FLIN - FLBR: Mixed Indicators Cheap Brazilian Equities Opportunities Ahead

2023-12-01 10:47:34 ET

Summary

• Franklin FTSE Brazil closely mirrors the performance of the FTSE Brazil Capped Index, making it an attractive option for investors seeking RIC concentration requirements.
• FLBR is concentrated in the finance, energy minerals, and non-energy minerals sectors, with notable holdings in major Brazilian banks and companies like Vale and Petrobras.
• Macroeconomic indicators, fiscal concerns, tax revenue trends, and commodity prices shape FLBR's future outlook, prompting cautious optimism amid risks.
• FLBR exhibits a modest P/E ratio of 7.7x, signaling attractive valuations compared to historical levels and presenting a compelling opportunity for long-term investors.

Franklin FTSE Brazil ETF (FLBR) is a fund designed to closely mirror the performance of the FTSE Brazil Capped Index, capturing approximately 85% of the free float-adjusted market capitalization of the Brazilian market before accounting for fees and expenses.

The FTSE Brazil RIC Capped Index, which FLBR follows, is a market capitalization-weighted index crafted to meet Regulated Investment Companies ((RIC)) concentration requirements in the United States. This regulatory framework stipulates that no single constituent can represent more than 20% of the index, and the combined weights of all components exceeding 4.5% cannot surpass 48% of the total index weight.

Given these regulatory compliance features, FLBR is an attractive option for investors seeking a benchmark adhering to RIC concentration requirements.

The fund comprises 86 Brazilian holdings, with a notable concentration in three key industries. The finance sector, led by major Brazilian banks like Itaú Unibanco ( ITUB ) and Bradesco ( BBD ), constitutes approximately 30% of the fund. Energy minerals companies, particularly Vale ( VALE ), make up 12%, while non-energy minerals, primarily represented by Petrobras ( PBR ) ( PBR.A ), are the fund's top holding, comprising 14%.

The index exhibits significant commodity exposure, with Vale and Petrobras collectively accounting for 26% of the fund. This characteristic endows the fund with both potential and risk, particularly in response to fluctuations in the economic cycle.

An alternative index popular among investors seeking exposure to the Brazilian economy is the MSCI Brazil 25/50 Index, mirrored by iShares MSCI Brazil (EWZ). Despite the high correlation in performance between FLBR and EWZ, there are notable distinctions. EWZ does not have concentration limits, boasts 50 holdings, and trades at an average volume of $735.43 million, surpassing FLBR's $706,980. However, EWZ carries a higher expense ratio of 0.58% compared to FLBR's 0.19%. Additionally, EWZ exhibits superior liquidity, with a lower average spread at 0.03%, as opposed to FLBR's 0.16%.

In summary, despite differences in liquidity and methodology, FLBR closely mirrors the movement of Brazilian stocks, akin to EWZ.

Throughout the past year, FLBR has demonstrated robust performance, registering a notable gain of 27.5%. This achievement is noteworthy, especially considering the high volatility experienced in 2022, particularly in the first half. The Brazilian economy exhibited improved control over inflation levels during this period, coupled with a trend of interest rate cuts.

When juxtaposed with the iShares MSCI Emerging Markets ETF ( EEM ), FLBR emerges as the superior performer, outpacing it in terms of returns.

Despite the recent sharp surge in FLBR and the Ibovespa, the Brazilian stock market index since the end of October, I still believe that numerous companies within Brazilian stock portfolios have appreciable growth potential. This conviction is primarily rooted in the undeniably cheap valuation of Brazilian equities compared to their international peers.

However, recognizing the need for an in-depth understanding of Brazil's macroeconomic situation to invest in FLBR, I emphasize the importance of observing critical economic indicators. Such observation provides greater clarity about the potential future direction of Brazilian equities, which I consider pretty complex, even with some indicators expressing concern for 2024, particularly in the fiscal sphere.

Macroeconomic Scenario in Brazil

When examining the latest macroeconomic data reported by the Brazilian economy, it becomes evident that the key factors influencing the movement of the FTSE Brazil Capped Index are economic activity, fiscal policies, inflation rates, interest rates, exchange rates, and the commodities outlook.

Economic activity: signs of cooling

The IBC-Br, often regarded as a precursor to GDP, experienced a decline of 0.6% in September, falling below market expectations of an increase of 0.2%. However, there was a growth of 1.3% in the yearly comparison. This monthly decrease was attributed to declines in the services and retail sectors, which contracted by 0.9% and 0.2%, respectively.

The favorable economic dynamics observed in the year's first half are beginning to exhibit signs of cooling. Brazilian Central Bank projections for the remainder of the year suggest a slow economic activity, potentially with marginal declines.

Tax revenue is flat, but the year should end with a deficit

In October, the federal government's tax collection reached R$215.6 billion, reflecting a minimal increase of 0.1% compared to the same period in 2022 but breaking the fourth consecutive month of diminishing tax revenue collection.

From January to October 2023, total tax revenue amounted to R$1.81 trillion, indicating a slight decrease of 0.8% compared to last year.

Moreover, according to the Brazilian National Treasury, the government recorded a primary surplus of R$11.5 billion in September. However, over the 12-month accumulated period, there was a negative result of R$71.4 billion, equivalent to 0.7% of GDP. This has prompted the Ministry of Economy to explore new sources of tax revenue rather than cut expenses.

As of August, the Net Public Sector Debt and Gross General Government Debt stood at 59.9% and 74.4% of GDP, respectively. Faced with a decline in revenue and ongoing expenditures, the Brazilian Central Bank anticipates the country concluding the year with a deficit of 1% of GDP. This serves as a warning sign for 2024.

Inflation in Brazil is on the rise but remains within the target range

The IPCA, the country's inflation index, has accumulated 4.82% over the last 12 months. The year-to-date accumulated IPCA for 2023 is 3.75%, while the figure for 2022 was 5.78%. Brazil's Central Bank has set a target of 4.53% for 2023, indicating that inflation is currently under control.

However, several risks deserve attention. The challenging external environments in the U.S. and China, recent pressures on oil prices, potential fuel price adjustments by Petrobras, the climatic impact of El Niño on food affecting agribusiness, and the conflicting fiscal scenario in Brazil may contribute to heightened inflation in the short term.

Sustained Decline in Interest Rates

In early November, the downward trend in interest rates continued as Brazil's monetary policy committee reduced the Selic rate by 50 basis points (0.5 percentage points), bringing it to 12.25% per annum. This decision aligns with the current economic context, where inflation is within the target range and indicates a cooling economic activity.

The primary concern of the Brazilian Central Bank centers around fiscal issues, as underscored in the latest meeting. The critical importance of eliminating the deficit by next year is recognized, especially considering that accomplishing this objective by 2023 may no longer be feasible. The market anticipates a further 50 basis points rate cut in December.

Foreign Exchange Rates Holding Steady

In November, the BRL-USD exchange rate concluded at R$4.93, slightly lower than the R$5.00 at the end of September. Experiencing depreciation in the month's initial half and reaching R$5.19, the exchange rate stabilized for the remaining period.

October was characterized by heightened tension in the international landscape, primarily from the expectation of prolonged high interest rates in the US. Additionally, geopolitical uncertainties in the Middle East contributed to the overall stress.

Commodities

In the case of oil, the recent geopolitical conflicts have introduced additional risk and uncertainty into the market, already impacted by production cuts from Saudi Arabia and Russia. With supply and demand relatively balanced and a low risk of escalation, the price of a barrel of oil has hovered around US$80.

However, Petrobras, which has deviated from international price parity since the beginning of this year, has moved in the opposite direction to Brent crude oil. This shift is primarily driven by its still very attractive valuation and promising distribution prospects.

Conversely, the price of iron ore remains elevated, reaching close to US$120/ton. This is attributed to robust demand from Chinese steelmakers and economic stimulus measures implemented by Beijing. Vale has closely mirrored the performance curves of the iron ore price.

Turning to agricultural commodities, the supply of soybeans and corn is expected to outpace demand for both markets, leading to a continued downward trend in prices in the coming months. Additionally, two significant events with potential repercussions on agricultural commodities in 2024 are El Niño and the commencement of the 2023/2024 harvest in Brazil.

Final considerations

Taking a forward-looking perspective, the investment landscape for Brazilian equities indicates that potential risks could translate into eventual rewards. The Brazilian stock market is currently characterized by a notably low valuation multiple, reminiscent of levels observed during the 2008 subprime crisis. Specifically, the FLBR exhibits a modest P/E ratio of 7.7x, emphasizing the potential for long-term investment opportunities.

Consequently, the FLBR remains an appealing option for exposure to emerging markets compared to its emergent peers. For instance, the iShares MSCI Emerging Markets ETF ( EEM ) trades at a P/E of 11x, the Franklin FTSE Mexico ( FLMX ) at 11.6x, and the Franklin FTSE India ( FLIN ) at 24.2x.

Regarding dividends, the FLBR also outperforms its emerging market peers with a yield of 10.7%, arguably its most notable strength. This is especially significant considering its high exposure to historically substantial dividend-paying entities within commodities and the financial sector.

Examining the macroeconomic outlook, my concern arises from Brazil's fiscal situation, casting doubt on achieving a zero deficit by 2024. Despite this, the Brazilian Real remains resilient due to two contributing factors: a positive trade balance and Brazil's real interest rate, which is among the highest globally, thereby discouraging excessive investments.

The FLBR presents a highly discounted valuation, given the Brazilian stock market's historically low multiples, positioning it as a favorable option compared to other emerging countries. Inflation appears to be manageable at the moment, and with a downtrend in interest rates, there's a likelihood of substantial economic activity in 2024.

Despite risks and uncertainties, I adopt a cautiously optimistic, bullish stance on the Franklin FTSE Brazil.

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