In Ibovespa We Trust Lower Rates, Stronger Growth and Increased Equity Flows - Itaú BBA
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In Ibovespa We Trust Lower Rates, Stronger Growth and Increased Equity Flows Strategy Team Marcos Assumpção, CFA Jorge Gabrich, CNPI Lucas Tambellini, CNPI André Dibe Guilherme Reif +55-11-3073-3021 +55-11-3073-3048 +55-11-3073-3023 +55-11-3073-3222 +55-11-3073-3066 marcos.assumpção@itaubba.com jorge.gabrich@itaubba.com lucas.tambellini@itaubba.com andre.dibe@itaubba.com guilherme.reif@itaubba.com
Executive Summary
Constructive on Brazilian equities. Our positive view can be summarized in three main points: low interest rates for the longer term, stronger
expected GDP growth, and potential flows to equities. This constructive view is backed by: i) our belief that the pension reform will be approved,
confirming the continuity of fiscal adjustments in Brazil, and ii) the government’s strong economic team, which has a focus on solving Brazil’s fiscal
problems through reducing expenses, selling assets, and encouraging investments through concessions. Main Topics Discussed:
The new norm: Low interest rates in Brazil. We expect Brazil to enter an era of low interest rates driven by i) fiscal discipline with controlled
government spending; ii) financial deepening, increasing capital market’s share in the economy; and iii) low industry-capacity utilization, which could
allow for low interest rates without pressuring inflation.
Stronger GDP growth ahead. The main drivers for growth will be increasing investments and rising productivity, allowed by the expected fiscal adjustment (lower spending could be
turned into higher capex), a low-risk concession program, and micro reforms. As a result, Brazil’s potential GDP growth, which is currently at 1.5%, could increase to 2.5%-3.5%
The great rotation to equities. We believe that most investor profiles are under-allocated in Brazilian equities. We see room for local investors to add equity exposure as they search
for higher yields, and foreign investors could also increase positions in Brazil as they see a decline in political and economic risks.
Pension reform – the BRL 1 trillion question. Our scenario depends on the new government’s fiscal discipline, which will be measured by the success of the pension reform
achievement. We dedicate a special section to analyzing why the pension reform is crucial for Brazil’s public accounts and provide a guide with the main topics that investors should
be monitoring in the coming weeks (lawmakers’ positioning, timeline, milestones and savings breakdown).
Itaú insights: Top management interviews. We interviewed four of our top executives in order to confirm our views for the equities market. Both Gabriel Guedes (Head of Corporate
Credit) and Felipe Wilberg (Head of Fixed Income and Project Finance) discuss how the declining interest rates have been affecting the credit, fixed-income and project finance
businesses. Luis Severiano (Head of Private Banking) and Cesar Ming (Head of Financials and Institutional Investors, Corporate Banking) share similar views, that both the private
banking and the pension fund industries have room to increase equity exposure.
Attractive valuation: Ibovespa at 11.3x P/E, in line with historical average, but with strong earnings growth potential. We expect domestic companies to post recurring earnings
growth, fueled by both operating leverage (demand pick-up and fixed-cost dilution) and financial leverage (declining interest rates and lower hedging needs).
Overweight Domestics, underweight Commodities and Financials. Our views on Brazilian equities can be broken down into four themes: i) an upturn in the domestic economic cycle;
ii) improved efficiency at state-owned enterprises (SOEs); iii) compelling valuation; and iv) deleveraging. Our allocation suggests that we are overweight domestic names (60%),
underweight Commodities (20%) and underweight Financials (20%). We updated our recommended portfolio by including Multiplan (exposed to GDP growth) and JBS
(deleveraging) and are taking profit from Localiza and Fleury as valuations are fair at current levels. In the report, you will also find our stock recommendations details (page 28).
Index
Section 1 The New Norm: Low Interest Rates in Brazil .............................................................................. 4
Section 2 Stronger GDP Growth Ahead ............................................................................................................ 12
.
Section 3 The Great Rotation to Equities ......................................................................................................... 21
Section 4 Valuation and Allocation: Prefer Brazil Domestic Exposure ................................................ 26
Section 5 The BRL 1 trillion Question ................................................................................................................. 32
Section 1 The New Norm: Low Interest Rates in Brazil
The New Norm: Low Interest Rates in Brazil
Real Interest Rates Could Go Down to Unprecedented Levels
Low real interest rates if fiscal balance is restored. Our expectation of lower interest rates for Neutral real rate* is currently at 2.4% and could further decline. The real rate, measured by
the longer term in Brazil is based on three pillars: i) fiscal discipline with controlled government the difference between the interbank rate (DI) and projected inflation, is currently at 2.4%,
spending and a reduced BNDES presence; ii) financial deepening, with capital market’s well below the levels observed in the past decade (see chart below). This lower real rate can
increasing share in the economy and rising non-earmarked credit; and iii) low industry-capacity be explained by the reduction in financial subsidies and deeper financial conditions offered
utilization, which could allow for low interest rates without pressuring inflation. by market participants.
Our positive call on equities depends on fiscal adjustments in Brazil – pension reform is crucial. Real rates could go lower, as idle capacity is unlikely to pressure Inflation in the short term.
We believe that the approval of pension reform is the most important trigger to stabilize Given the current low industry-capacity utilization of 74%, we see room for real rates to
debt/GDP levels, which would permit lower interest rates and likely reestablish foreign remain below the long-term neutral real rates of 2.5%-3% (Macro team’s estimate) in order to
investors’ confidence in Brazil. We delve deeper in the details of pension reform in a separate stimulate the economy. Our Macro team estimates Selic rates at 5.75% by YE19 and 5.5% by
section, given its importance to our constructive call on equities. YE20. For inflation, Itaú estimates controlled inflation (IPCA) of 3.6% in 2019 and 3.6% in 2020.
Chart 1: Real Interest Rates Could Continue to Drop: DI Rate (%) – Focus CPI Projection (%) Chart 2: Industry Capacity Utilization (%) - NUCI
20 88
18 86
16 84
14 82
80
12
78
10
76
8
74
6
72
4 70
2 68
0 66
2002 2004 2006 2008 2010 2012 2014 2016 2018 Dec-03 Dec-06 Dec-09 Dec-12 Dec-15 Dec-18
Source: Itaú BBA, Bloomberg, MCM, FGV * Neutral real rate = interest rate that leads the economy to reach its growth potential without inflationary pressure
5
The New Norm: Low Interest Rates in Brazil
Chart 1: BNDES Concessions Over GDP Chart 2: Government Quarterly Spending Growth
Fiscal Discipline and Financial 12%
5%
Deepening on Spot
8%
4% % of GDP
Fiscal discipline is crucial to keeping rates low. First,
4%
continued efforts to keep fiscal accounts healthy 3%
and to reduce the share of BNDES’ credit
concessions on the economy are measures that 0%
2%
reduce government spending and allow for lower
real interest rates. In our opinion, the approval of a -4%
1%
strong pension reform will send a clear message of
improved fiscal discipline. On the other hand, a lack 0% -8%
Sep-03 Sep-08 Sep-13 Sep-18
of government-spending control could lead to Sep-03 Sep-08 Sep-13 Sep-18
higher interest rates, slower growth, weaker
Chart 3: Non-Earmarked Credit Chart 4: Share of Capital Markets in GDP
currency and increased inflationary pressure.
30%
Financial deepening (crowding in) likely to continue. 29%
Second, the improvement in credit conditions % of GDP % of GDP
27%
offered by market participants, measured by non- 25%
earmarked credit and the share of capital markets 25%
in GDP, has the potential to amplify the investment 23%
20%
alternatives, leading to a higher savings rate, which
21%
also reduces the neutral interest rate.
19%
For details on the impact of fiscal discipline and 15%
financial deepening on neutral interest rates, please 17%
refer to our Macro ream’s report (Brazil: Are low 15%
10%
rates the new normal?) Sep-03 Sep-08 Sep-13 Sep-18
Sep-03 Sep-08 Sep-13 Sep-18
Source: Itaú BBA, BCB, BIS, National Treasury
6The New Norm: Low Interest Rates in Brazil
Chart 1: One-Year DI Rate Spread Over One-Year Libor
Financial Deepening and 18%
The Local Debt Market Boom 16%
14%
Three reasons behind the local debt market boom. The local debt market is 12%
flourishing due to a combination of: i) lower interest rates in Brazil, evidenced by the
10%
low spread between local rates and Libor (see chart); ii) the reduced presence of
8%
BNDES and government banks in the credit market; and iii) increasing demand for
alternative investments (including private credit) as local investors search for higher 6%
yields. 4%
2%
Increased demand for local debt reduces the need to issue bonds abroad. Until
0%
recently, any Brazilian corporate willing to issue a 10-year debt had to issue bonds in
2004 2007 2010 2013 2016 2019
U.S. dollars. As a result, companies that generated revenues domestically would
have to hedge these liabilities, increasing their debt cost. Chart 2: Itaú BBA Coverage Debt Funding by Type
Detailed analysis shows there is room to profit from liability-management
Total BRL Total BRL 430
programs. We performed a comprehensive analysis comparing the debt profile of
1,040 Billion
most companies we cover (nearly 100 companies, as we excluded banks and 18%
Billion 29% Excluding
financial services from this analysis), and concluded that 28% of their debt is still 37%
concentrated in foreign-currency bonds (see chart). Overall, the debt of these Exporters
companies totals BRL 1 trillion, with more than 50% being concentrated in U.S.-
56%
dollar bonds, mainly from Petrobras and Vale. After excluding the exporters 26%
(commodities and capital goods), the debt outstanding drops to BRL 430 billion,
with nearly 30% still concentrated in foreign-currency bonds. We believe the current 34%
scenario of lower interest rates in Brazil will allow companies to: i) refinance older
and more expensive debt, and ii) issue long-term debt in BRL, thus reducing their Local Currency (Bonds) Local Currency (Banks) Foreign Currency
hedging need and overall funding cost.
Source: Itaú BBA, Economatica, Bloomberg
7The New Norm: Low Interest Rates in Brazil
Chart 1: Local Bonds Volume Clearly Picking Up (BRL Billion) Chart 2: Local Bonds Maturities Extending (Years)
Local Market Debt Boom Signs 160.0 7.0
140.0
The development of the local debt market can be 6.0
confirmed by: 120.0
5.0
100.0
Volumes are picking up. Local bond offerings rose 4.0
80.0
to record-high levels, reaching BRL 160 billion in
60.0 3.0
2018 (Graph 3). In our view, volumes could increase
further if corporates were to enter a period of 40.0 2.0
heavier investment, which will depend mainly on 20.0 1.0
the evolution of the reform agenda. 0.0 0.0
Infrastructure is the clear highlight. There is strong 2013 2014 2015 2016 2017 2018 2013 2014 2015 2016 2017 2018 2019
demand for infrastructure bonds, shown by their
Chart 3: Local Bonds Coupon (%) Trending Down Chart 4: Bond-Offering Purpose (% of BRL Volume)
increased share in total bonds. The continued
auction of ports, airports, and road concessions 16.0% 100% Refinance
will likely sustain this segment’s share. 14.0%
90%
80% Debt Rollover
Lower coupons and longer maturities. The 12.0%
70%
combination of increased demand from investors Others
10.0% 60%
for higher yields and a reduced supply of bonds, 8.0% 50% Acquisition
given the reduced investment activity, has been 40%
6.0%
pressuring coupons downward. At the same time, 30% Fixed Assets
4.0% Investment
maturities are expanding, showing increasing 20%
2.0% Infrastructure
appetite for this asset class (local debt). 10% Investment
0.0% 0% Working Capital
2013 2014 2015 2016 2017 2018 2019 2013 2014 2015 2016 2017 2018 2019
Source: Itaú BBA, Anbima,
8The New Norm: Low Interest Rates in Brazil
Chart 1: Share on the Ibovespa and P/E by Segment Table 2: Domestic-Sector Gain From Not Hedging (in Points)
How Lower Interest Rates Could Old New Δ %
Affect the Ibovespa
Ibovespa
P/E - 11.3x (+) EBIT 5764 5764 - -
(+) Interest Received 296 296 - -
P/E - 9.1x
Ibovespa could trade at a higher multiple (12.2x P/E Exporters Annual Coupon (%) 8.3% 7.0% -1.3% -
vs. 11.3x historical average), assuming that domestic 20% P/E - 13.0x (+) Interest Paid -1656 -1394 261 -15.8%
companies (ex-financials) would benefit from higher Domestics (=) EBT 4405 4666 261 5.9%
earnings generated by lower hedging costs. 44% Efective Tax Rate 25% 25% - -
P/E - 11.2x Net Income 3303 3500 196 5.9%
We have broken down the Ibovespa into three Financials
35% Additional ROE
segments: i) domestic companies, which generate Book Value 21142 Generated From
revenues in Brazil; ii) exporters, which have a natural Additional ROE 0.9%
Recurring Increase in
hedge and thus will continue to issue debt in USD at Net Income
competitive rates; and iii) financial companies. We
focused our exercise on the potential impact on Table 3: Domestic Sector P/E After Re-Rate Chart 4: Ibovespa P/E After Re-Rate
domestic companies (ex-financials).
Current Forward P/E 13.0x Gordon Growth
We estimate that the domestic segment could Historic Payout Ratio 50.0% Model to find the Current Re Rate
reduce its hedged cost of debt from 8.3% to 7.0%, Cost of Equity 11.7% implicit growth
assuming that all debt is converted into local debt Implied Growth 7.8%
instruments following the local debt market boom.
Implicit Growth = Ke – (Payout x E/P) 11.3x 12.2x
According to our calculations, the resulting
reduction in financial expenses would raise net Historic Payout Ratio 50%
income by 6% and improve ROE by 0.9% ROE for the Additional ROE 0.9%
domestic segment. These additional earnings would Additional Growth 0.46% 1.7x Re Rate
allow domestics’ P/E to re-rate to 14.7x (from 13.0x), New P/E 14.7x
leading the Ibovespa multiple to reach 12.2x (from
Additional Growth = (1- Payout) X Additional ROE 8.0% Price Upside
11.3x).
Source: Itaú BBA, Economatica, Bloomberg
9The New Norm: Low Interest Rates in Brazil
Views from Itaú BBA:
Credit market competition is getting fiercer. Gabriel Guedes mentioned that credit spreads (in the CIB and large corporate segment) are tightening
and most operations are offering limited guarantees/no covenants. Looking at our records, the vast majority of Itaú BBA’s lost transactions are
explained by price competition. According to our internal calculations, most of those transactions were closed with questionable returns. The
increasing competition can be mainly attributed to large private players, which are gaining market share from public banks and BNDES (see chart
below).
Developing local debt market with extended maturities. For the first time in many years, local companies can issue long-term (10-year) debt in local
Gabriel Guedes
currency at competitive cost. This is unprecedented, and it opens room for many companies to issue long-term debt without needing to bear the
Head of Corporate hedging cost. This trend was made possible mainly by the recent decline in interest rates.
Credit at Itaú BBA
Lower rates are allowing unusual product offerings. For example, exporters are issuing local debentures (10-year) in BRL (Brazilian real) and hedging
into USD (U.S. dollar) at a more competitive cost than the traditional 10-year foreign-currency bond issuance. This trend highlights the declining cost
of debt in Brazil.
Chart 1: Annual Credit Concessions Market Share (%)
Debt is being raised mainly for Utilities, concessions and M&A deals. Gabriel Guedes is seeing
100%
increasing credit demand for i) the Utilities sector (mainly renewables); ii) concessions (brownfield
and greenfield); and iii) M&A deals generated by the end of a weak economic cycle and the sale of 80%
government assets. Additionally, there has been marginal credit demand for capex purposes,
mainly from those companies that have underinvested in the previous few years. 60%
Active portfolio reshuffle is a strategy to maintain Itaú’s competitiveness in the credit market. In
40%
order to serve our clients’ credit needs while maintaining decent returns measured by RAROC
(risk adjusted return on capital), Itaú is actively rotating its credit portfolio, taking advantage of 20%
new business opportunities and market liquidity fueled by institutional and private investors.
0%
2012 2013 2014 2015 2016 2017 2018
Private Banks Public Banks BNDES
Source: Itaú BBA, BCB
10The New Norm: Low Interest Rates in Brazil
Views from Itaú BBA:
Credit spreads likely to remain under pressure . Felipe Wilberg expects credit spreads to remain under pressure as local banks and investors are
aggressively increasing their corporate-credit exposure, while most companies are not undertaking heavy investment programs in the short term. In
summary, the banks’ supply of loans is exceeding corporate demand for bonds.
Corporate loans are being channeled to liability management and M&A rather than capex budgets. This type of loan demand is not creating a
sustainable increase in the banks’ credit portfolios, as: i) for liability management, the money raised is usually used to pay down an existing higher cost
Felipe Wilberg debt; and ii) for M&A, the seller is also using the proceeds to reduce debt levels.
Head of Fixed Different views from local and foreign investors create a short-term arbitrage window in the debt market. On one hand, local investors have limited
Income at Itaú investment alternatives and are looking for higher yields in the debt market – this trend could allow the local bond market to continue growing. On
BBA the other hand, foreign investors are taking a cautious stance on Brazilian companies given the still-uncertain economic outlook. As a result,
corporates are issuing local bonds more cheaply than hedged bonds in U.S. dollars.
New products are being developed in this lower interest rate environment. Infrastructure funds (debenture Chart 1: Itaú BBA CIB Yearly Credit Concession by Type
12.431), which are tax exempt, are flourishing as investors (particularly private investors) seek higher yields.
Additionally, real estate funds are growing quickly. According to CVM, 78 new funds were created in the past
25%
twelve months and traded volumes reached BRL 67 million/day, a 45% increase over the past twelve months. 39%
53%
Project finance is coming back. Demand for project-finance operations has also increased recently, mainly in 30%
the Utilities (transmission lines and renewables) and road-concession segments. 25%
High expectations for credit demand from Energy, concessions (airports) and Sewage sectors. There are high 15%
expectations that the new round of government concessions (which started with airports and ports) and 46%
36% 32%
regulation changes leading to government asset sales (Energy and Sewage sectors) could support a positive
investment cycle, driving credit demand upward.
2016 2017 2018
Foreign Curency Local Currency Local Bonds
Source: Itaú BBA
11Section 2 Stronger GDP Growth Ahead (Higher Investments and Productivity)
Stronger GDP Growth Ahead
The New Growth Agenda: Fiscal Adjustment, Micro Reforms and Asset Sales
Fiscal adjustment, micro reforms and asset sales are the main drivers behind a Capital and productivity improvements are the levers for growth in Brazil. According to a
more constructive GDP-growth expectation. The potential growth of Brazil’s study run by our Macro team, Brazil’s potential GDP-growth level is nearly at 1.5%.
GDP, which is currently at 1.5%, could increase to 3.5% assuming fiscal Considering the Solow growth model, growth can be broken down in three areas of
adjustments and micro reforms are delivered. See our Macro team’s report: contribution (capital, labor and productivity). In our opinion, improvements in capital and
Reforms could bring Brazil’s potential GDP to 3.5% productivity will be the main drivers of growth in Brazil; given that the demographic bonus is
over, we should not expect strong contributions from the labor factor.
Fiscal discipline is crucial for growth. The main opportunities are: i) pension
reform; ii) new readjustment policy for minimum wage; and iii) limiting wage
increases for public servants. These measures could have a strong fiscal impact Chart 1: Brazil’s Growth Composition (Solow Growth Model)
on public accounts, reducing the pressure on expenses and creating room for Growth breakdown
investment. Average Estimated Capital Labor
Period Productivity
Micro reforms could lead to increased productivity. The new administration Growht Potential Contribution Contribution
seems focused on approving measures that would reduce bureaucracy and 1961 - 1964: Inflation and rupture 3.4% 4.4% 2.5% 2.1% -0.2%
improve productivity. We highlight the tax reform (simplifying the current 1965 - 1966 4.4% 4.2% 2.6% 2.1% -0.5%
structure), opening the economy, and implementing labor reform to lead to 1967 - 1974: Economic "Miracle" 9.4% 9.4% 3.6% 2.0% 3.8%
1975 - 1980: Oil crisis 6.6% 6.5% 3.6% 1.8% 1.1%
improved productivity, an important source of growth.
1981 - 1990: Lost decade 1.6% 1.7% 1.5% 1.5% -1.2%
Asset-sale program could lead to increased investment and productivity in the 1991 - 1994: Trade liberalization, privatization and
2.7% 2.4% 0.6% 1.4% 0.3%
future. The new government has a clear plan to focus on necessary services inflation
1995 - 2002: Stabilization and reforms 2.6% 2.6% 0.9% 1.2% 0.4%
(security, health and education) and to sell non-core assets. The concession
2003 - 2010: Macroeconomic tripod consolidation
program and the sale of some state-owned companies could lead to increased and commodities boom
4.0% 3.4% 1.1% 1.1% 1.2%
investments in infrastructure, supporting growth and improved logistic 2011 - 2016: Commodity bust and new economic
0.3% 1.6% -1.3% 0.7% -0.5%
efficiency in the future. matrix
Total 3.9% 4.0% 1.9% 1.5% 0.6%
Source: Itaú BBA
13Stronger GDP Growth Ahead
Chart 1: Evolution of Brazil’s Manufacturing Productivity per Person
What went wrong in the past?
120
GDP growth has averaged 1.0% in the past 10 years. Brazil’s GDP growth has been sub- 100
optimal in the past 10 years, particularly during the period of the worst recession ever, in
80
2015-2016. In our view, the weak growth in the past decade can be mainly explained by
two factors: 60
Low public savings. The reduced savings from the public sector limits investments, thus 40
reducing capital formation and productivity gains that could have been made through the
use of more-efficient equipment and technology. For example, we recently met Mr. 20
Rodrigo Garcia, Vice Governor of São Paulo State, who mentioned that 97% of the state
0
budget is already earmarked for obligatory expenses, leaving only 3% of the state budget
1970
1972
1974
1976
1978
2008
1998
2000
2002
2004
2006
2010
1990
1992
1994
1996
1988
1980
1982
1984
1986
for investments. If the pension reform is not approved, the room for investment could fall
to zero in two years, as inactive public employees will soon surpass the number of active Chart 2: GDP per-Capita Evolution – Brazil and Peers (Purchasing Power Parity)
public servants.
20.5
Microeconomic inefficiency. Productivity improvements in Brazil have been meager since
the seventies, because of complexity on the regulatory, tax and labor relations fronts. 16.1
These factors are frequently referred to as Brazil’s cost (custo Brasil). Indeed, labor 14.9
14.1
productivity in Brazil has been stagnant, while most other countries, both developing and
developed, have registered important productivity gains over the years.
Brazil was losing the growth race. As a result, the gap between the per-capita GDP of Brazil
and of developed countries has widened, while the difference between Brazil and other
developing countries has narrowed (see chart 2). Looking at per-capita GDP adjusted to (in USD Thousands)
purchasing-power parity from the IMF, per-capita GDP for Peru and Colombia is very close
2012
1992
2016
2018
1990
1994
2010
1996
2014
1982
1988
1980
1984
1998
2002
2000
2004
2006
2008
1986
to Brazil’s levels.
Source: Itaú BBA, GGDC, IMF
14Stronger GDP Growth Ahead
But GDP Could Grow 3.5% With Full Reforms
Chart 1: Real GDP Growth
Reforms (macro and micro) could be the main catalyst for growth. According to our Macro team, Brazil’s
potential GDP growth could increase to a healthy 3.5%, from 1.5% currently, if i) a strong fiscal adjustment is 7.6%
implemented, aligned with BRL 1 trillion savings on the pension reform (in 10 years); and ii) microeconomic
inefficiencies are removed (infrastructure, logistics, legal, tax, and regulatory). 4.0%
3.0% 2.5%
Fiscal adjustment could add 1.5% to potential GDP. The positive impact on GDP would come from lower 1.9%
1.1% 1.1% 1.3%
government expenses, which could translate into higher investment as a percentage of GDP. The additional 0.5%
1%
1.5% potential GDP growth is compatible with strong savings from the pension reform (nearly BRL 1 trillion
in 10 years), which would allow investment/GDP to recover to 20% (from 15% currently). As a sensitivity, a -0.1%
milder pension reform (BRL 550 billion savings) would add 0.75% to potential GDP growth.
-3.5% -3.3%
Microeconomic reforms could add 0.5% to potential GDP. The productivity improvements coming from
2019F
2011
2013
2017
2016
2012
2015
2010
2018
2014
2009
2020F
labor reform and the potential tax reform, coupled with an aggressive concession program (improved
infrastructure) and new regulations reducing uncertainties in specific sectors (such as sanitation, telecom, Brazil GDP (%) CAGR
oil & gas), could lead potential GDP to increase 0.5% in the longer term.
Asset-sale program could reduce public debt and increase private investments. The Brazilian government Chart 2: Table Macro and Micro Reform Potential
has created a Special Secretary of Divestment, led by José Salim Mattar (formerly Localiza’s Chairman),
focused on selling non-core assets. According to Mr. Salim Mattar, there are nearly BRL 1 trillion worth of Potential GDP¹ Microeconomic reforms
assets (state-owned companies, concessions and real estate assets) that could be sold in order to reduce Macroeconomic adjustments Without reforms With reforms
the Government’s high public debt, which is currently BRL 3.8 trillion (net debt).
Domestic savings 15% 1.5% 2.0%
Our Macro team estimates GDP growth at 1.3% in 2019 and 2.5% in 2020. Itaú estimates a gradual and (% of GDP) 20% 3.0% 3.5%
cyclical recovery in GDP growth, mainly in 2020. The sustainability of higher GDP-growth levels will depend ¹ Rounding numbers
mostly on the government’s fiscal commitment, but could be also helped by the development of positive
microeconomic reforms and asset-sale programs that lead to higher productivity.
Source:: IBGE, Itaú BBA
15Stronger GDP Growth Ahead
Potential to Increase Productivity Through Micro Reforms Chart 1: Time Companies Spend Doing Taxes (in Hours)
1958
1058
Tax reform, concessions, privatizations and sector reforms could boost Brazil’s productivity. We
believe that pension reform will be the government’s priority, given the critical fiscal condition of
public accounts. However, other efforts related to micro reforms are complementary, and would
stimulate growth. Assuming that these efforts are fruitful, we could expect stronger GDP growth 311 296
275 260 255
streaming from an increased investment/GDP ratio. 240
218 210
175 168
Tax reform could simplify companies’ structures. Brazil is one of the countries where companies spend 142 129
105
the most time to comply with tax obligations (see chart 1). As a case in point, Gerdau needs more than
100 employees to fulfill Brazil’s tax requirements, while in their U.S. operation (which is nearly the same
size as the operation in Brazil), fewer than 10 employees perform a similar task. That said, simplifying
the tax system in Brazil could improve corporate agility.
Infrastructure remains a significant bottleneck. Brazilian corporates often blame poor logistics and
infrastructure as reasons for their low competitiveness (see chart 2). In our opinion, the successful Chart 2: Infrastructure Rank (Position)
deployment of a comprehensive concession program could improve companies’ efficiencies in the
longer term, reducing the infrastructure bottleneck. On page 17, we list all the concessions in various #5 #7 #9 #11
#29 #41 #49
sectors (airports, ports, railroads, roads and energy), which could lead to BRL 100 billion in investments. #51 #63 #64 #68
#81 #83 #85
Of note, the government has successfully auctioned 12 airports and 10 port terminals in the past few
months, raising nearly BRL 3 billion in concession fees.
Source: Itaú BBA, World Bank
16Stronger GDP Growth Ahead
Concessions Could Lead to More Than BRL 100 Billion in Investments
Airports Ports Railroads Tollroads Energy
Done Done Done To Do To Do (2019)
12 airports auctioned in 3 4 Ports: 3 in Cabedelo/PB and Ferrovia Norte-Sul (FNS) BR-364/365/GO/MG Transmission Auction
blocks: 1 in Vitória/ES Jataí/GO – Uberlândia (437 Km) 15 blocks
Liquid Bulk Terminal Auctioned on 3/28/19 2nd Half
Northeast:
1st Half
Recife/PE: João Pessoa and Auctioned on 3/22/19 Investments: BRL 2.8 billion
Campina Grande/PB; Maceió/AL; Energy Generation Auction
Aracaju/SE; and Juazeiro do BR-101/SC (211 Km) A-4 e A-6
Norte/CE 6 Ports: 5 in Belém/PA and 1 in Jun 2019 and Sep 2019
Vila do Conde/PA To Do
Dec 2019
Center-West: Liquid Bulk Terminal 4 projects: Energy Generation Auction in
Todos no MT: Várzea Grande
(Cuiabá) Alta Floresta, Barra do Auctioned on 4/05/19 EF-354 Concession Roraima
Garças, Rondonópolis and Sinop Tramo Norte do Ferroanel de São May 2019
Investments: BRL 632 million Paulo Concession Projects in Study:
Southeast: EF-170 (Ferrogrão) BR-364/RO/MT Investments: BRL 14.8 billion
Vitória/ES and Macaé/RJ EF-334
To Do SP-225 (Centrovias)
Auctioned on 3/15/19 BR-116/RJ/SP (Dutra)
Investments: BRL 21.7 billion
7 projects: BR-153/282/470/SC To Do (after 2020)
Investments: BRL 3.5 billion 3 in Paraná (Paranaguá), 2 in BR-364/GO/TO
Pernambuco (Suape), 1 in São BR-040/MG/RJ Transmission Auction
To Do Paulo (Santos) and 1 in Amapá BR-116/RJ Jun and Dec 2020, Jun and Dec 2021
(Cavaco)
6th and 7th rounds: Investments: BRL 50.0 billion Energy Generation Auction
Curitiba, Goiânia, Congonhas and Investments: BRL 2.5 billion
Santos Dumont Apr and Sep 2020, Apr and Sep 2021
Source: Economy and Infrastructure Ministries
17Stronger GDP Growth Ahead
Mind the Pressure – Potential
Overhang on Sale of Company Stakes Table 1: BNDES, BB and Caixa Stakes in Listed Companies (December 2018)
Listed assets could be a quick source of cash for the
Stake Market
government. BNDES, Banco do Brasil and Caixa have, Company Ticker Owner Stake (%) ADTV (BRL mln) Days of Trading
Value (BRL mln)
together, stakes in 44 listed companies totaling BRL 135
billion. PETROBRAS PETR4 BNDES 57,577.0 15.0% 1,862.85 31
VALE VALE3 BNDES 17,088.8 6.4% 1,169.02 15
BNDES is the main holder of equity stakes. Thirty-eight of JBS JBSS3 BNDES 11,918.2 21.3% 120.15 99
the 44 stakes belong to BNDES. They also participate on ELETROBRAS ELET6 BNDES 8,539.9 18.7% 94.60 90
the board of 17 invested companies, making them one of BB SEGURIDADE* BBSE3 BB 7,988.4 14.0% 127.72 63
Brazil’s largest investment firms. CIELO CIEL3 BB 6,247.9 29.0% 162.24 39
CEG CEGR3 BNDES 4,306.8 34.6% n.m n.m
Concentration is high. The top 10 stakes, by market value, SUZANO SUZB3 BNDES 4,011.8 6.8% 245.83 16
amount to BRL 123 billion (~90% of total portfolio). IRB IRBR3 BB 3,057.6 10.0% 102.83 30
Government entities’ share in the invested companies is COPEL CPLE6 BNDES 2,473.7 24.0% 34.19 72
also usually high; they own more than 10% of eight out of B PATAGONIA BPAT33 BB 1,682.9 80.0% n.m n.m
the top 10 companies. MARFRIG MRFG3 BNDES 1,561.9 33.7% 22.68 69
CEMIG CMIG4 BNDES 1,242.8 5.5% 169.40 7
Mind the pressure. The potential sale of large equity stakes
AES TIETE TIET11 BNDES 1,225.1 28.3% 15.37 80
could represent a short-term overhang for some BANCO PAN BPAN4 CEF 1,205.7 33.0% 2.21 546
companies. The largest 10 positions owned by government KLABIN KLBN11 BNDES 1,036.6 5.2% 77.44 13
entities represent, on average, 46 days of trade (excluding EMBRAER EMBR3 BNDES 762.2 5.4% 71.41 11
outliers). We acknowledge that these asset sales will be TUPY TUPY3 BNDES 705.2 28.2% 12.44 57
planned in an organized manner (secondary offers and Others 3,134.9
block trades), thus reducing the potential pressure on the
TOTAL 135,767
stocks.
*We consider Banco do Brasil would only sell up to 14% of their total ~66% stake on the company
Source: Itaú BBA, BNDES, Banco do Brasil, Caixa Economica Federal
18Stronger GDP Growth Ahead
Investment Risk Reduction Could Chart 1: 4G Is Still in Only 57% of Mobiles Chart 2: Penetration of Basic Services in Brazil (%, as of 2016)
Yield Great Benefits 43.2%
56.6%
PLC 79 could lead to investments in 4G. For Telecom, the 24.6%
approval of PLC 79 would set the framework for fixed-voice 0.0% 0.5% 2.4%
9.9% 99.9% 98.7%
93.9%
concession operations to sell real estate assets and reduce
obligatory capex, thus opening room to increase 262 271 281
258 244 236 229
investment in broadband projects. As a reference, 4G
penetration in Brazil is still low at 57% (see chart 1), even 130 51.9%
102
seven years after its initial deployment. As a comparison, 60
India’s 4G penetration is 98%.
25
0 1 7
PM 868 could reduce political risk and potentially increase 2012 2013 2014 2015 2016 2017 2018
investments in Sanitation. This sector is underpenetrated, 4G lines (millions)
4G as % of mobile lines
Total lines (millions)
Energy Solid Waste Water Sewage
with ~90% of the population having access to potable Chart 3: % of Warranty Amount Received on Credit Default Chart 4: Years Until Credit Recovery
water and ~50% to sewage collection. World Bank
estimates that every BRL 1 invested in sanitation is 88.6 4.5
84.5 84.4 82.4 4.3
translated into BRL 5 savings in public health care expenses. 78.6 4
The approval of PM 868 would be very good news for the 69.4 69.1
Sanitation companies that could be privatized, such as 3.2
Copasa and Sabesp.
2 2
High legal risks inflate funding costs. In regard to judicial 38.6
35.1 33.5 1.8 1.7
1.5 1.5
recovery, Brazil is badly positioned as: i) only 16% of 26 1.2
18.5 15.8 1 1
collateral is recovered (by amount); and ii) warranties take
four years to be collected. In our view, reducing the legal
risk by enforcing the current judicial recovery law could
improve those metrics and eventually lead to a decline in
funding costs and spreads
Source: Itaú BBA, Febraban, Anatel, ANA
19Stronger GDP Growth Ahead
Impact of Stronger Growth on the Ibovespa
Chart 1: Ibovespa Is Not a True Reflection of GDP in Brazil
Stronger growth will lead to improved earnings (higher revenues and operating 100%
leverage). We expect some companies to benefit from: i) improved demand
following stronger investments and growth; ii) operating leverage as fixed costs are 80% 33%
diluted when demand picks up; and iii) longer-term productivity gains due to
69%
increasing infrastructure investments and reduced bureaucracy. 60%
35%
Domestic companies to benefit the most from stronger growth. In our view, sectors 40%
such as Steel, Real Estate and Industrials, which are currently suffering from weak
8%
domestic demand and low capacity-utilization rates, could benefit the most from a 20%
32%
cyclical, but gradual recovery. 23%
0%
Some cautions on investing: Ibovespa will not reflect GDP growth entirely. In Chart 1, Ibovespa GDP
we highlight that the Ibovespa is heavily weighted toward commodities and the
financial sectors. As a result, the weight of domestic-related sectors on Ibovespa is Commodities Financials Domestics
only 34%, well below the domestic sectors’ exposure in Brazil’s GDP, according to Chart 2: More Than 20% of Ibovespa Earnings Do Not Depend on Brazil’s GDP
IBGE. In our view, this also shows that there is plenty of room for new companies
(mainly those exposed to domestic sectors) to be listed on the Ibovespa.
Ibovespa's Earnings Exports
Nearly 20% of the Ibovespa does not depend on Brazil’s GDP. In Chart 2, we note that Sectors (%) Exporting
Earnings Share Dependency
nearly 20% of the Ibovespa’s earnings are generated abroad, mainly through Mining 17% 90% 15%
commodity exports. In the case of the Mining and Pulp sectors, Chinese economic
Oil 17% 7% 1%
growth is far more relevant than Brazil’s GDP growth to determining these sectors’
Pulp & Paper 3% 80% 2%
earnings. For meat packers, the main regions that influence demand and earnings
Meat Packers 2% 80% 2%
are China, Southeast Asia and the Middle East.
Total 40% 53% 21%
Source: Bloomberg , Itaú BBA, IBGE
20Section 3 The Great Rotation to Equities
The Great Rotation to Equities
Chart 1: Ibovespa x DI Rate Actual Return Chart 2: Earnings Yield (Forward) Over DI (1 year) Bond Yield
Great Times Are Coming To 169% 1.60
Better to Buy Stocks
Equities 140% 1.40
Stocks have not been a good bet in the past 10 years… 1.20
Fixed income (SELIC) linked returns outperformed
equities (Ibovespa) over the past years. Adjusting for the 1.00
risk profile and volatility of those investment
0.80
alternatives, there were limited lapses of time when
investing in equity was rewarding. But, this time could be 0.60
different. We believe the conditions are in place for a
2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 Better to Buy Bonds
positive equity run: 0.40
IBOV DI 2007 2009 2011 2013 2015 2017 2019
i) Earnings yield is beating bond yields (Chart 2). From
2007 to 2017, bonds yield usually were higher than Chart 3: Share of Stocks in Brazilian Funds Portfolio (%) Chart 4: GEM and Global Funds Allocation in Brazil (%)
earnings yield. However, earnings yield have been 2.5% 18.0%
25%
stronger than bond yields in the past 2 years. 16.0%
ii) Lower rates will force Brazilian investors to search for 20% 2.0% 14.0%
higher yields. We would expect allocations to equities 12.0%
(amongst all funds managed) to continue increasing. 15% 1.5%
10.0%
Allocations to equities have increased timidly recently,
8.0%
but are still well below historical levels. 10% 1.0%
6.0%
iii) Foreign investors are still on a wait and see mode. GEM 4.0%
5% 0.5%
and Global funds’ allocation in Brazilian equities are Global Alloc. % in Brazil (rhs) 2.0%
below peak and last 10 year average. In our view, GEM Alloc. % in Brazil (rhs)
0% 0.0% 0.0%
foreign investors are waiting for clearer signs on the
2006 2008 2010 2012 2014 2016 2018 2007 2009 2011 2013 2015 2017 2019
pension reform to increase positions in Brazilian assets.
Source: Itaú BBA, Bloomberg, Anbima, EPFR
22The Great Rotation to Equities
Chart 1: Private Credit Funds AUM (BRL Billion) Chart 2: Infrastructure Funds AUM (BRL Billion)
Alternative Investments Gaining
113 10.0
Traction: Invest Responsibly 103
8.0
Yield searching is driving demand for alternative 89
products. Besides investing in equities, investors (mainly 6.0
individuals) are looking for other alternatives to increase 63
4.0
their returns. In this section, we discuss the main features
of: private credit funds, infrastructure funds and real 2.0
estate funds (REITs).
0.0
Private credit funds traditionally produce higher yields.
Jan-16
Jan-19
Oct-16
Oct-17
Jan-17
Jan-18
Oct-18
Apr-16
Apr-17
Jul-16
Jul-17
Apr-18
Jul-18
However, a strong demand for this product has led credit
spreads to low levels. We note that before investing in
2016 2017 2018 Jan-Mar 2019 Fixed Income FIDC
private credit funds, it is instrumental to analyze the
Chart 3: Number of REIT Investors in Brazil Chart 4: REITs Average Daily Trading Volume (BRL Million)
quality of issuers’ balance sheet and comprehend the
risks associated with those investments, including the 300.000
67
impact of a default on the principal amount invested. 252.768
250.000
Infrastructure funds: tax exemption is their main
highlight. These funds invest in infrastructure bonds 46
200.000
which have a minimum of 4 years of maturity at launch
and pay a premium over a floating rate (usually IPCA or 150.000 29
23 23
DI), thus mimicking the government’s inflation linked 21
bonds (NTN-B), but with higher risk. 100.000
REITs is the best way to get Real Estate sector exposure. 50.000
Real estate funds offer liquidity, decent dividend yields,
diversification and the option to invest in real estate - 2014 2015 2016 2017 2018 2019
spending low tickets. 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
Source: Itaú BBA, Bloomberg, Anbima, B3
23The Great Rotation to Equities
Views from Itaú BBA:
Chart 1: Pension Fund Investments in Stocks – 2017 (%)
Pension Funds allocation to equities remain very limited. According to industry data,
equity investments currently represent less than 20% of Pension Funds assets. 41%
However, if we strip Previ’s * position, pension allocation to equities (ex-Previ) drops to 35%
nearly 5% of assets under management, showing the limited willingness from pension
fund managers to run equity risk in the short-term. On the other hand, funds with
19%
deficit are also taking a conservative investment approach as they do not want to run 17%
13% 13%
the risk of further deterioration of their deficit, and eventually ask for further sponsors’ 11%
Cesar Ming 7% 6%
contributions.
Head of Financials
and Institutional Pension Funds will have to seek alpha in case interest rates continue to decline. Cesar
Investors, Ming brought some interesting insights about some measures Pension Funds are
Corporate Banking Brazil Brazil
at Itaú BBA considering to implement in a low interest rate environment. Funds are discussing Ex Previ
diversification into other asset classes and strengthening their teams with professionals
Chart 2: Brazil Pension Funds Allocation to Equities (%)
coming from the asset management industry. Assuming a scenario of lower interest
rates for longer, Pension Funds’ equities allocation should start to increase gradually.
45%
Positive signs of pension reform approval could be a trigger for increased equity positioning. Most pension funds Equities % t = 0.10 + 0.61* (Equities % t-1) + 0.97*
are still on the sidelines waiting for a clear sign of pension reform approval, which could be the catalyst for a 40%
(Two-year GDPt) + 0.75* (GDPt) – 0.00074* (5-year
CDS/100)
structural decline in real interest rates. In that scenario, some pension funds that operate with surplus could
35%
consider to reduce their actuarial target levels, currently around IPCA +5%.
30.0%
Pension funds are starting to look at different investment alternatives. As the outlook for lower interest rates 30%
materializes, pension funds are also considering to increase allocations in local corporate bonds (credit) and in 25%
hedge funds. Some funds are testing the waters on foreign investments (usually hedging currency risk) and on
Structured Operations Certificate – COE (mostly involving equity risk exposure). 20% Model
18.9%
Equities + Equity Funds
15%
Dec-97 Dec-00 Dec-03 Dec-06 Dec-09 Dec-12 Dec-15 Dec-18
Source: Itaú BBA, Economatica, Anbima, OECD , Abrappm, BCB, Bloomberg * Previ is Banco do Brasil’s pension fund and currently has more than 50% of assets allocated in equities, which includes relevant stakes in companies like Vale, Petrobras and JBS
24The Great Rotation to Equities
Views from Itaú BBA:
Chart 1: Household Financial Assets Wealth Distribution (%)
Strong potential to increase equity exposure in the private industry. According to 1%
Anbima, the percentage of equity exposure on private portfolios is around 20%
currently. However, if we were to exclude private investors’ controlling stakes in 11%
listed companies, their active equity allocation would likely drop to lower levels.
Assuming a scenario of low and declining interest rates, Luiz Severiano sees a great 43%
21%
potential for private investors to increase equity exposure. As an anecdote, there
Luiz Severiano are still many private investors with zero equity exposure.
Head of Private Recent strategy to increase equity allocation is still timid. Itaú’s private clients
Banking at Itaú BBA exposure to equities have grown only modestly in the past six months, likely 24%
evolving in line with the industry trend. According to Anbima, the stake of equity in
private portfolios have increased to 21.0% in February 2019 from 19.6% in
December 2018. Funds Fixed Income Equities Pension Plans Others
Chart 2: Ibovespa by Participant Share (%)
Private investors are still positioned on long-term inflation indexed bonds. Private investors are still well positioned
on longer maturities inflation indexed bonds (NTN-Bs 2050 and beyond).given their: i) great return (CPI + 5%) until 100%
Others 1%
December 2018; ii) low risk (Government bond) and iii) hedge option – if the economic outlook deteriorates, inflation 90%
80%
would likely go up accordingly. In most countries, inflation indexed funds trade at a discount to real rates, while in Institutional
70% Investor 30%
Brazil it is still trading at a premium (see explanation below).
60%
Financial
Declining real rates will be the main catalyst for increased equity allocation. Assuming the necessary reforms are 50% Institutions 5%
approved and fiscal discipline is restored, Luiz Severiano believes real interest rates could drop to unprecedented 40%
Foreign
low levels. Real rates measured by Selic rates minus inflation, which are currently at 2.6% could eventually reach 30% Investor 46%
lower levels, even testing 1% for a short-period of time. This scenario would likely be accompanied by a decline in 20%
Individuals 18%
inflation linked bond spreads (NTN-Bs), leading to a gradual rotation into equities and increased Ibovespa volumes. 10%
0%
2009 2011 2013 2015 2017 2019
Source: Itaú BBA, Economatica, Anbima, Bloomberg
25Section 4 Valuation and Allocation: Prefer Brazil Domestic Exposure
Valuation and Allocation: Prefer Brazil Domestic Exposure
Ibovespa Target at 117,000 points Chart 1: Ibovespa Target Sensitivity to Ke and EPS Growth Chart 2: Brazil Ke Assumptions
Our Ibovespa YE19 target is 117k (21% upside potential). According to our Brazil Ke Cost of Equity
sensitivity, for every 20 bps of lower cost of equity (Ke), our Ibovespa target 11.1% 11.3% 11.5% 11.7% 11.9% 12.1% 12.3%
(+) US 10 year Treasury Bill 3.0%
would increase by 5%. For every 5% increase in EPS growth, our target would 22% 121 115 109 104 99 95 91
(+) LT Inflation (Brazil) 3.8%
increase by 4%. Our Ke could decline if Brazil’s country risk continues to drop
2019 EPS Growth YoY
27% 126 120 114 108 103 99 95
(-) LT Inflation (US) 2.3%
(we use EMBI at 2.7%) or if the inflation differential also drops (currently at 32% 131 124 118 113 108 103 99
(+) Sovereign Risk, EMBI+ 2.7%
1.8%). 37% 136 129 123 117 112 107 102
(=) Risk Free, long term 7.2%
Earnings risk seems to be low at this point. According to Chart 3, the gap 42% 141 134 127 121 116 111 106
(+) Equity Risk Premium 4.5%
between actual and consensus estimates on earnings has narrowed recently, 47% 146 139 132 125 120 115 110 Ke: Cost of Equity 11.7%
reflecting a reduced risk of negative earnings surprises. 52% 151 143 136 130 124 119 114
Additionally, we believe that interest-rate expectations Chart 3: Ibovespa Earnings Expectations vs. Actual Chart 4: Ibovespa Expected ROE vs. P/BV
embedded in models are still high. According to the
Focus survey, Selic rates would end 2020 at 7.5%, while Area: Earnings Expectations
8000 20 2.2
our Macro team estimates Selic to reach 5.5% by YE20. In 7000 Black bar: Actual Ibovespa Earnings 18 2
our view, lower interest rates could be an important 16 1.8
6000 1.6
14
source of earnings growth in the coming months. 5000 1.4
12
1.2
ROE expansion could lead to a richer valuation. The 4000 10
1
8
Ibovespa has traded on average between 1-2x P/BV over 3000 0.8
6 0.6
the past 10 years. In periods of lower ROE (close to 9%), 2000 4 0.4
P/BV levels reached a bottom of 1x. For the coming 1000 2 0.2
years, we could see ROE further expanding with a more 0 0
0
2011
2016
2019
2009
2010
2012
2013
2014
2015
2017
2018
benign macro scenario, thus leading P/BV valuations to -1000
higher levels.
Jan-11
Jan-12
Jan-17
Jan-14
Jan-08
Jan-09
Jan-13
Jan-15
Jan-16
Jan-10
Jan-18
Expected ROE 12 M P/BV
Source: Itaú BBA, Bloomberg
27Valuation and Allocation: Prefer Brazil Domestic Exposure
Chart 1: Ibovespa P/E
P/E at 11.3x – Who is hot and who is not? 15.0x
Ibovespa is trading at 11.3x P/E, in line with the historical average, but with 14.0x 13.9x
strong earnings growth potential. For 2020, we estimate 10% earnings 13.0x
growth, which could be conservative if the pension reform is approved, the 12.0x
11.3x
economy picks up, and companies benefit from a low-interest-rate, high- 11.0x 11.3x
GDP-growth environment. 10.0x
Brazil’s low P/E is explained by its sector breakdown. Energy and Materials, 9.0x
8.7x
which make up most of commodities’ weight on the index, are the two 8.0x
sectors with the lowest P/E in Brazil (9.1x and 7.5x respectively) followed by 7.0x
2011
2011
2009
2009
2010
2010
2012
2012
2018
2018
2013
2013
2014
2014
2015
2015
2016
2016
2017
2017
2019
Financials (11.3x). Those three sectors have around 60% of the index weight,
explaining why Brazil has a persistently lower P/E than its peers in LatAm. IBOV P/E 10 Yrs Avg. +-SD2
Brazil sectors are still mostly cheap. Brazil is cheaper than its emerging- Chart 2: MSCI Brazil P/E Sector Analysis (EM Peers as Maximum and Minimum)
market peers in five out of the nine sectors presented in chart 2. Materials 40.0
and Health Care in Brazil are the most discounted among selected Brazil in Orange
35.0 EM Peers as Maximum and Minimum
countries. Telecom Services, Energy and Consumer Staples also seem to be 30.0
the most attractive on valuation when compared with peer countries. 25.0
Financials could be added to this mix, as they are trading in line with their 20.0
peers. 15.0
Industrials and Consumer Discretionary are trading at a premium to peers. 10.0 Brazil P/E
These two sectors are among the most expensive in Brazil, and valuations 5.0
are also relatively more expensive than its EM peers. As a result, we would 0.0
Cons. Stap.
Energy
Health Care
Industrials
Cons. Disc.
Financials
Utilities
Materials
Telecom
take extra caution when adding exposure to these sectors, as valuations
seem to be stretched already.
Source: Itaú BBA, Bloomberg, MSCI
28Valuation and Allocation: Prefer Brazil Domestic Exposure
The Brazil Buy List
Prefer domestic exposure. Our investment thesis continues to be: i) an upturn in the domestic
economic cycle; ii) improved efficiency at state-owned enterprises (SOEs); and iii) compelling Domestic
valuation. We are adding a fourth theme to our portfolio, which is deleveraging. Our allocation Ibovespa Greater SOE Economic Compelling Declining
Segments Efficiency Cycle Valuation Leverage
suggests that we are overweight domestic names (60%); underweight commodities (20%) and Ibovespa Buy List Upturn
underweight Financials (20%). This allocation is more aligned with GDP composition as we discussed Weights Allocation
earlier.
Short-term volatility is likely: Prefer quality and liquidity. In our view, the market will continue to be
driven mostly by the political news flow in Brazil in the short term, assuming a fairly stable global
Domestic Cyrela
environment (flattish Fed funds rate until YE19). In that scenario, we would favor quality names among Kroton
33% Ex- Copasa Azul
TIM
our preferred sectors and focus on liquid stocks. As investors gain confidence in the pension-reform Financials Multiplan
approval, they could add risk to their portfolios, then the deleveraging theme could gain momentum.
Theme #1 – Domestic economic cycle. Although economic activity has been weak in 1H19, we continue 60%
to believe that pension reform could be a propeller for growth, and we would like be exposed to
Homebuilders (through Cyrela), Malls (Multiplan), and Airlines (Azul).
Theme #2 – More-efficient SOEs. The government continues to voice its intention to foster increased Financials
Banco do
Bradesco
efficiency at SOEs, as reinforced by the administration’s top officials. At the federal level, we like Banco 35% Brasil
do Brasil; at the state level, we like Copasa (Minas Gerais), which also is likely to gain from an eventual
approval of a new regulatory framework for the Sanitation sector (MP 868).
Theme #3 – Compelling valuation. Here our preferred sector is Education (through Kroton) and 20%
Telecom (TIM). These sectors have underperformed the Ibovespa in 2018 and would benefit from
stronger job expansion, which is likely ahead. We also like Petrobras’ valuation, as the company is
expected to benefit from increasing FCF following production growth and increasing net margin. Commo-
32% Petrobras JBS
dities
Theme #4 – Deleveraging. We expect highly leveraged companies to benefit because lower interest 20%
rates and stronger growth could lead to improved earnings. JBS is in a sweet spot, as it could benefit
from improving operating dynamics (higher margins on increased protein prices) and better financial
results (lower financial expenses due to reduced debt levels and improved liability management).
Source: Itaú BBA
29Valuation and Allocation: Prefer Brazil Domestic Exposure
Deleveraging Could be the Next Hot Topic
Chart 1: % of Debt in Foreign Currency x Equity as % of Enterprise Value
Highly leveraged companies could benefit from a better
scenario in Brazil. We believe that companies that offer both TUPY3
100%
financial and operating leverage could be the main beneficiaries
of a cyclical recovery in Brazil, supported by stronger GDP BRKM3
growth (2-3%/year) and lower interest rates.
PETR4
Debt-to-equity transfer could be powerful. In our view, 80%
companies that are currently considered distressed (equity GGBR4
MYPK3
representing a small percentage of enterprise value) could be
Foreign Currency (% of Total)
CSAN3
positively affected by the combination of improved operating KLBN11
results and stronger FCF that will help the companies to 60% CSNA3
deleverage. BRFS3
SBSP3
RAIL3
Liability management could lead to significant earnings growth.
First, highly leveraged companies are the ones to benefit the CMIG4
40% UGPA3 POMO4
most from a lower-interest-rate environment. Second, domestic JBSS3
NATU3
ENGI4
companies that were pushed to issue long-term debt in U.S.
SMTO3
dollars are now able to issue local-debt bonds at attractive rates, CPFE3 CAML3
resulting meaningful savings in financial expenses. 20%
EQTL3 RAPT4 USIM5
Investors could also search for operating leverage. In our view, ALUP11
CSMG3 AALR3
some sectors such as Steels, Industrials and Real Estate (to a ELET6 CCRO3 LCAM3
ENEV3
lesser extent), which are currently suffering from weak domestic OMGE3 ELPL3 VLID3 TAEE11
MRVE3 KROT3
0% ECOR3 EVEN3
demand and low capacity-utilization rates, could also be viewed CPLE6 AMAR3
40% 45% 50% 55% 60% CPRE3 65% ENBR3 70% 75% SAPR11 80%
as attractive sectors in a cyclical and gradual recovery.
Equity to EV
Source: Itaú BBA, Economatica
30Valuation and Allocation: Prefer Brazil Domestic Exposure
Chart 1: Vale, Suzano and Ibovespa Performance Since June
30%
Risk Factors – In Case You Want to Hedge 20%
25%
Our base case is centered around a constructive scenario for Brazil with the approval of the pension reform 10%
and limited headwinds coming from the external environment.
0%
However, we note that our call is subject to internal and external risks that can affect equities’ valuation in -4%
Brazil. Please find below a list of what we consider the most significant risks that could negatively impact -4%
-10%
cost of equity and earnings growth:
-20%
External risks: a quicker-than-expected return to a hawkish stance from the Fed, further deterioration in
global economic growth (Brexit, other crisis), and an escalation of trade war, impacting Chinese growth. -30%
These events would likely lead to an increase in cost of equity through a higher 10-year Treasury bond and Jun-18 Aug-18 Oct-18 Dec-18 Feb-19 Apr-19
increased country risk. VALE3 SUZB3 Ibovespa
Possible internal news flow: Negative news flow on the pension reform or truckers’ strike, which would Chart 2: VIX Over Last Five Years
further pressure GDP and earnings growth in the short term, and limited advances on the micro-reform 35
agenda through tax reform, privatization, concessions and sectorial reforms (Telecom and Water Utilities),
30
which are important to reduce the governments’ debt and encourage new investments.
25
Vale and Suzano are good hedges, as both have very limited correlation with the Ibovespa. Vale has a beta
of 0.69 and Suzano, 0.33. 20
15
Our Commodities team prefers Vale due to: i) better commodity price outlook (more for iron ore than pulp)
and valuation (Vale is trading well below historical average at 4.2x EV/EBITDA 19E, negatively impacted by 10
the Brumadinho accident). 5
0
Aug-15
Aug-17
Aug-16
Aug-14
Aug-18
Dec-14
Dec-15
Dec-18
Dec-17
Dec-16
Apr-17
Apr-16
Apr-19
Apr-14
Apr-15
Apr-18
Source: Itaú BBA, Bloomberg
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