EWZ - VanEck Brazil Small-Cap ETF: Good Value On Offer But Risks Remain

2023-05-03 19:57:32 ET

Summary

• VanEck Brazil Small-Cap ETF hasn’t fared well over the past year, delivering negative returns of 16%.
• Underlying conditions in Brazil don’t look too encouraging, although bond investors will appreciate the recent fiscal framework.
• Brazilian small-caps offer fantastic value, particularly considering the long-term earnings growth potential of this cohort.

The Brazilian economy is moving forward like someone driving a car with their foot on the brake. - Guido Mantega.

Introduction

The VanEck Brazil Small-Cap ETF ( BRF ) focuses on over 100 small-cap stocks that are either incorporated in Brazil or outside Brazil, but generate 50% of their revenues (or related assets) from that country. Over the past year, BRF hasn’t fared too well, delivering negative returns within the mid-teens threshold, while also significantly underperforming a benchmark of developed and emerging market equities outside the USA.

Could this trend linger as we progress through the year? Well, here are a few things that could weigh on BRF’s prospects.

Notable Considerations

As noted in last week’s global section of The Lead-Lag Report, Brazil looks like it may have staved off potential deflationary risks for now, which looked increasingly likely at one stage, primarily driven by the ferocity with which the Brazilian central bank had tightened rates.

However, I would still urge investors not to get carried away, as the labor market isn’t in the best of shape. After dropping to levels of 7.9% in December, the unemployment rate has steadily crept up every month this year and recently came in at 8.8%. Meanwhile, employment levels, too, have been trending lower since Nov, with roughly 2m workers going out of the payrolls. With a loose labor market of this sort, it is difficult to make the case for ample real wage growth, particularly when you consider that core inflation is still around the 7% levels.

The industrial side of things will play a key role in BRF’s prospects as those stocks account for the largest share of the portfolio. Unfortunately, the scenario here too looks a bit wobbly with industrial production on the slide for 3 straight months now.

Worryingly, the latest report of the forward-looking manufacturing PMI suggests that Brazilian industrials will continue to have a rough ride for the foreseeable future. New factory orders continue to sink, while the level of production cuts have rarely been so low over the past 3 years.

The commodity-heavy profile of Brazil too puts its balance of payments position in a tricky spot as global recession risks gather steam. In fact, a recent guest on Lead-Lag Live had suggested that even though the green agenda and growing de-globalization would be supportive of commodity themes as a multi-decade play, in the short-term industrial commodities are likely to be vulnerable.

The difficulties faced by various cogs of the Brazilian economy may prompt the central bank to bring down the Selic rate from levels of 13.75% (although this is unlikely to take place in the upcoming May meeting). This would not reflect well on the Brazilian Real and currency dynamics, more so as the dollar looks like it is forming a bottom. In this week’s edition of The Lead-Lag Report, I’ve noted how growing risk-off conditions in the markets could see investors flock to dollar-denominated assets boosting the greenback’s allure.

If there’s one silver lining in all this, it would perhaps be the advent of a new fiscal framework under the Lula regime that should help bring the Brazilian house under order. For instance, growth in fiscal spending will be pegged to 70% revenue growth; if the primary budget surplus is not attained the spending growth peg would drop to 50% thus curtailing spending. In yesterday's "Leaders-Laggers" section of The Lead-Lag Report, I noted how default risks in emerging market debt have been building slowly, but fiscal developments from Brazil as we've seen recently, should provide some support.

Conclusion

Notwithstanding the macro picture, I suspect Brazilian small-caps may gain ample favor amongst bargain hunters on the lookout for suitable value opportunities within the Latin American landscape. The chart below shows us that the relative strength ratio of Brazilian small-caps as a function of Latam stocks typically tends to move in one direction for large periods before reversing.

Currently, the ratio looks relatively oversold, but could witness some renewed interest as it has recently dropped to levels last seen in 2016 from where there was a strong reversal.

According to YCharts, VanEck Brazil Small-Cap ETF currently trades at a rather compelling forward P/E of just 8x ; sure, it may not be as alluring as the corresponding multiple (P/E of just 6.3x ), of the flagship iShares MSCI Brazil ETF ( EWZ ), but also do consider that small-caps offer a far better runway of earnings growth potential. To elucidate on this facet, note that while EWZ’s constituents look poised to deliver long-term earnings growth of 12% which is decent enough in itself, VanEck Brazil Small-Cap ETF could deliver earnings growth that is over 2x greater at 24.3% !

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