Brazil's high powered economy

Key Points:
External headwinds most culpable in 2011 for poor equity returns, 2012 (thus far) has seen returns of 18.8%
Positive policy support should see the Brazilian economy stage a strong comeback in 2012
Growing consumer strength poised to benefit 2 key sectors - Consumer Sectors, Financials Sector
Demographic and Structural changes present investors with opportunities to benefit from Brazil's continuing transformation
Brazil currently offers potential upside of 27%, maintain 4.5 Star "Very Attractive" rating
After a horrid year in 2011 where it lost -24.7% as a combination of rate hikes to combat inflation and a weak global economic outlook took hold, the Brazilian stock market has come roaring back in 2012 with returns of 18.4%.

EXTERNAL HEADWINDS MOST CULPABLE IN 2011
Ever since the re-ignition of the European debt crisis in the middle of 2011, Brazil’s economy has faced significant headwinds.
The uncertainty took its toll on the local economy with economic activity deteriorating as both capacity utilisation and industrial production began to fall, leaving 3Q 2011 GDP coming in slightly negative at - 0.1% on a quarter-on-quarter basis.
Internally, Brazil had been fighting its nemesis that is inflation in 1H 2011, hiking its key Selic interest rate to 12.50% as it sought to cool an overheating economy which also suffered from rising commodity prices. In addition, lending curbs were introduced in an effort to reduce credit available and reduce Brazil’s demand-pull inflation.
As for the Bovespa, the materials, industrials and utilities sectors were amongst the hardest hit as a result of the above while the Financials benefitted from the initial rate hikes before succumbing to pressure emanating from troubled Europe as well as rate cuts in 2H 2011.

With the closure of 2011, 2012 has spelt much better news for the Latin American nation.

Currently, the Brazilian government has undertaken several measures ranging from the slashing of its key Selic rate to cutting taxes on various goods in an attempt to boost growth since 2H 2011. With the government prioritising growth over inflation control, we take a closer look at 2 key sectors which are poised to deliver.

CONSUMER SECTOR - FROM STRENGTH TO STRENGTH
Brazil’s domestic consumption story, based on demographic and positive structural changes is something that’s not new to investors. However, what investors might not know is that the story has continued gaining in strength. Retail sales in Brazil have been climbing higher and higher, growing by close to 7% for the second consecutive month on a year-on-year basis in November and December, on the back of rising real wages and historically low unemployment (thanks to job creation), with retail sales growing by 7% for the second consecutive month on a year-on-year basis as seen in Charts 1 and 2 below.

CHART 1: RISING RETAIL SALES & REAL INCOME















CHART 2: MORE JOBS, LESS UNEMPLOYMENT


The strengthening of incomes and the creation of more jobs has also seen family expenditure become more resilient as compared to the past.
During the financial crisis of 2008-2009, although family expenditure did not contract, this key component of Brazil’s’ economy saw its growth rate fall significantly from 7.7% to 2.7% on a year-on-year basis from September 2008 to December 2008 in spite of the seasonal effect normally seen in December (holiday sales).
In the most recent episode of the European debt crisis, family consumption held up significantly better and demonstrated its new-found resiliency with a less painful fall from a 5.6% growth rate in June 2011 to a 2.8% rate in September 2011 (Chart 3).

CHART 3: CONSUMPTION'S INCREASING RESILIENCE


Taking a closer look at the retail space, the decision by the government to cut taxes for household goods has seen the purchases of furniture and appliances continue to hold its pace of growth steady with data showing a healthy year-on-year gain of 15.3% in December 2011. Supermarket retail sales have like-wise kept up its pace of growth, registering a growth rate of 4.6% in the same period. However, retail sales for apparel & footwear have slowed as a result of a minor slip in consumer confidence as the weak external environment saw consumers reduce their discretionary spending.

Given the increased stature of the Brazilian consumer, both the Consumer Discretionary and Consumer Staples are expected to benefit from the resilience of Brazil’s consumption story and its growing strength.

FINANCIAL SECTOR - LONG TERM BENEFICIARY
The financial sector in Brazil has long been on the up and up. Credit loan growth in the country has been growing steadily over the course of the decade as a conflux of factors allowed such phenomenal growth.

The very same demographic and structural changes in Brazil that has seen the consumer sector do well have also positively impacted the Financials sector.
With increasing affluence, credit cards and loans to service mortgages (which in part is also due to urbanisation, a structural change), the Brazilian financials have a benefitted from the consumer boom.
Consumer credit has almost doubled over the past since December 2007, while default rates still remain in an acceptable range of 7-7.5%, a far cry from the 8.5% seen during the peak of the financial crisis in 1H 2009 (Chart 4).

CHART 4: CONSUMER CREDIT BOOM


Looking at the larger picture of total private sector loans outstanding, currently, the total amount of these loans only reach approximately USD 1.2 trillion, with a booming economy in the backdrop and as the Middle Class in Brazil grows, incomes increase and urbanisation takes place rapidly, the financials are a sector which is poised for further rapid expansion.

The decision by the Brazilian central bank to cut interest rates is a double-edged sword for financials as although it will cut the rate with which they lend at, the rate at which they borrow to fund their operations will be reduced as well. Historically, the average banking spread for Brazil has averaged 27% with the latest figure as of end December 2011 registering a reading of 26.9%, almost spot on with the long-term average (Chart 5).

CHART 5: AVERAGE BANKING SPREAD


While margins are important for banks, we believe that an increase in the growth of demand for credit in Brazil as a result of lower borrowing rates will more than sufficiently make up for any shortfall in profits as a result of a potential narrower lending spread.

CONCLUSION

Any country moving from an “Emerging Market” status to “Developed Market” status provides investors with several opportunities to capitalise on demographic and other structural changes; in Brazil’s case, the ever-growing consumer spending power and the need for financial services will see the Consumer Staples, Discretionary and the Financial Services sectors prosper.

At current levels, the Bovespa is trading at a price-to-earnings ratio of 9.0X based on 2013’s earnings, representing a potential upside of 27% (as of 7 March 2012) by then when compared to its fair value of 11.5X. We have a 4.5 Star “Very Attractive” rating on Brazil, and a 5 Star rating on the larger Global Emerging Markets.

China A-shares

Key Points:
The China A-shares market can present investors with a unique investment opportunity, as it differs in several aspects from the H-shares and red chips market, a market comprised of Hong Kong-listed Chinese companies. In particular, its sector weightings differ significantly
The valuation of the CSI300 index (a proxy for the China A-shares market) has reached an extremely attractive level
The market will give investors exposure to China’s economic growth story.The latest shift towards accommodative policy in both monetary and fiscal policies will set the Chinese equity markets for a rally, keeping a three-year investment horizon in mind .
The Chinese equity market is one favoured single-country equity market, keeping a three-year investment horizon in mind.
Use the Hang Seng Mainland 100 (HSML 100) index as a benchmark for the Chinese equity market. This benchmark comprises of both H-Shares and Red Chips, which are Hong Kong-listed Chinese companies. While these companies give exposure to the Chinese economic fundamentals, A-shares is a different asset class altogether, exhibiting some different characteristics and opportunities. In this article, we will look at the investment opportunities that lie in the China A-Shares market.

WHAT IS UNIQUE ABOUT THE A-SHARES MARKET?
The fundamental difference between the A-shares and H-shares or red chips market is the opportunities that exist to invest in them. A-shares stocks are only listed on the Shanghai and Shenzhen Stock Exchanges whereas H-shares stocks are listed in the Hong Kong Stock Exchange.

Due to regulatory restrictions in mainland China, foreign investors cannot freely invest in the A-shares market. There are currently only three types of investors who are qualified to invest in this market: Chinese citizens or companies, investors with a Qualified Foreign Institutional Investors ("QFII") status or investors with a Renminbi Qualified Foreign Institutional Investors ("RQFII") status.

Using the China Securities Index 300 (CSI300) index as proxy for the China A-Shares market.

Table 1: Summary of Differentiating Characteristics
A-Shares H-Shares Red Chips
Benchmark Index CSI300 Index HSML100 Index
Exchange Shanghai /Shenzhen Hong Kong Stock
Currency RMB HKD
Incorporated Mainland China Outside of Mainland China

Apart from being more restrictive, the A-shares market presents a whole different opportunity. First of all, stocks are denominated in its local currency (yuan) which means that investors will be exposed to currency movements, which is beneficial if you are expecting an appreciation of the yuan. Secondly, although some companies have dual listings in Hong Kong, the A-shares universe is much more fruitful and broad, comprising of over 2,000 stocks.

Finally, the sector allocation in the A-Shares market, as measured by the CSI300 index, differs significantly from that of the HSML100 Index. As we can see from Chart 1, the HSML100 index is heavily weighted in the financials, energy and telecommunication services sectors. On the other hand, the CSI300 index has a significantly larger weighting towards industrials and materials; this weighting reflects the Chinese economy’s actual GDP composition more accurately. Furthermore, we can also note that the CSI300 Index is more weighted towards the consumer sector, with consumer discretionary making up 8.1% of the index, as opposed to 5.0% for the HSML100 index. This means that A-shares investors will have a greater exposure to China’s domestic consumption story, which we expect will become increasingly important to the Chinese economy in the coming years.

CHART 1: SECTOR ALLOCATION OF THE A-SHARES AND H-SHARES/RED CHIPS MARKET



RECENT DEVELOPMENTS
As mentioned earlier, there are heavy restrictions in investing into the China A-Shares market. There will be some time before investors can freely invest directly into Chinese equity markets, but in the recent years and even months, we have seen some major steps made towards liberalising the Chinese currency as well as the equity markets.

QFII
One of the ways to invest in Chinese equities is via obtaining a QFII quota. The QFII quota was introduced in 2002 and since then 117 institutions have successfully received a license and quota. Up until 20 January 2012, US$22.2 billion worth of investment quota has been approved. However, the quotas under the QFII program are currently capped at US$30 billion.

Despite the fact that there are still some major obstacles, further efforts to liberalise the capital markets were seen by the introduction and approval of the first batch of RQFII quotas.

RQFII
RQFII is another way to invest in Chinese equities. The significant batch of RQFII quotas approved since end-2011 is a sign that China has intent to open up its capital markets further to foreign investors. 21 institutions and 20 billion yuan worth of RQFII quotas have been approved since end-2011. However, not only does the RQFII differ from the QFII program in its currency (RQFII uses Renminbi as opposed to US dollars), there is also a restriction of up to 20% that can be invested in equities using the RQFII quota, unlike the QFII quota. Nonetheless, we can observe the move as a signal that China will gradually liberalise its capital markets and liquidity for foreign investors will improve over time.

SEIZE THE OPPORTUNITY WHILE VALUATIONS REMAIN ATTRACTIVE!

Investing in the A-Shares market will expose investors to the same macroeconomic fundamentals of the Chinese economy as the H-Shares or Red Chips will. As we outlined in the article, Prepare for a Chinese Rally, we expect that resilient economic growth and a shift towards accommodative policy in both monetary and fiscal policies will set the Chinese equity markets for a rally, keeping a three-year investment horizon in mind. These two points are just as applicable to investing in the A-shares market.

H-Shares/Red Chips

The one fundamental difference important for investors is the market’s valuations. The HSML100 index is also trading at an extremely attractive level after its forward 12-month PE dipped below the 10.2X level, which is one standard deviation below its historical mean. Since the start of the year, the Chinese equity market has already embarked on a rally; however, valuations are still attractive as the HSML100 index’s 12-month forward PE was at 9.8X (as of end-February 2012), a 3.6% discount from the 10.2X level.


A-Shares

Some investors may already be aware that the A-shares market has historically been at a significant premium to the H-shares or red chips market. One of the reasons explaining this premium is due to the dominance of retail investors in the A-shares market, whereas other markets are dominated by institutional investors. The investment restrictions which bar foreign investors from participating, firstly limits the possible investors into the A-shares market. Secondly, there is a limited range of investment options open to people in mainland China, which is what pushes retail investors towards equity markets in order to park their money, pushing up the valuations of A-shares stocks.

As we can see in Chart 3, at its peak in 2007, the CSI300 index’s forward PE was trading at a 74% premium to the HSML100 index’s. However, the good news is that, in the recent two years, the two indices’ valuations have been converging. CSI300 index’s valuation is currently trading at a 9% premium (as of end-February 2012) to the HSML100 index’s, a significant decline from the historical average of 28%.


The tightening gap between the two indices’ valuations indicates cheapness of the A-shares market. Since the reasons which push A-share valuations at a premium will persist in the market as long as the market remains restricted, we should continue to see the market priced at a premium. Furthermore, in the past, when the premium between the two indices contract to such levels, the CSI300 index market has seen a steeper subsequent upside (compared to the HSML100 index).

CHART 2: A-SHARES TO H-SHARES AND RED CHIPS PREMIUM


On the other hand, as we can see in Chart 3, using a similar analysis as we did in evaluating HSML100 index’s valuations, we can see that the CSI300 index’s forward 12-month PE has dropped below its historical mean since 2010. Since then, it pierced through the 12.2X level towards the end of 2011, which is one standard deviation below its historical mean. Even though the index has rebounded along with other equity markets around the globe, valuations are still trading at a 12.5% discount from the 12.2X level (as of end-February 2012).

CHART 3: ESTIMATED MARKET VALUATION OF THE CHINA SECURITIES INDEX 300 (CSI300) INDEX


Apart from looking at the market’s PE ratio, it is also appropriate to look at the market’s estimated Price-to-Book ratio (PB) and estimated Return on Equity (ROE). Since the CSI300 index is composed largely of capital-intensive activities and financial institutions, such as companies in the materials and industrials sectors, PB is a suitable measure for its market valuation.

Intuitively, since PB is a valuation measure and ROE is a profitability measure, these two measures should be moving together since you would be willing to pay more for a more profitable company. If we look at Chart 4 however, we can observe that the PB of the CSI300 index has been steadily declining since the end of 2009. But this does not seem to merely represent a retreat from previously overvalued companies, because at the same time we saw ROE increase rapidly. Up until end-February 2012, the estimated ROE reached 19.4%, inching closer to the highest levels seen in 2008. The divergence in PB and ROE is a rare phenomenon which further indicates the attractiveness in the A-shares market valuation.

CHART 4: COMPARING PROFITABILITY WITH VALUATIONS OF THE A-SHARES MARKET



In conclusion, not only will the China A-shares market be supported by economic growth fundamentals and a shift towards accommodative policy, its valuation has also reached extremely attractive levels, if we consider PE, PB and ROE measures. According to our estimates, as of end-February 2012, the estimated PE for the CSI300 Index is at 10.3X and 8.3X for 2012 and 2013 respectively, significantly lower than its fair value of 15X.