Dear investors,
Our investment history is almost entirely on the Brazilian stock market. While most Brazilian investors believe that our stock market is not a good investment environment, due to the country's political and economic turbulence and because of the famous comparison of the IBOV's return with the CDI in recent decades, we have a different view. Although a passive stock investment strategy does not have very attractive prospects, there is a lot of room for good returns with active management. This was the strategy we successfully executed over the last decade. However, recently we started looking more outside Brazil.
In 2022, this theme of international investments gained some evidence, as several multimarket funds invested in foreign economies and even the general public began to seek investments outside the country, through new brokerages that offered accounts to operate abroad. However, this movement was driven by fear about the Brazilian economy and the consequent desire to diversify into other geographies, while our motivation is quite different. Let's explain why we still like the Brazilian stock market and why, even so, it made sense for us to seek investments in other countries as well.
The good side of the Brazilian stock market
Investing in stocks is a competitive activity. To have returns above the index, it is necessary to achieve more than the market average. As with any competitive dynamic, the first thing a participant would like to know is who the other competitors are and how challenging it is to overcome them. Thus, an important question is: who invests in the Brazilian stock market? A good reference for this information is the participation of each type of investor in the total volume traded on the spot market for shares, reported by B3 itself on a monthly basis:
Investors in B3’s Total Monthly Volume (April 2024)
For foreign investors, Brazil is a completely peripheral market. The total value of companies listed on the Brazilian stock exchange represents ~2% of the global stock market and only ~70 companies are worth more than U$ 2 billion. Below this value, the American market classifies shares as small caps. In other words, for an American institutional investor, we are a small emerging market of small caps. Many foreigners who invest in Brazil do so as part of a portfolio diversification strategy in emerging markets, evaluating the average valuation level of the stock market and the expected growth of the Brazilian economy in relation to that of developed economies. Few will carry out in-depth analyzes of Brazilian companies.
Individual investors have varied profiles, but generally do not have in-depth technical knowledge and do not have as much free time to dedicate to stock analysis. Most do superficial analyzes or follow the recommendations of a subscription service that provides market analysis.
That leaves institutional investors and financial institutions. These are professional, qualified investors, with a dedicated team and information systems. However, this category involves both equity funds and other types of funds, particularly multimarkets, and most of them do not have active equity management strategies. They may track the index portfolio, and tactical variations around them, or pay more attention to balancing stocks and other asset classes than selecting the best stocks.
In other words, less than 30% of Brazilian stock market participants (potentially, much less) are actively doing in-depth analysis of specific companies. Furthermore, many investment funds still face the problem of having a volatile investor base who despairs when the market mood deteriorates and begins to withdraw, so that even if the fund manager believes it is time to buy more, he may be forced to sell to return the money to his shareholders.
This is the competition we face in Brazil. The typical investor who operates on our stock exchange pays less attention to details about listed companies than to the country's macro environment. This generates volatility in share prices that, at times, is not correlated with the financial results expected for each company. This is the perfect environment for fundamental investors to operate: a market in which share prices vary greatly around each company's intrinsic value estimates, which is precisely the necessary condition for there to be opportunities to buy cheap and sell expensive.
The bad side of the Brazilian stock market
In contrast, there are three characteristics that we consider bad about our stock market. The first is the small amount of assets. Today, there are 340 companies listed on B3 and only 214 of them have liquidity greater than R$ 500 thousand per day, still considered quite low, but which allows us to operate with small positions. This greatly limits the universe of opportunities we have to evaluate.
The second negative factor is that the Brazilian economy is not strong in sectors that simultaneously have high profitability and competitive advantages at a global level. For example, several of our listed companies operate in commodity sectors, characterized by volatile earnings that make it difficult to accurately estimate their fair value. Others are highly regulated or under state control, with the consequent unpredictability brought about by possible political interference. Removing businesses in sectors that we consider to be of little interest from the list leaves between 100 and 150 companies. It is a very small set of opportunities and, consequently, the number of excellent investment theses that it is possible to find in this environment is quite restricted.
The third aspect is Brazil's legal uncertainty, mainly in relation to tax issues. In several businesses, even with correct and diligent executives, significant legal disputes arise over the amount of taxes owed by the company. The inconvenience of this scenario for investors is that, in several investment theses, there is a chance that the company will lose a relevant part of its value if the court decision goes against their claim. Litigations tend to be complex, with a very uncertain conclusion period and outcome. To illustrate how disruptive this is, in a particular investment thesis we evaluated a tax dispute that lasted more than 10 years. We read more than 500 pages of process, held meetings with several lawyers and the result of all this work was an estimate of the order of magnitude of the losses associated with each possible scenario of conclusion of the litigation, a very vague notion of the chances of each scenario materializing and the expectation that the case would still take years and years to resolve.
Why do we start looking outside
The balance of good and bad factors in the Brazilian stock market still seems positive to us. It offers good investment opportunities, with a certain frequency, for those who are willing to do careful work in selecting the companies in which to invest. However, international scholarships caught our attention because an atypical window of opportunities emerged.
What developed countries are facing now are inflationary crises very similar to the Brazilian one, with the difference that Brazil began combating inflation about a year before the United States and Europe. Thus, while our central bank is already carrying out interest rate cuts, the central banks of other countries are still at a similar stage to what Brazil was in the second half of 2023: at the peak of interest rates, discussing how long they will have to maintain them or whether any extra increase will be necessary.
The reaction of investors to this scenario of rising interest rates around the world was the same as what we saw happening in Brazil: there was a large migration of capital allocated in shares to fixed income securities and, consequently, share prices fell with the sales pressure. Therefore, several exchanges are at valuation levels well below their historical average, the same scenario we see here in Brazil. The current supply of penny stocks is a global phenomenon.
In the midst of this tumultuous macroeconomic environment, it is worth noting that not everything is cheap. Amid the attractive average valuation, there are bargains and companies trading at daring prices. A notable example is the price level of American big tech companies. Without a doubt, these are companies of excellent quality and great potential, but it is not obvious to say that valuations in the range of 25 to 60 times price/earnings are great bargains.
Is investing abroad more difficult?
The big disadvantage of investing abroad is having to deal with the risk of exchange rate fluctuation, which is like the price of commodities: impossible to predict. In theory, the relationship between two currencies should vary only depending on the difference between inflation in the two currencies, but, in practice, the real exchange rate can spend very long periods away from this theoretical equilibrium point. For example, the analysis below shows the relationship between dollars and reais (USD/BRL) since 1999, when Brazil adopted the floating exchange rate regime. The red line is what the exchange rate should have been over time if the theory worked perfectly and the blue line is the actual exchange rate.
Real vs. real exchange rate theoretical (USD/BRL)
The analysis serves as a reference for where the exchange rate should gravitate in the long term, but it does not help much in predicting what the exchange rate will be in the coming years. The problem with this is that a large variation in the exchange rate can spoil the return on a successful investment from the point of view of the local currency of the invested company, if the conversion of capital back into reais is done at a much worse rate than the current one. at the time the investment was made.
We take two precautions to mitigate exchange rate risk: the first is the good old safety margin: to invest outside Brazil, we require a greater discount in the share price in relation to its fair value, to compensate for the extra risk; the second is to avoid investments in cyclical businesses abroad, as the exchange rate could be unfavorable at the time of the sectoral cycle that is conducive to selling shares.
Apart from the exchange rate problem, there are no major impediments to investing in other countries, as long as those with a stable economy and business environments that we are able to understand are selected. The type of fundamental analysis we carry out is applicable to any geography and today physical location matters little to be able to collect data and communicate. Setting up video conferences with executives in London is as simple as setting up meetings with executives in São Paulo.
The advantages of looking around the world
The main impact of looking outside Brazil is that we expanded our universe of possible investments from 214 companies to more than 25 thousand shares listed around the world. The advantage is statistical: the chance of finding extraordinary opportunities in a sample space of 25 thousand stocks is much greater than finding something extraordinary among 200 local stocks, in the same way that it is easier to find a person who is 2.20 meters tall in a group of 25 thousand people than in a group of 200. This way, we can be much more rigorous in the selection criteria and still expect to find actions that meet our requirements.
Another characteristic that favors us is that the stock markets in developed countries are much larger than the Brazilian one, both in relation to the size of the companies and the size of the investment funds that operate in them. In the American market, equity funds with less than USD 1 billion are considered small and below USD 10 billion are still considered medium. This is why companies that are worth less than USD 2 Billion are considered small caps.
Today Ártica Long Term has around R$ 250 million (~USD 50 MM) under management, a tiny size by global standards, which translates into a relative advantage to operate in developed markets. For us, it is a good investment of time to analyze in depth a company where we can allocate 10% of our portfolio (USD 5 MM), with daily liquidity above USD 100 thousand. For a typical American fund, stocks of this size are too small and not even worth the effort to analyze. In other words, it is not good American managers that we will be competing with when we evaluate shares of companies worth USD 1 or 2 billion. As what matters most to us is the return generated for our investors, we will continue to make the most of the advantage brought by our current size and seek to operate in the least competitive environments possible.
What we've done so far
For about 6 months, we have been looking at stocks in places with business cultures with which we already have some familiarity: the United States and Western European countries. To date, we have invested in two companies listed on the London Stock Exchange. The fact that they were both English was a coincidence, we didn't find them aiming exactly at England.
One of them is a small cap that fits well into the typology we described, with a market cap of ~R$ 600 million and daily liquidity of ~R$ 750 thousand. Too small for most English funds to care about. It grew by 21% per year, on average, over the last 5 years and maintained an average return on equity of 15%.a., in pounds sterling. We purchased shares in this company at a valuation of approximately 5x Price/Earnings.
The other is a large cap worth tens of billions of dollars. It is a mature global business that no longer has significant growth, but maintains good profitability, strong cash generation and is being traded at 7.5x Price/Earnings, whereas it used to be traded between 10-15x Price/Earnings before the inflationary crisis. In this thesis, what attracted us was not exactly these price references, but the fact that the chance of losses is low and there is a potential for significant appreciation of the business within a few years, due to changes in the sectoral context.
As you noticed, we still don't want to open up which companies they are, as they are small positions in our portfolio and we may still buy more. If they reach a relevant size, we will provide more details about them in a future letter.
Check out the comments from Ivan Barboza, manager of Ártica Long Term FIA, about this month's letter in YouTube or in Spotify.
