Dear investors,
In October last year, we wrote our vision on how the Lula government would act in the new term. The excerpt below shows our expectations at the time:
“(…) The biggest risk is that Lula will end the spending cap and return to economic intervention policies, as he defended during his campaign, but we believe that the configuration of the new National Congress and the alliances created to win the elections are relevant brakes for policies in this direction. If not prevent them completely, they should at least postpone them and make them milder.
In fact, with the center-right National Congress and the left-wing president, negotiations tend to be slower and more conflictive, making the Executive's actions in general more difficult. Therefore, it is to be expected that Lula will adopt a more center-oriented stance.”
The prediction has proven to be reasonably correct, so far, and derives from a broader opinion we have about the Brazilian political environment: our legislative structure is so complex and we have such fragmented party bases that it is difficult to carry out relevant transformations in the country in a few years, both for bad and for good. (we explain this point better in September 2022 letter).
Even so, public debates remain heated, divided between antagonistic narratives. On the one hand, there are those who believe that the country will be saved by more intense government action in social programs and, on the other hand, there are those who believe that we will collapse due to fiscal irresponsibility and poor public management. Our vision is more bland: we believe it is more likely that the country will continue following its historical average, certainly mediocre, but far from catastrophic.
Despite this unexciting prospect, we remember that obtaining good returns from investing in the stock market depends more on asymmetries between the price and the real value of shares than on an exuberant economic environment. Our average historical return has been around 30% per year over the last 10 years, although this was a period when the Brazilian economy was not as successful.
So, let's look at our impressions of the first quarters of Lula's government and prospects for the coming years.
Fiscal responsibility on a knife's edge
Even before the new government took office, turmoil had already arisen around statements about ending the spending cap and increasing investment and public spending, without details on the sources of resources to implement such plans. Added to the fact that it is part of the ideology of leftist governments to work for a larger and more active state, the statements provoked great concern in the financial market that this line of action would generate fiscal deficits in a country already in debt, which could lead to the Brazilian economy into a vicious cycle of rising inflation, interest rates and public debt. As a consequence, the first months after the election results were one of widespread pessimism.
In August of this year, the spending ceiling was, in fact, eliminated and replaced by the new fiscal framework. While the spending cap rule predicted that public spending could not grow in real terms (the budget would only be adjusted for inflation), the new framework adopted the logic that, if the country's economy is growing, it is enough for public spending to increase at a slower pace so that the government has positive results and is able to reduce its debt over time. Thus, the rule was implemented that the real growth in expenditure will be equivalent to 70% of the real growth in the government's primary revenue. However, a range was established with predefined limits for the maximum (2.5% per year) and minimum (0.6% per year) expansion of expenses. This implies that even in a year of economic stagnation, government spending would still grow, thus worsening the fiscal deficit challenge. In other words, the success of this new system is conditioned on the growth of the Brazilian economy.
Despite this structural flaw, the framework was better than much of the market expected and accompanied by targets for generating positive fiscal results in the coming years. The government has reinforced its commitment to these goals and the economy minister has gained some credibility in the market for his efforts towards greater fiscal responsibility. With this, the general mood changed from pessimistic to skeptical. Although the risk of a fiscal deficit is still present, 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 is not just about 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 capacity, but austerity is always an unpopular line 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 have greater governability. Thus, the strategy that has been pursued is to seek additional revenue for the State in every way within the reach of the Executive Branch, flirting with the limits of what is technically plausible to argue. In this context, tension around fiscal responsibility is expected to persist throughout the Lula government.
Dispute against BACEN
In the context of the fiscal surplus target and the framework that requires economic growth to remain functional, the Lula government 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 financial burden of public debt. Therefore, reducing interest rates would be the easiest way to help the Brazilian economy. However, this solution, like many other simplistic solutions, does not take into account other factors linked to the problem and the possible undesirable consequences that may arise from the same action.
BACEN increased interest rates to combat the inflation that emerged after the pandemic and, analogously to a doctor who prescribes that the use of antibiotics continue even after the symptoms disappear, it decided to maintain the high interest level for longer for fear of that an early reduction would cause inflation to return. As monetary policy is not a deterministic science, there was room for much discussion around the need to keep interest rates high for so long. The government put political pressure on BACEN for months, even questioning the merit of keeping it independent of the Executive Branch, but found no legislative support to impose its will on BACEN. In this way, the monetary tightening plan was maintained until August, when the first interest rate cut and the intention to carry out progressive and linear cuts were announced, conditioned on the government maintaining its commitment to fiscal responsibility.
Despite the agitation surrounding this issue and the perception that the current government's commitment to fiscal responsibility may be more the result of a lack of alternatives than of a deep conviction, this clash clearly highlights how, nowadays, no Brazilian president has the power to implement its decisions without broad support from political allies. Therefore, several concerns that circulated in newspapers throughout the first quarters of the year did not materialize. We are likely to experience a long period of political noise and, as long-term investors should do, we will remain skeptical about extreme government measures materializing.
Expansion of intervention in state-owned companies
The Executive Branch is not so restricted in all its areas of activity. In some areas, decisions are made without depending on other bodies, and in these cases, we see a greater risk of unmoderated actions. This is the case of interventions in state-owned companies or companies in which the government has a relevant stake, directly or indirectly. In these situations, the government votes as a shareholder, chooses executives and decides to adopt specific plans.
New executives and advisors have already been appointed to Petrobras, Caixa Econômica Federal, Previ, Banco do Brasil and several other lesser-known entities that have not received as much media attention. Several of these appointments were clearly political, involving people with professional backgrounds that were quite disconnected from the responsibilities of the positions they assumed. This topic always brings up each person's political opinions, but what matters to us is interpreting the practical effect of these actions.
Executives and directors are generally chosen based on expectations of their positive contributions to the company's business. The practice of choosing people with experience in the field is based on the premise that past success in a given area is a much better predictor of future success in the same area than other possible criteria. Therefore, we interpret that the government's main objective, when choosing people with a professional background completely different from what will be required in the position, is certainly not to seek the best for the company. There remain two alternatives: those elected were chosen for their loyalty to those who appointed them, to take measures in the government's interest that may be different from the interests of other shareholders; or the position was granted as a bargaining chip for some political contribution in another field. Both scenarios are bad for 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 to invest in companies under state influence, as the impacts of these interventions are very difficult to predict and, therefore, require a margin of additional security.
The Brazilian stock market and the global scenario
The issue of state interventions is more particular to Brazil, but problems of fiscal responsibility and disputes with central banks due to monetary tightening policies affect several countries today. The root of the problem was the way in which world governments decided to act in the context of the pandemic: health measures strongly affected productivity, governments distributed newly printed money to the population to support themselves during the pandemic, inflation came as a side effect of these two factors and Consequently, several central banks increased interest rates to combat inflation, causing a slowdown in the global economy that continues to this day.
In relative terms, Brazil does not seem to be in bad shape. We started raising interest rates about a year before developed countries and, as a consequence, we have already started the cycle of interest cuts while these countries are still finishing their cycle of raising interest rates. This means that we are closer to resuming economic growth, which would make our country a good destination for international investments in the window of time in which other countries have not yet entered the economic recovery phase. However, in the very short term the effect may be reversed.
For now, our economy continues to face challenges because the beginning of the interest rate cut cycle is still very recent and has not yet had an impact on companies' results. Additionally, fixed income investments in developed countries are becoming more attractive due to rising interest rates in these locations. Consequently, we have observed a reallocation of part of the capital that was invested in the Brazilian market abroad. This movement of capital outflow from the stock market resulted in a drop in 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, American government bonds, tend not to produce such lasting effects, as interest rates will only remain at this atypically high level temporarily. Furthermore, the variation in interest rates in international markets is not a predominant factor in earnings estimates for most Brazilian companies. Therefore, we have a situation in which the share price of several companies has moved 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 is worth remembering that the calculation of intrinsic value depends on several subjective assumptions that each investor adopts, so there is a wide range of opinions regarding which intrinsic value is most appropriate for each company. In theory, the price represents the point of balance between the views of intrinsic value of the entire market, made up of countless competent analysts, but this broad and abstract conception reveals itself to be imperfect when looking at things more closely. An example will help you understand this point.
Imagine that a large institutional investor has R$ 500 billion under management and decides to invest 2% of its total portfolio (R$ 10 billion) in Brazil. As the investment represents a very small portion of his total equity, this investor decides not to carry out in-depth analyzes of Brazilian companies directly and chooses a Brazilian manager to allocate this capital to B3 companies. Some time later, this investor decides to reduce his exposure to Brazil to 1% and redeems R$ 5 billion from the Brazilian fund in which he had invested. Therefore, the manager is obliged to sell R$ 5 billion worth of shares on B3, regardless of his view on the intrinsic value and price of the shares in his portfolio, and contributes to the fall in the price of the shares in question. Even if there are investors interested in buying these shares after the fall, they may not have enough capital to fully offset the effect of the capital outflow. In other words, it is possible that smaller investors have a deeper understanding of a company whose shares are being traded, and even if they believe that the intrinsic value of the shares is significantly greater than the price after the drop, an investor's decision to large caps, who may not even know the name of that specific stock in their portfolio, will drive the break-even price lower.
This example has similarities with the reality of the Brazilian stock market, which is a variable income market of lesser global importance, with around half of the capital invested 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 that we recognize this configuration and avoid the assumption that the market share price reflects an omniscient assessment of the intrinsic value of each company.
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 the intrinsic value and guarantees good returns for those who bought shares at low prices. However, it is necessary to understand that in “sooner or later” there is the possibility of “late”. These asymmetries can persist for years on end. Therefore, it is necessary to be patient and understand that prices may take time to converge even in correct investment theses. In our July 2023 letter, we told you about some of our theses that took years to prove correct, but ended up being quite profitable.
Another relevant point is that the existence of these asymmetries does not depend on a favorable general economic scenario. On the contrary, they tend to appear precisely when the market mood is pessimistic. So, the strategy of investing in variable income when the scenario is good is not necessarily the best. Just as it is more advantageous to buy a car with a broken headlight for half the price than to wait for the repair and pay the full price, it is also more sensible to invest in shares at reduced prices during periods of pessimism than to wait for the scenario to improve, as shares will become more expensive and asymmetries between intrinsic value and market price may decrease or even disappear.
Finally, it's important to keep your own humor as close to neutral as possible, no matter what the tone of the newspaper headlines. Especially because political turbulence, fragility of public accounts and questionable government measures make up the normal scenario in Brazil. During our career investing in the stock market, we experienced few periods of optimism with the Brazilian economy and, even so, we had excellent returns.
We confess that it can be tedious waiting for the scenario to improve and a new cycle of rising prices to begin, but we invest in search of 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
