September 8, 2015
Sovereign Valley Farm, Chile
By late 2002, the national currency of Brazil (known as the “real”) was practically in free fall.
In barely six weeks the real had lost nearly a quarter of its value, and in mid-October 2002, the real hit its weakest level in history at 4 per US dollar.
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Thing is, the weakness in the Brazilian currency thirteen years ago wasn’t based on any rational, objective data.
It’s not like the Brazilian government had accumulated $18 trillion in debt, or another $42 trillion in unfunded liabilities.
In fact Brazil’s debt to GDP ratio was less than 50% at the time (compared to over 200% for, say, Italy).
Most of the ‘crisis’ was simply an emotional reaction to what was happening next door in Argentina, which had recently defaulted on its debt.
Foreign investors lumped all of Latin America together and started dumping everything– stocks, bonds, currency.
Many well-heeled Brazilians panicked.
And, believing that the real was on a one-way street to total destruction, they moved their money into the ‘safety and security’ of US dollars.
This turned out to be the wrong move.
Over the several years, the panic quieted and investors realized that none of their fears were backed up by any actual data.
Growth returned. And by August 2008, the real hit an all-time high of 1.55 per US dollar.
Investors who thought they were ‘smart’ by selling the real at its all-time low and buying the US dollar at its all-time high had managed to lose over 60% of their wealth in six years.
This highlights a rather strange sentiment of human psychology: investors seem to prefer buying assets when they’re expensive, and selling them when they’re cheap.
It has to do with a deep flaw in our ability to properly assess risk.
In any situation, there’s always the PERCEIVED risk and the ACTUAL risk.
Perceived risk is based on feeling and emotion. Actual risk is based on data. You can probably guess which one is more accurate.
We can see signs of this in nature; when small animals feel threatened, they’ll often puff themselves up and make intimidating growls, all in an attempt to increase their predator’s perception that a fight would be risky.
The western banking system is another example.
The US government is broke. The US Federal Reserve is nearly bankrupt. The US banking system is pitifully illiquid.
And the FDIC’s insurance fund fails to meet the minimum level of capitalization as required by its own regulation.
This is a system where the ACTUAL risk is quite high. Yet the PERCEIVED risk is shocking low since the public believes that everything in the banking system is OK.
That’s generally the time to be selling… or at least heading toward the exit– when the actual risk is much higher than the perceived risk.
Conversely, when the actual risk is much LOWER than the perceived risk, it’s time to buy.
That’s the case today in developing markets. Especially here in Latin America.
Two obvious examples are Chile and Colombia.
Colombia is still tainted with a reputation of cocaine and kidnapping, even though the country moved on from that long ago. Still, the perceived risk is very high.
Chile generally stays out of the news, and thus it is hard for ignorant investors to distinguish the country from its neighbors.
Both economies are commodity exporters.
And given the weakness in commodity prices, the market perceives the risk for all commodity exporters to be high.
But this is feeling. Emotion. Not fact.
The data show that both countries are among the most reliable and fastest growing in the region with rapidly expanding middle classes and solid public finances.
Chile, for instance, has zero net debt, a solvent pension system, and a banking system with strong levels of capital and liquidity.
Both have robust and growing domestic economies as well.
There’s certainly an economic slowdown right now. But looking at the currency markets, both the Chilean peso and the Colombian peso have lost roughly 40% of their value over the last few years.
That strikes me as absurd.
Are these economies 40% weaker? Is their long-term potential 40% worse?
Doubtful. The fundamental growth trends are still very much intact.
The only difference is that for anyone with incredibly overvalued US dollars to spend, assets in these places are dirt cheap– whether it’s real estate, or shares of well-managed productive companies.
On a related note, I was recently reading an analyst report about mining giant BHP Billiton, in which the analyst lamented the usual risks that weak commodities will hurt the company’s earnings…
… but in the end he admitted that the company had a great balance sheet, management team, and business model.
Right now BHP is trading nearly at the value of its net tangible assets and paying a 7% dividend yield.
And the analyst concluded, almost begrudgingly, that this was a once in a generation (if not once in a lifetime) opportunity to buy into a great company at such a cheap valuation.
I won’t be cliché and say that Latin America (particularly Chile and Colombia) is now a once in a lifetime opportunity. Or even once in a generation.
But given the historical data, it’s pretty clear that this is at least a once in a decade opportunity.