EWZS: Brazilian Small-Caps Warrant Consideration With Caution

The iShares MSCI Brazil Small-Cap ETF (NASDAQ:EWZS) seeks to track the investment results of an index composed of small-capitalization Brazilian equities.

EWZS offers an efficient way to gain exposure to small-capitalization Brazilian equities in a dollarized manner. The ETF trades on Nasdaq and comprises 91 holdings from a market cap of $300 million to $2 billion. To obtain the planned outcome, the index fund buys weighted ADRs (American Depositary Receipts) of Brazilian small-caps to replicate the index result.

ADRs are share certificates issued by American financial institutions backed by international securities. In the case of the EWZS, the ADRs are backed by Brazilian securities.

However, as the fund’s investment is in US dollars, exchange rate variations affect the value of the index fund. This means that when the share price of Brazilian small-caps rises, EWZS will not necessarily increase proportionally, and vice versa. This happens because the increase will be compromised if the dollar appreciates. On the other hand, if the dollar depreciates, the effect of the rise in the EWZS will be attenuated.

Therefore, it is worth clarifying that the combination of the variations between the performance of Brazilian small-caps and the foreign exchange make up the share price of the EWZS.

The Brazilian stock market (Ibovespa), especially small-caps, which have ample potential for value, is still at significantly discounted multiples despite a good appreciation over the first half of this year.

Hence, EWZS presents a compelling opportunity to gain exposure to the growth of the Brazilian economy. The fund’s allocation is noteworthy, with 50% of its exposure concentrated in small-cap companies from sectors such as industrial, consumer discretionary, and consumer staples. This diversification reduces the overdependence on the performance of the Brazilian economy based on commodity giants like Petrobras (PBR) and Vale (VALE), which collectively account for approximately 20% of the Ibovespa index.

Consequently, investing in EWZS may offer a more balanced approach and an alternative to mitigating outsized cyclical risks associated with heavy exposure to commodity-driven companies.

Although there are several sizable political and macroeconomic risks in betting on the superior performance of Brazilian small-caps from now on, I see Brazilian equities with a relevant undervaluation that may still pay off as the base interest rate enters a steeper downward curve shortly.

Recent performance

Over the last two years, the post-pandemic bear market has been characterized by high inflation and increasing interest rates worldwide, leading to a significant devaluation of the Brazilian stock market.

This impact has been particularly felt among small-cap stocks, which are more susceptible to the high-interest rate environment. Additionally, the depreciation of the Brazilian Real against the USD from 2021 to 2022, primarily driven by interest rate hikes, further contributed to the decline of EWZS by approximately 45% from June 2021 to the early months of this year.

The monetary policy so far very well conducted by the Brazilian Central Bank to curb inflation where consisted of gradually increasing the basic interest rate (Selic) from 2% between the end of 2020 and the beginning of 2021 to up to 13.75% in September, resulting in a drop in inflation (CPI) from 12.13% at its peak in May last year to 3.1% in the previous report – even reaching lower levels than the world’s major economies.

The fall in Brazilian inflation has brought a good mood back to the markets, where small-caps are contributing to the gains of EWZS, up almost 40% year-to-date, almost correcting their fall in recent years. GDP figures for this year, showing the economy’s strength, also helped to sustain the recovery. The latest GDP projection by the Brazilian Central Bank is for a 2.18% increase this year, as is the 2024 projection of 1.22% growth.

In addition, the prospect of interest rates starting to fall in the second half of the year has also served as a strong stimulus for the stock market and makes the outlook favorable for the small-cap sector.

As a result, the Brazilian Real has experienced a turnaround, appreciating against the US Dollar and converging below $5 for the first time since the pandemic began. This development further enhanced the positive performance of EWZS.

Brazilian equities are still too cheap

During the first half of this year, the markets experienced ups and downs, driven by the agitated re-election of President Lula. This situation led to intense volatility, causing the Ibovespa to break the 100,000 point level downwards by the end of March, reaching the peak of bearishness. Largely as a result, the EWZS plummeted to $10 per share.

However, since the market processed the impact of the new fiscal framework proposed by the current economic team as not as bad as anticipated, the Brazilian stock market quickly accelerated its performance returning to levels close to 120,000 points recently.

Although small-caps’ valuation has risen, it is still below the averages. With a P/E of 7.38, the EWZS portfolio is still trading at a discount to the historical average. In comparison, Brazil’s mid large Caps index currently has a P/E of 7.0x.

The Brazilian stock market, Ibovespa, currently has a projected price-to-earnings ratio of 7.4x, a discount of over 30% to the historical average of 11.0x. Even when removing the commodities companies, or Petrobras and Vale, the P/E goes to 10.0x and 9.3x, respectively – lower than their historical averages.

This means that the EWZS is nearly at the same valuation as the Brazilian large caps, since the recent rally in small-caps has caused multiples to expand.

Also, if we break the Brazilian stock market down by industry, we see that all sectors in Brazil are trading at multiples below or close to their long-term averages. This provides a general outlook of how the market has been valuing Brazilian equities as a whole.

The chart below illustrates in the gray bars the maximum and minimum P/E ratio in the last ten years, the orange bar the average during the previous ten years, and the yellow signal the current levels of the main sectors of the Brazilian economy.

Cautionary signs

The recent favorable performance of Brazilian equities due to discounted valuation and a perception that the Brazilian stock market is full of opportunities and that the economy is showing promising signs for the future seems to be a consensus.

However, when looking at where it can go wrong, there are several points to consider that make investors in Brazilian assets set their expectations right.

Population leverage:

Worrying data shows that 80% of Brazilian households have debt, with 30% defaulting. In addition, household debts represent about 33% of the national GDP. It is alarming that approximately 70 million people have a negative debt in the country, equivalent to almost half of the adult population.

Thus, the high leverage of Brazilian families may be one of the main reasons that may affect optimism for the country’s economic growth, mainly reflected in Brazilian equities. But it is worth noting that there are still many uncertainties about how this situation will develop. Exposure and smaller companies with slight market dominance can be risky in a pessimistic scenario of high defaults and future GDP contraction.

Brazilian tax reform:

The Brazilian government has recently approved a tax reform, which may bring and is still expected to bring several uncertainties that may affect the profitability of companies since the rates have not yet been established. Uncertainties over the taxation of dividends and the new fiscal framework of the Lula government, which envisions taxes of at least $110 billion for public purposes, could make for an expensive bill for the private sector in Brazil.

The pace of interest rate cuts:

Finally, there is little chance that Brazilian equities, in general, will rise in the absence of a lower interest rate, or at least the expectation that there is a path to it. At the most recent meeting, of the Brazilian Central Bank, the base interest rate (Selic) was kept at 13.75% and lowered expectations of a cut soon by reinforcing that it will persevere until it consolidates not only the disinflation process but also the anchoring of expectations around its targets, which has shown further deterioration.

The bottom line

While a cautious and selective approach to Brazilian small-caps is warranted, interest rates will likely remain at high levels for longer than anticipated, as the Brazilian Central Bank indicates. Political risks loom due to the potential impacts of the tax reform on the private sector, coupled with an unstable macroeconomic scenario affected by threats of a US market recession and a global economic slowdown.

Despite these challenges, Brazil’s economic conditions could yield favorable results if interest rates continue to fall toward more normalized levels. Historical market trends show that equities tend to gain momentum when interest rates approach a downward trend. Additionally, closely monitoring the movement of the yield curve is crucial for investors. While small-caps are particularly sensitive to falling interest rates, this presents an additional reason for confidence in investing in funds like EWZS.

In light of the ongoing reduction in the basic interest rate and its projected trajectory, maintaining a cautious exposure to the Brazilian small-cap sector offers an excellent opportunity to capitalize on potential positive outcomes. This approach allows investors to navigate the initial phase of the interest rate reduction curve and positions portfolios for potentially favorable returns in my view.