article 08-28-2014

Brazil: A Ripe Market for Bottom-Up Stock Pickers

Brazil's Economy: Challenges Present Opportunity

Why do you find Brazil an attractive area for potential investment?

Dilip Badlani: Brazil is the largest market in South America, representing approximately half the GDP and half the population of the continent. From our perspective as bottom-up stock pickers, Brazil is arguably the most vibrant market in South America, despite the country's recent challenges.

What are some of Brazil's biggest challenges?

Dilip: The environment in Brazil has changed over the past five years. It was one of the worst performing markets in 2013, largely due to the reversal of the commodities trade. A slowdown in the country's mining sector, caused primarily by weakness in China, greatly affected Brazil's economic growth.

Jim Harvey: Consumer spending accounts for about 60% of GDP, and the economy remains languid. So while unemployment is low, so is productivity. Inflation continues to be a daunting challenge, and more recently the possibility of a recession has been posing a significant threat.

In addition, the World Cup, which drew approximately a million tourists, took time and attention away from the country's pressing economic problems, while over $15 Billion was spent on projects that will generate minimal if any economic or social return. Another hurdle in Brazil's road to recovery is the upcoming elections in early October, which have stalled spending by both consumers and businesses.

The Importance of Careful Stock Selection

With all the country's macro headwinds, what gives you confidence in Brazilian companies?

Dilip: We've visited several countries over the last year. In Brazil the mood was pretty depressed compared to some of the other places we've been. Sentiment is low, and people are waiting for things to turn around. However, we've seen in the past that the country has a lot of potential. The economy is fragile, but in terms of business conditions it feels like things are nearing a bottom. And in fact, this is what we heard from a number of management teams.

Jim: First and foremost, we are bottom-up stock pickers. Brazil's challenges only reinforce our focus on balance sheet strength, free cash flow, and shareholder-friendly corporate governance—the types of characteristics we look for in Royce International Micro-Cap Fund's portfolio.

Talk a little bit about your research process and how you attempt to uncover quality.

Dilip: In late July we met with 14 Brazilian companies. These on-the-ground meetings give us a good sense of a company's culture, its strengths and weaknesses. This becomes especially important during down times.

We are generally attracted to micro-caps that are able to exhibit operating leverage, which is the ability for operating income to grow at a better rate than sales. This is easier to do when revenues are growing at a fast pace. On the other hand, challenges become apparent when a business slows or when revenues are not growing as quickly as they were in the past.

It's during these times that we want to understand the overall resilience of a business. Meeting with management teams gives us a sense of their true mettle. We want to come away from meetings feeling confident that management has the right cost structure in place and is focused on the long-term health of the business. And most importantly, we want to gain a clear sense of how management thinks about allocating capital, because to us this is the ultimate determinant of success or failure in a business. 

Economic troubles notwithstanding, there are a number of Brazilian micro-cap and small-cap companies that are profitable market leaders with decent growth profiles. The Brazilian companies that we're interested in are pretty conservatively managed—often because they've been scarred by extraordinary levels of inflation over the years, which have given them a fairly cautious outlook.

Are there commonalities in quality among the Brazilian companies you're interested in?

Jim: Economic troubles notwithstanding, there are a number of Brazilian micro-cap and small-cap companies that are profitable market leaders with decent growth profiles. The Brazilian companies that we're interested in are pretty conservatively managed—often because they've been scarred by extraordinary levels of inflation over the years, which have given them a fairly cautious outlook.

We also saw a large degree of insider ownership in the companies we met with, which adds to our confidence when considering an investment.

Dilip: Our current holdings are either Novo Mercado listed,1 which represents a higher standard of corporate governance, or on the way to getting there, which we find important.

Even in a slow growth environment, we believe our Brazilian holdings should remain profitable. In addition, despite the outcome of the election, visibility should generally improve, capital spending should resume, and hopefully consumer confidence will rebound. 

What Insider Ownership Reveals

Let's go into some companies that you currently like.

Dilip: On an individual stock basis, what we're finding has been very interesting. Time For Fun (T4F Entertainment) has faced numerous challenges over the past three years. The company operates three segments—concert promotion, ticketing, and venue management. It is the exclusive distribution partner for Live Nation in Brazil.

T4F is the largest live entertainment promoter in South America and one of the largest in the world. This is typically the kind of business where, if you look at major countries around the world, there is usually one dominant player. In Brazil's case it is T4F.

How is the stock undervalued and what do you like about the business?

Dilip: Five to six years ago, as Brazil was booming, several competitors entered the market, which drove up the cost of goods sold—essentially the price paid to musicians and performers. As the economy slowed, T4F's competitors had to exit the market as they did not have sufficient scale to survive. So the company has really regained control of the industry. We think the underlying business is still a good one.

Jim: We like that the CEO has no interest in being a rock star or hanging out with celebrities—he simply wants to make money. He's been in the business for three decades, and his goal is to give audiences a good experience while providing performers a strong return. By doing this successfully over time, he creates value for shareholders.

What gives you confidence in the business going forward?

Jim: The stock is currently down about 75% since its IPO. The CEO is buying shares in the open market and the company has a share buyback in place, which we view as a sign of confidence in the company's future. As business conditions normalize, we believe the share price should react favorably. Even with modest economic growth, we think T4F will  do well because so much supply has come out of the industry and demand is quite steady, as people continue to enjoy forms of entertainment that cannot be experienced at home—concerts, shows, sporting events, and the like.  

Brazil's Real Estate Market

Are there any other areas in Brazil's market where you are seeing limited supply and, conversely, compelling buying opportunities?

Dilip: Continuing on the theme of industries that have seen considerable shrinkage, we like Brasil Brokers Participacoes and LPS Brasil Consultoria de Imoveis. The real estate brokerage business in Brazil is essentially a duopoly where two companies have the dominant market share. A lot of the mom and pop brokers have gone out of business because volumes have not been strong enough to cover their costs.

Share prices are way down because the real estate market is so weak. There are several reasons for this: consumer sentiment is low, cautious homebuyers seem to be delaying purchase decisions until after the elections, and the economy essentially came to a standstill during the World Cup. So this year has been particularly bad.

What do you like about this type of business and what do you think will help the industry to eventually turn around?

Jim: What we like about these businesses is that they're usually profitable, even during downturns. There's operating leverage in the business, but that works both ways: When things turn south, profitability gets hit. But as the real estate market recovers, which we're expecting, these companies should benefit. We also like that they consistently generate cash and pay generous dividends.  We also appreciate the fact that there is a large degree of insider ownership at both companies.

Being long-term investors, we think that buying shares at these depressed levels will eventually reward us.

Our current holdings are either Novo Mercado listed, which represents a higher standard of corporate governance, or on the way to getting there, which we find important. Even in a slow growth environment, we believe our Brazilian holdings should remain profitable.

Learning from Experience

Are there any instances where Royce's 40+ years of investment experience plays a major role in your investment decisions? Can you give an example as it relates to your Brazilian investments?

Jim: Brasil Insurance Participacoes e Administracao is a collection of insurance brokers that have been acquired over the years. This is essentially a turnaround story.  The firm has a new management team that's led by a CEO who was hired earlier this year. He comes from Allianz, one of the largest insurance companies in the world, where he was responsible for running that company's businesses in several different countries throughout Latin America. This new leadership team brings a degree of outside professionalism that the business badly needed.

Dilip: Royce's domestically oriented funds have owned several U.S. insurance brokers throughout our history, so we understand the business model. This new CEO recognizes that the company's most valuable asset is its brokers. So he immediately set out to ensure that the relationship between the company and its brokers is a healthy one. Management is providing the tools and the platform they all need to enable them to grow their businesses and facilitate cross-selling, which ought to help in the long run.

The company's problems are easy to understand—prior acquisitions were not handled well. However, we think the new CEO and his management team will be able to turn the business around. Hopefully, within a year or so, we should start to see results.

Jim: The Brazilian insurance market is one of the largest in the world. The new CEO described to us how the volume potential is enormous, and as a top two or three player in the country, Brasil Insurance should benefit.

Looking for Competitive Advantages and the Importance of Corporate Governance

Can you give an example of a Brazilian company where you think management is making the right steps to remain profitable?

Dilip: Contax Participacoes is the largest call center company in Brazil and has a number two position in three other South American countries. It has done all the requisite work to become Nova Mercado listed, which should happen within the next year.

At Royce we're familiar with these types of service-oriented businesses. What's different about Contax is Brazil and other parts of South America are distinct markets where the lower-priced Indian players are unable to participate, primarily because English is not the primary language.

Jim: A business owner who was one of the company's first customers is now the CEO. We came away from our meeting feeling that he had a firm grasp of the overall potential within the organization.  He's been with the company for roughly two years and has added a new vigor at Contax. In addition, a new CFO came on board recently.

Dilip: The management team now has more of a focus on running the company for profitability. Last year, when sales were down, profits actually increased because of management's improved focus on margins.

Jim: We were also happy to see the company announce its plans to improve corporate governance by becoming a Novo Mercado-listed company. That is something the market in Brazil tends to reward.

Important Disclosure Information

Jim Harvey and Dilip Badlani are portfolio managers of Royce & Associates, LLC, investment adviser to The Royce Funds. In addition to managing Royce International Micro-Cap Fund (RMI), Jim is Portfolio Manager for Royce Heritage Fund (RHF), Royce Micro-Cap Discovery Fund (RDF), and Royce Select Fund II (RS2). He also serves as Assistant Portfolio Manager for Royce Dividend Value Fund (RDV), Royce Global Dividend Value Fund (RGD), and Royce Micro-Cap Trust (RMT). In addition to managing RMI, Dilip serves as Assistant Portfolio Manager for RGD and Royce International Smaller-Companies Fund (RIS). The thoughts and opinions expressed in this piece are solely those of Mr. Harvey and Badlani and may differ from those of other Royce investment professionals, or the firm as a whole. There can be no assurance with regard to future market movements. There can be no assurance that companies that currently pay a dividend will continue to do so in the future.

This material is not authorized for distribution unless preceded or accompanied by a current prospectus. Please read the prospectus carefully before investing or sending money. Royce International Micro-Cap Fund invests primarily in micro-cap stocks, which may involve considerably more risk than investing in larger-cap stocks The Fund may invest a significant portion of its assets in securities of companies headquartered in foreign countries, which may be subject to different risks than investments in securities of U.S. companies, including adverse political, social, economic, or other developments that are unique to a particular country or region. (Please see "Investing in Foreign Securities" in the prospectus.) Therefore, the prices of the securities of foreign companies in particular countries or regions may, at times, move in a different direction than those of the securities of U.S. companies. (Please see "Primary Risks for Fund Investors" in the prospectus.) The Fund's broadly diversified portfolio does not ensure a profit or guarantee against loss.

Percentage of Fund Holdings as of 6/30/14 (%)

T4F Entertainment 0.00 0.00 0.00 0.00 0.00 0.00 0.00
Brasil Brokers Participacoes 1.01 0.23 0.00 1.68 0.02 0.74 0.00
LPS Brasil Consultoria de Imoveis 0.96 0.20 0.00 1.20 0.00 0.00 0.00
Brasil Insurance Participacoes e Administracao 0.00 0.00 0.00 0.00 0.01 0.00 0.00
Contax Participacoes 0.47 0.00 0.00 0.00 0.00 0.00 0.00

(T4F Entertainment and Brasil Insurance Participacoes e Administracao were added to the portfolio on 7/24/14 and 7/23/14, respectively. As of 7/31/14 T4F Entertainment represented 0.49% and Brasil Insurance Participacoes e Administracao represented 0.38% of the net assets of Royce International Micro-Cap Fund.)

There can be no assurance that any of the securities mentioned in this piece will be included in these portfolios in the future. References to specific securities in this piece are not intended as recommendations and should not be relied upon as the basis for anyone to buy, sell, or hold any security.

1 Novo Mercado (New Market) is a listing segment of BM&F Bovespa for the trading of shares issued by companies that commit themselves voluntarily to adopt corporate governance practices in addition to those that are required by law.



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