article 10-27-2014

Why Consider Brazil Now?

We see Brazil as a country whose investment appeal appears evident based on enduring themes, including burgeoning middle-class consumption, a young and unlevered population, business acumen in fields as diverse as agriculture and manufacturing, and more. 

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Setting off last month for my seventh visit to Brazil, we brought far less lofty ambitions in our search for investments we believe will produce a better outcome over time. After joining Royce in 2006, Brazil was the second country I visited to source investments. In 2009, Chuck Royce joined me for another productive visit, and this time I was joined by my Royce colleagues Jim Harvey and Dilip Badlani.

As of September 30, 2014, Brazil is the fifth-largest country allocation of Royce International Smaller-Companies Fund with a 7.0% weighting.

International Smaller-Cos Portfolio Country Breakdown as of 9/30/14
% of Net Assets1,2

International Smaller-Cos Russell Global ex-US Small Cap
Japan 14.5 21.1
France 9.2 1.6
United Kingdom 8.5 10.0
Hong Kong 8.4 1.3
Brazil 7.0 1.3
India 6.7 3.4
Germany 4.3 2.6
Malaysia 4.1 2.0
China 4.0 5.7
Switzerland 3.3 1.8

1 Represents countries that are 3% or more of net assets.
2 Securities are categorized by the country of their headquarters.

As a team of value-oriented investors, we are often attracted to markets that are out of favor. For example, on our fourth visit to India last winter, we decided to ramp up our commitment to this market in Royce International Smaller-Companies Fund in light of the disconnect between negative sentiment and the relatively encouraging fundamentals we saw in the small-cap companies with which we met.

Last month, we trained our sights on Brazil, in part because years of negative investor sentiment towards this BRIC (Brazil, Russia, India, China) country have depressed valuations and potentially strengthened the margin of safety.

For five years, the BRIC markets have underperformed U.S. equities by a wide margin, and Brazil's equities have been the weakest of the bunch. We were also inspired to visit Brazil because of its recent "Buffett indicator," i.e., the ratio of market cap to GDP, which Warren Buffett calls "probably the best single measure of where valuations stand at any given moment."3

We think Brazil's smaller companies thus offer a compelling combination of compression in both valuation multiples and profit margins, setting the stage in our opinion for margin and multiple expansion.

When it comes to developing markets such as Brazil, otherwise rational investors often vacillate between euphoria and despair. Today, sentiment towards Brazil's small-cap market is clearly much closer to despair. The MSCI Brazil Small-Cap Index (MXBRSC) is trading near multi-year lows, and actually below its level prior to the 2008 financial crisis.

We think Brazil's smaller companies thus offer a compelling combination of compression in both valuation multiples and profit margins, setting the stage in our opinion for margin and multiple expansion. If we are right, this double whammy should mean very healthy returns for investors.

If we can look beyond the negative headlines about Brazil, we see a country whose investment appeal appears evident based on enduring themes, including:

  • Purchasing power parity
  • Burgeoning middle-class consumption
  • A young and unlevered population
  • Low unemployment
  • Agriculture and manufacturing
  • Room for infrastructure improvement
  • Political reform

Having visited the country many times, we see a more encouraging landscape for Brazil's higher-quality small- and mid-cap companies. We see social mobility with few contemporary parallels fueling more sustainable consumption. We see a country that excels like no other at agriculture, and is underappreciated for its manufacturing expertise. We see a country with room for long-term growth.

With the recent re-election of incumbent president Dilma Rousseff to a second term, investor expectations are exceedingly low, with the consensus assuming an extension of muted growth, an uptick in inflation, and more of the same in terms of policies. We beg to differ. Dilma's slim victory margin of just 3% over Social Democratic Party candidate Aecio Neves—the tightest margin in a Brazilian presidential contest since World War II—does not create a strong mandate and emboldens the opposition.4 Furthermore, it may encourage her to pursue reforms necessary to solidify her legacy after her first term, which excelled at low unemployment but saw Brazil's Ibovespa Index lose 25% of its value and its currency lose 34% versus the U.S. dollar.5

In general, markets tend to respond negatively to election victories by left-of-center leaders like Dilma, but quite often their bark is worse than their bite in terms of policies effecting business, leading to an upside surprise for investors in share prices. Investors reacted with similiar concern to the election of Dilma's predecessor Lula da Silva in 2002, fearing the worst from the Workers Party he and Dilma share, but were rewarded handsomely over the eight years of his two terms. 

In our view, Brazil's margin of safety has significantly increased at this juncture, given depressed profit margins and compressed valuations. For those investors brave enough to consider Brazil now, we believe the rewards for courage could be more fun than Carnival bacchanal.

For a more detailed discussion on small-cap opportunities in Brazil, download the full whitepaper.

Important Disclosure Information

The thoughts and opinions expressed in this piece are solely those of the person speaking 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.

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 Smaller-Companies Fund may invest a significant portion of its assets in foreign companies, which may be subject to different risks than investments in securities of U.S. companies, including adverse political, social, economic, currency 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.) In addition, as of 9/30/14 the Fund invested a significant portion of its assets in a limited number of stocks, which may involve considerably more risk than a more broadly diversified portfolio because a decline in the value of any of these stocks would cause the Fund's overall value to decline to a greater degree. The Fund invests primarily in small-cap and/or mid-cap stocks, which may involve considerably more risk than investing in larger-cap stocks. (Please see "Primary Risks for Fund Investors" in the prospectus.) Russell Investment Group is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Russell® is a trademark of Russell Investment Group. The Russell Global ex-U.S. Small Cap Index is an unmanaged, capitalization-weighted index of global small-cap stocks, excluding the United States. The MSCI Brazil Small-Cap Index (MXBRSC) is designed to measure the performance of the small-cap segment of the Brazilian market. The Bovespa Index tracks approximately 50 stocks traded on the Sao Paulo Stock, Mercantile & Futures Exchange. It is composed by a theoretical portfolio with the stocks that accounted for 80% of the volume traded in the last 12 months and that were traded at least on 80% of the trading days. The Dow Jones Industrial Index is a stock market index that shows how 30 large publicly owned companies based in the United States have traded during a standard trading session in the stock market. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

3 http://www.businessinsider.com/warren-buffett-stock-market-indicator-2014-7
4 The Telegraph, http://www.telegraph.co.uk/news/worldnews/southamerica/brazil/11189233/Mudslinging-dominates-final-moments-of-Brazil-election.html
5 Bloomberg

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