EWZ - EWZ: Surf The Uptrend Now But Beware Of The Rollercoaster In The Long Run

2023-08-01 10:42:22 ET

Summary

• The iShares MSCI Brazil ETF has been on an upward trend with a +30.93% YTD return, indicating positive momentum and a potential long opportunity.
• The current P/E ratio of the iBovespa is near its all-time low, suggesting that the market may be undervalued and presenting a great buy opportunity.
• Expectations of interest rate cuts by the Brazilian Central Bank could stimulate economic growth and drive stock market performance in the medium term.

Investment Thesis

The iShares MSCI Brazil ETF ( EWZ ) has been experiencing an upward trend since the beginning of the year, with +30.93% YTD, indicating positive momentum. This trend seems to be just starting and presents a potential long opportunity for investors in the following months and possibly for a few years ahead.

The current P/E ratio of the iBovespa ( IBOV ), the benchmark index of the Brazilian Stock Market, is near its all-time low at P/E multiple of 5.48x. Historical data has shown that investors who bought the index at extremely low P/E ratios have witnessed significant appreciation in the following years. This indicates that the market may be once again undervalued, presenting a great buy opportunity.

The market expects the Brazilian Central Bank to start cutting interest rates by September. The lower interest rates will create a favorable environment for businesses and potentially benefit companies listed in the index, therefore stimulating economic growth and driving stock market performance in the medium term. It's important to acknowledge that the Brazilian market is known for its volatility, and that the past returns have not matched the risks that investors experienced. Therefore, I don’t recommend investing in EWZ aiming for the long term, as there are better and safer options available in the global market. Brazil has historically experienced higher inflation rates compared to developed countries such as the US or the Eurozone. Currency risk should definitely be accounted for by investors, as fluctuations in the Brazilian real did impact the returns of EWZ negatively, turning it into a bad investment for the past 15 years. Even though the Brazilian market had a remarkable appreciation from 2002 until the peak of the housing bubble, its returns have been surpassed by indices such as the S&P 500 or the All-World Index, and both these indices demonstrated much lower volatility during the same period.

A brief description of EWZ and the Brazilian Stock Market

The iShares MSCI Brazil ETF, or simply EWZ, is an exchange-traded fund (ETF) that aims to track the performance of the MSCI Brazil 25/50 Index, which is designed to measure the equity market performance of large and mid-cap companies in Brazil. The Brazilian Stock Market is one of the largest stock exchanges in the world by market capitalization. It plays a crucial role in the Brazilian economy and serves as a major platform for capital raising, trading, and investment.

As I write this article, the iBovespa consists of a basket of 86 stocks selected based on their market capitalization and liquidity, with some of the largest ones by market cap being Petróleo Brasileiro S.A. ( PBR ), Vale S.A. ( VALE ), and Ambev S.A. ( ABEV ). The index represents around 80% of the total market capitalization of the exchange. The Brazilian Stock Market features a wide range of companies from various sectors, including finance, energy, telecommunications, consumer goods, and commodities, and investors can find both domestic Brazilian companies and multinational corporations listed on the exchange.

The main and single stock exchange in Brazil is the B3 S.A. ( BOLSY ) Stock Exchange, which operates through an electronic trading system, and the market has both regular trading sessions and after-hours trading. It also offers different order types, such as limit orders, market orders, and stop orders, allowing investors to execute trades based on their preferences. The Brazilian Stock Market is regulated by the Brazilian Securities and Exchange Commission ((CVM)). The CVM, just like the U.S. Securities and Exchange Commission, oversees the operations, transparency, and compliance of listed companies, brokers, and other market participants, ensuring the integrity of the market.

iBovespa is known for its volatility and, just like any other stock market, can be influenced by a range of factors, including domestic and global economic conditions, political developments, currency fluctuations, commodity prices, and investor sentiment. This volatility can present both opportunities and risks for investors, which can have direct exposure by investing through the EWZ ETF.

EWZ surfing an uptrend and why it should remain that way

As I write this article, EWZ is accruing a positive +30.93% return YTD. To be honest, I knew an uptrend could start anytime, but I didn’t think it was going to be now. President Lula has just been re-elected at the beginning of the year and I believe this is the market's way of adjusting its previous pessimism to a lighter mood after seeing that the new president also cares for the market. Even so, the market is indeed showing signs that it does not want to stay in the low post-pandemic levels, and EWZ share price has once again hit a mark only found in the bull run pre-Covid. Actually, right now, It’s sitting at only -10% down from the peak point of 2019 (see image below).

We all know that analyzing any stock during a short timeframe will produce great volatility, and it’s no different for EWZ. But, if you are able to stomach a few months of oscillation, you might as well reap the potential upside that the Brazilian Stock Market has in store. I truly believe there is a great appreciation in the couple of years ahead, and not because I’m biased for being a native Brazilian and for having long positions on domestic stocks, when it comes to investments, I’m as brutally realistic as it can be. I’m optimistic because the historical data have provided countless times that investors who bought the Brazilian Index on very low P/E ratios and very high-interest rates scenarios were greatly compensated.

iBovespa Price-to-Earnings and entry points

When we analyze a single company stock, we always take into consideration price multiples such as P/E, EV/Ebitda, Price/Book, Price/Sales, and so on. Although we shouldn’t always rely on those metrics to make our investment decisions, they sure provide great insights when compared to their own historical figures or against peers in the sector. Now, when we are analyzing a broad basket of securities, like the EWZ ETF, these ratios seem to become even more precise, especially the P/E. After all, now that we have more samples comprised in a single basket, the probability of an underpriced multiple indicate that this basket is indeed underpriced is higher.

In summary, I’m a true believer that, when we are dealing with an entire economy or broad markets, all comes down to regression to the mean. This means that overpriced markets tend to eventually fall down and underpriced markets will eventually bounce back up to this mean. The graph below shows the P/E multiple of the iBovespa index throughout the years since 2001, statistically indicating that the current ratio is near its all-time lows and poses a potential buy opportunity.

In addition to that data, which might be enough to convince many investors already, I’d like to talk about the impact that the national interest rate ( Selic rate ) has on the Brazilian stock market. I can’t speak for other economies but, when it comes to the Brazilian one, the stock market tends to have an inverse relation to changes in interest rates. To make it easier to visualize, I compared the historical prices of EWZ against the historical Brazilian interest rate since 2001, where you can see this specific behavior I’m talking about.

You should approach this comparison ignoring EWZ’s total return and the absolute positions of the lines, since they are measuring two different things – stock price and annual interest rate. What you should be looking at here are the swings and movements against each other. For example, from 2001 to 2003, Brazilian interest rates climbed until a peak of around 26% YoY, where EWZ dropped to a new all-time low. After that, interest rates started to drop until 2008, the peak of the housing bubble, and EWZ only appreciated in this same timeframe.

Now, in the following period, Brazil was also recovering from the housing bubble, just like everyone else. But, we can also see that the Selic rate was never low, bouncing back and forth within the range of 8% and 14% YoY, which, in my opinion, contributed to the deep low of 2016, combined with political issues such as the impeachment of former President Dilma. And then again, rates started to drop and EWZ started to go up. From 2020 onwards, we all know what the pandemic did to the entire world.

Wrapping up, I believe the data interpreted from both graphs is enough to back up my stance of why I believe EWZ is a good buy opportunity now.

Potential risks for long- and medium-term investors

Well, although the Brazilian market seems to be a great buy option now, nothing in the investing world comes without risks. First and foremost, risk alone is a vague factor without mentioning the timeframe studied. As I said at the beginning of this analysis, although I love my country, I don’t see many benefits of holding the Brazilian basket for the long run unless you live in Brazil. EWZ has certainly delivered poor results over the past 15 years or so.

So, the first risk comes for those who wish to buy and hold the entire Brazilian market for decades. In my humble opinion, not worth it. The volatility imposed by Ibov does not justify its returns, even for native Brazilian investors. I say that because the Brazilian market delivered an annual average of +6% above inflation in Brazilian Reals (BRL:USD) (USD:BRL). The return per se is not bad, but you could have achieved it and more with much less risk by investing in a broad ETF like the Vanguard Total World Stock Index Fund ( VT ), which diversifies your capital across the entire globe. And this return becomes even worse for investors that live in the US or other developed countries with strong currencies, because the BRL deteriorated a lot over the years against the Dollar, Euro, British Pound, Japanese Yen, and others (see image below).

The second risk is concerning investors aiming for the medium term, who wish to surf on the potential uptrend and possibly exit as soon as things become fishy again. Those are the ones this analysis is made for. You see, maybe the interest rate cuts I talked about don’t really happen as soon as expected, and then the potential rise in the market gets postponed to a year later or so. Or simply because Brazil is not a country for amateurs, and the political risks that keep hovering over the market end up affecting the economy more than expected, again postponing the market expansion analysts are predicting.

Those are the risks that medium-term investors should be aware of when using this analysis for guidance. Even considering all that, I still stand my ground believing that there is an opportunity now if you have some patience and can stomach the possible volatility that is inherent to this emerging market. Just don’t take too long to decide, cause an uptrend is already happening.

Conclusion

In my view, the current market conditions present a great opportunity to buy EWZ shares. The Brazilian stock market has been on an uptrend, with EWZ recording a positive return of +30.93% year-to-date. The re-election of President Lula, although a pessimistic factor in the beginning, has actually brought optimism to the market. The low P/E ratio of the iBovespa index and expectations of interest rate cuts indicate that the market is undervalued and may experience appreciation in the coming years.

However, potential long-term investors who live and spend in strong currencies should be aware of the Brazilian market's volatility and historical underperformance compared to other indices, such as the S&P 500 or the All-World Index. Having said that, the currency risk associated with the Brazilian real should be considered, as inflation rates have always been higher than those in developed countries and they might as well remain so.

Investors with a medium-term outlook and the ability to withstand market fluctuations could benefit from this opportunity. While there are risks, the data suggests that EWZ offers potential upside given the current economic climate and the likelihood of market regression to the mean.

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