a world-class management," says Howe.
And he's adding to his position in
, the electricity company. Typically, utilities serve as defensive stocks in market meltdowns. When this storm blows over, Copel is likely to be privatized and obtain a new, more favorable tariff structure, Howe reckons.
Many investors, attracted by its apparent cheapness, are piling into the telco sector. Francois Gour, who helps manage the
Global Stabilization and Recovery Fund
, a hedge fund that focuses on crisis-hit markets, has been accumulating
Tele Celular Sul
, both small-sized cell-phone companies.
At Thursday's opening price, Telemig and Tele Celular Sul trade at an apparently alluring 4.1 and 7 times forecast 1999 earnings, according to MSDW. But Gour is not rushing in. "We don't try and pick the bottom. We try and accumulate steadily at a low average price," he says.
Greg Heywood, co-manager of the
Emerging Markets Fund, has been buying more-liquid telcos like
, which covers Sao Paulo, and fixed-line operator
Tele Norte Leste
. The latter, with a MSDW-projected 1999 price-earnings ratio of 5.6, is "off-the-chart cheap," says Heywood, whose fund returned 1.4% from Jan. 14 through Feb. 3.
Bargains or Bust?
Brazilian stocks definitely seem irresistible bargains -- even when risks are factored in. For example,
, measured by price-to-earnings ratio, is more than three times more expensive than Brahma, while
multiple is 10 times that of Tele Celular Sul.
But in a crisis, nothing is this simple. Take Aracruz. While the company's dollar inflows do make it a safer bet, investors have to weigh this with the fact that it also holds some $750 million in short-term government dollar-linked debt. If the government were to default on these bonds, Aracruz would have to book a large loss. If these bonds were suddenly worth nothing, then Aracruz would trade at nine times cash flow (as measured by enterprise value to earnings before interest, taxes, depreciation and amortization), instead of its current six times, says Fred Searby, conglomerates analyst at
But Howe says that even if the government were to default, it would still make sense to hold Aracruz. A default would hit other sectors -- particularly the banks -- far harder than it would big exporters like Aracruz.
How far can investors rely on earnings forecasts when Brazil is likely to experience both a recession and sharply higher inflation this year? This concern particularly applies to the telco and power sectors. Revenues would be hurt if tariffs do not rise by as much as inflation. The government allows the telcos to raise call rates in line with inflation, but there could be a long lag before the companies can actually put up rates.
And in the grinding recession most economists expect in Brazil, some analysts expect the cellular companies in particular to experience lower-than-expected customer growth and higher-than-expected non-paying accounts.
A much weaker currency also could be negative. The real-based cost of imported capital equipment goes up, and companies that have large dollar borrowings are going to see debt costs soar in real terms.
But the fund managers are playing down these threats.
First, with the glaring exception of power company
, which has dollar debts totaling an estimated $9 billion, most large Brazilian companies are not highly leveraged in foreign currencies. Gour says a good proportion of the telcos' capital spending is made locally in reals -- not dollars. He also points out that cellular phone usage, after a couple of bad quarters, recovered powerfully in Asia, despite the big economic slowdowns still afflicting the region. He expects the same for Brazil.
What's more, with the exception of Tele Norte Leste, Telemig Celular and
, all 12 of the NYSE-listed Brazilian telcos are owned by large foreign firms that would be extremely unlikely to let their recent acquisitions experience real hard times.
There's also a way around the earnings conundrum. Montgomery's Heywood agrees that it is hard to come up with dependable revenue and profits forecasts in slump conditions, but he says that many companies still look cheap on asset-based valuations. For example, he calculates that
Tele Centro Sul
, the fixed-line operator that covers the wealthier regions of Parana and Santa Catarina, among others, trades at around $650 per line. The cost of putting in a line -- or its "replacement cost," to use analysts' jargon -- is a much higher $1,200, he says.
Perhaps the weakest part of the Brazil buyers' strategy is the claim that they may as well buy now, because it's too difficult to spot the bottom. Some investors believe that the crisis is not over until a solution is found for the government debt problem.
If a default happens, stocks will plummet. Geoffrey Symonds, manager of the
Trace Global Opportunities Fund
, a hedge fund that invests in emerging markets, has not bought a Brazilian stock since the devaluation. "I want to see a number of macroeconomic problems resolved. If they aren't, things will get worse," he says.