2023-08-11 02:21:10 ET
Summary
- The iShares MSCI Brazil ETF remains a highly attractive and undervalued resource play.
- The ETF is heavily weighted towards materials and energy, with Vale and Petrobras comprising over one quarter of the market and almost one half of earnings and dividends.
- The recent drop in Brazilian real yields relative to the US has removed support for the currency, which poses the main downside risk to the EWZ.
The bull market in the iShares MSCI Brazil ETF (EWZ) remains firmly intact and the recent dip represents another opportunity to get exposure to this undervalued resource play. Despite gaining more than 20% since my last article in April, the MSCI Brazil still trades at less than half of the MSCI Emerging Market index in terms of valuations. Much of this undervaluation comes from the high weighting of Vale (VALE) and Petrobras (PBR), but even excluding these commodity stocks, the Brazil discount is likely to continue rewarding investors through the high dividend yield.
The EWZ ETF
EWZ tracks the performance of the MSCI Brazil index and charges an expense fee of 0.58%. The ETF holds 50 companies at present and is heavily weighted towards commodities. The ETF is heavily exposed to commodity prices, with materials and energy making up a combined 37% of the index, and the Brazilian currency is also correlated with commodity prices, making the EWZ a resource play. The Materials sector accounts for 19% of the index, thanks to iron ore giant Vale, which has a 13% weighting. The Oil & Gas sector accounts for an additional 18% due to oil major Petrobras. The ETF currently offers a dividend yield of 8.8%, but this should fall over the coming months back towards the forward yield on the underlying MSCI Brazil index, which is currently 6.4%.
Despite Outperformance The Valuation Discount Remains Huge
The MSCI Brazil continues to trade at an incredible discount to the MSCI World and MSCI Emerging Markets indices, with a PE ratio of just 6.5x. The current PE ratio is on par with that seen at the height of the global financial crisis even as DM and EM benchmarks trade significantly above those levels.
In part, the PE discount reflects extremely high profit margins which are widely expected to decline following the recent drop in commodity prices. Even on a forward PE basis, though, Brazil continues to look cheap at just 8.3x.
These cheap valuations are reflected in the MSCI Brazil's world beating dividend yield, which even after falling by over a half from its peak is still 6.4%.
Vale And Petrobras Only Partly Responsible For Valuation Discount
Vale is a global iron ore producer which trades with a PE ratio of around one third of the MSCI World Materials index at just 5.3x, and a dividend yield of 8.4%. Petrobras, the state-owned oil giant, trades at an equally large discount to the already-cheap global energy sector. The PE ratio is just 2.8x, while the dividend yield is almost 16%.
Combined, these two stocks make up 27% of EWZ's holdings, yet are responsible for almost half of total earnings and dividends and so investors may prefer to hold these stocks alone rather than the entire index. However, even if we exclude these two stocks the MSCI Brazil still trades at a steep discount to historical valuations as well as the MSCI EM index, with a PE ratio of 8.7x and a dividend yield of 4.7%. By buying the EWZ, I gain exposure to Vale and Petrobras but with much less volatility, specific company risk, and exposure to a recession-driven commodity slump, while still generating a significant dividend yield.
A Currency Reversal Is The Main Risk
In my previous article on the EWZ, I argued that currency strength should help drive gains in the ETF, after adding to its gains since then, the outlook has deteriorated thanks to a sharp drop in real yield spreads versus the US dollar. Brazil 2-year inflation-linked bond yields are now just 257bps above those of the US, with the spread having fallen from 400bps in April. Meanwhile, the 10-year real yield advantage has fallen to its lowest level seen in a decade, outside of a few months at the end of 2019.
This suggests that the real does not have the strong fundamental support that it previously did, which leaves the EWZ more exposed to a bout of global risk aversion and a dollar rally. For this reason, I am shifting from a 'strong buy' recommendation to a 'buy' recommendation on the EWZ. However, the ETF is still likely to continue outperforming, particularly relative to developed stocks as cheap valuations make for strong total returns from dividend income.
For further details see:
EWZ: Bull Market Not Over Yet