Royce Funds: Why Consider Brazil Now? by Royce Funds
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
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.
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.
