Brazil one year after the elections

Dear investors,

In October of last year, we wrote our vision on how the Lula government would act in the new termThe excerpt below reflects our expectations at the time:

“(…) O maior risco é que Lula acabe com o teto de gastos e volte às políticas de intervenções econômicas, conforme defendeu durante sua campanha, mas acreditamos que a configuração do novo Congresso Nacional e as alianças criadas para ganhar as eleições sejam freios relevantes para políticas nesta direção. Se não impedí-las completamente, deveriam ao menos postergá-las e torná-las mais amenas.

In fact, with a center-right National Congress and a left-wing president, negotiations tend to be slower and more contentious, hindering the Executive's actions in general. Therefore, it's expected that Lula will adopt a more centrist stance.

The prediction has proven reasonably accurate so far, and stems from a broader view we have of the Brazilian political environment: our legislative structure is so complex and our party bases so fragmented that it is difficult to bring about significant transformations in the country in just a few years, for better or for worse. (We explain this point further in September 2022 letter).

Even so, public debates remain heated, divided between opposing narratives. On one side, there are those who believe the country will be saved by more intense government action on social programs, and on the other, there are those who believe we will collapse due to fiscal irresponsibility and poor public management. Our view is more bleak: we believe it is more likely that the country will continue following its historical average, certainly mediocre, but far from catastrophic.

Despite this unexciting outlook, we must remember that achieving good returns from investing in the stock market depends more on asymmetries between the price and the real value of shares than on a vibrant economic environment. Our average historical return has been around 30% per year over the past 10 years, although this was a period in which the Brazilian economy was not as successful.

So, let's look at our impressions of the first quarters of Lula's government and our perspectives for the coming years.

Fiscal responsibility on a knife edge

Even before the new government took office, turbulence arose surrounding statements about ending the spending cap and increasing public investment and spending, without providing details on the sources of funding to implement such plans. Combined with the ideology of leftist governments to strive for a larger and more active state, these statements sparked significant concern in the financial market that this course of action would generate fiscal deficits in an already indebted country, potentially leading the Brazilian economy into a vicious cycle of rising inflation, interest rates, and public debt. As a result, the first months following the election results were marked by widespread pessimism.

In August of that year, the spending cap was effectively eliminated and replaced by the new fiscal framework. While the spending cap rule stipulated that public spending could not grow in real terms (the budget would be adjusted only for inflation), the new framework adopted the logic that, if the country's economy is growing, public spending simply needs to increase at a slower pace for the government to achieve positive results and be able to reduce its debt over time. Thus, the rule was implemented that real expenditure growth will be equivalent to 70% of the real growth in government primary revenue. However, a range with predefined limits was established for maximum (2.5% per year) and minimum (0.6% per year) expenditure growth. This implies that, even in a year of economic stagnation, government spending would still grow, thus exacerbating the fiscal deficit challenge. In other words, the success of this new system is contingent on the growth of the Brazilian economy.

Despite this structural flaw, the framework performed better than much of the market expected, accompanied by targets for generating a positive fiscal result in the coming years. The government has reinforced its commitment to these targets, and the Minister of Economy has gained some credibility in the market for his efforts to promote greater fiscal responsibility. As a result, the general mood has shifted from pessimistic to skeptical. Although the risk of a fiscal deficit remains, the likelihood of a scenario of uncontrolled spending by a government that neglects the issue now seems more remote.

However, the problem is quite complex. It's not just a matter of determining whether the fiscal result will be a deficit or a surplus, but also how these results will be achieved. The most obvious approach would be to reduce government spending until it matches revenue collection capacity, but austerity is always an unpopular course of action and is unlikely to be adopted by a government that, in addition to having the opposite political inclination, needs to garner more popular support and political allies to achieve greater governability. Thus, the strategy being pursued is to seek additional revenue for the state by every means available to the Executive Branch, pushing the limits of what is technically plausible. In this context, tension surrounding fiscal responsibility is expected to persist throughout Lula's administration.

Dispute against BACEN

Within the context of the fiscal surplus target and the framework that requires economic growth to remain functional, the Lula administration launched several criticisms of the Central Bank and its president, Roberto Campos Neto, attributing Brazil's economic difficulties to the high interest rate policy. The logic behind this criticism is quite clear: high interest rates hinder economic growth and increase government spending on the public debt. Therefore, reducing interest rates would be the easiest way to help the Brazilian economy. However, this solution, like many other simplistic solutions, fails to consider other factors intertwined with the problem and the potential unintended consequences that may arise from the same action.

The Central Bank of Brazil (BACEN) raised interest rates to combat the inflation that emerged after the pandemic and, similar to a doctor prescribing continued antibiotic use even after symptoms have disappeared, decided to maintain the high interest rate level for longer for fear that an early reduction would trigger inflation. Since monetary policy is not a deterministic science, much debate arose surrounding the need to maintain high interest rates for so long. The government exerted political pressure on the Central Bank (BACEN) for months, even questioning the merits of maintaining its independence from the Executive Branch, but found no legislative backing to impose its will on the BACEN. Thus, the monetary tightening plan was maintained until August, when the first interest rate cut and the intention to implement progressive and linear cuts were announced, conditional on the government maintaining its commitment to fiscal responsibility.

Despite the turmoil surrounding this issue and the perception that the current government's commitment to fiscal responsibility may be more a result of a lack of alternatives than a deeply held conviction, this clash clearly highlights how, these days, no Brazilian president has the power to implement their decisions without broad support from political allies. Therefore, several concerns that circulated in the newspapers throughout the first quarters of the year have not materialized. We are likely to face a long period of political upheaval, and, as long-term investors should, we will remain skeptical about the implementation of extreme government measures.

Expansion of intervention in state-owned companies

The Executive Branch is not so restricted in all its areas of activity. In some areas, its decisions are made without relying on other agencies, and in these cases, we see a greater risk of unmoderated actions. This is the case with interventions in state-owned companies or companies in which the government holds a significant stake, directly or indirectly. In these situations, the government votes as a shareholder, selects executives, and decides on the adoption of specific plans.

New executives and board members have already been appointed to Petrobras, Caixa Econômica Federal, Previ, Banco do Brasil, and several other lesser-known entities that haven't received as much media attention. Several of these appointments were clearly political, involving individuals with professional backgrounds largely disconnected from the responsibilities of the positions they held. This topic always brings up political opinions, but what matters to us is interpreting the practical impact of these actions.

Executives and board members are generally chosen based on the expectation of their positive contributions to the company's business. The practice of choosing people with industry experience is based on the premise that past success in a given field is a much better predictor of future success in the same field than other possible criteria. Thus, we interpret that the government's primary objective, in choosing people with professional backgrounds completely different from what will be required for the position, is certainly not to seek the best interests of the company. Two alternatives remain: those elected were chosen for their loyalty to their appointees, to take measures in the government's interest that may be distinct from the interests of other shareholders; or the position was granted as a bargaining chip for some political contribution in another field. Both hypotheses are detrimental to anyone who is a government partner in these companies.

Given this history, both of recent interventions and those made during previous left-wing governments, we will continue to demand a higher level of return for investing in companies under state influence, as the impacts of these interventions are very difficult to predict and, therefore, require an additional margin of safety.

The Brazilian stock market and the global scenario

The issue of state intervention is more specific to Brazil, but fiscal responsibility issues and disputes with central banks due to monetary tightening policies affect several countries today. The root of the problem was the way global governments decided to act during the pandemic: health measures severely affected productivity, governments distributed newly printed money to the population to sustain themselves during the pandemic, inflation arose as a side effect of these two factors, and, consequently, several central banks raised interest rates to combat inflation, causing a global economic slowdown that continues to this day.

Relatively speaking, Brazil doesn't seem to be in a bad state. We started raising interest rates about a year before developed countries and, as a result, we've already begun the cycle of interest rate cuts while these countries are still finishing their cycle of interest rate hikes. This means we're closer to resuming economic growth, which would make our country a good destination for international investment during the window of time when other countries haven't yet entered the economic recovery phase. However, in the very short term, the effect could be the opposite.

For now, our economy continues to face challenges because the start of the interest rate cut cycle is still very recent and has not yet impacted corporate results. Furthermore, fixed-income investments in developed countries are becoming more attractive due to rising interest rates there. Consequently, we have observed a reallocation of part of the capital that was invested in the Brazilian market to overseas markets. This capital outflow from the stock market has resulted in falling prices and has kept a considerable portion of investors with a pessimistic outlook. However, we have a different view.

Price vs. Intrinsic Value

Capital movements caused by the attractiveness of, for example, US government bonds tend not to produce such lasting effects, as interest rates will remain at this atypically high level only temporarily. Furthermore, interest rate fluctuations in international markets are not a predominant factor in earnings estimates for most Brazilian companies. Thus, we have a situation in which the share prices of several companies have been moving due to temporary shifts between asset classes, out of step with the variation in the intrinsic value of listed companies, determined by their long-term cash generation.

It's worth remembering that calculating intrinsic value depends on several subjective assumptions adopted by each investor, so there's a wide range of opinions regarding the most appropriate intrinsic value for each company. In theory, price represents the balance between the intrinsic value views of the entire market, formed by countless competent analysts, but this broad and abstract concept proves flawed upon closer inspection. An example will help understand this point.

Imagine that a large institutional investor with R$500 billion under management decides to invest 2% of its total portfolio (R$10 billion) in Brazil. Since the investment represents a very small portion of its total assets, this investor decides not to conduct in-depth analysis of Brazilian companies directly and chooses a Brazilian manager to allocate this capital to companies listed on the B3 exchange. Later, this investor decides to reduce its exposure to Brazil to 1% and redeems R$5 billion from the Brazilian fund in which it had invested. Thus, the manager is forced to sell R$5 billion in shares on the B3 exchange, regardless of its view on the intrinsic value and price of the shares in its portfolio, contributing to the price decline of the shares in question. Even if there are investors interested in buying these shares after the decline, they may not have sufficient capital to fully offset the effect of the capital outflow. In other words, smaller investors may have a deeper understanding of a company whose shares are being traded, and even if they believe the intrinsic value of the stock is significantly higher than the price after the decline, the decision of a large investor, who may not even know the name of that particular stock in his portfolio, will drive the equilibrium price down.

This example bears similarities to the reality of the Brazilian stock market, which is a less significant global equity market, with approximately half of its invested capital coming from foreign investors. For many of these investors, Brazil is not the focus of their analysis, and therefore, it is understandable that some decisions are made with less detail. The important thing is to recognize this configuration and avoid the assumption that stock prices reflect an omniscient assessment of each company's intrinsic value.

Investing is a slow activity

Asymmetries between value and price are the source of investment opportunities because, sooner or later, the price converges to something close to intrinsic value, guaranteeing good returns for those who purchased shares at low prices. However, it's important to understand that sooner or later, there's also the possibility of later. These asymmetries can persist for years. Therefore, it's important to be patient and understand that prices can take time to converge even with sound investment theories. In our July 2023 letter, we discussed some of our theories that took years to prove correct but ended up being quite profitable.

Another relevant point is that the existence of these asymmetries doesn't depend on a generally favorable economic scenario. On the contrary, they tend to appear precisely when the market mood is pessimistic. Therefore, the strategy of investing in equities when the scenario is good isn't necessarily the best one. Just as it's more advantageous to buy a car with a broken headlight at half price than to wait for the repair and pay the full amount, it's also wiser to invest in stocks at reduced prices during pessimistic periods than to wait for the scenario to improve, as stocks will become more expensive and the asymmetries between intrinsic value and market price may diminish or even disappear.

Finally, it's important to maintain a neutral outlook, regardless of the tone of the newspaper headlines. This is especially true because political turmoil, fragile public finances, and questionable government policies are commonplace in Brazil. During our stock market investing career, we've experienced few periods of optimism regarding the Brazilian economy, yet we've still had excellent returns.

We admit it can be tedious waiting for the situation to improve and for a new cycle of rising prices to begin, but we invest for returns, not entertainment.

“Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.” – Paul Samuelson