Brazil: Beyond iron ore, oil and pulp

December 01, 2010   Suzy Kenly Waite

A Q&A with Allan Hadid, chief operating officer of BRZ Investimentos, the third largest asset management firm in Brazil.

Photo courtesy of Allan Hadid

It must be annoying to hear one’s country consistently praised for its natural resources—attributes for which talent is irrelevant. So when investors continue to speak of Brazil’s value as a commodity exporter to China, it flusters Allan Hadid, the chief operating officer of BRZ Investimentos, which with $2.45 billion is Brazil’s third largest asset management and hedge fund firm. He believes that the country’s budding credit and secondary markets offer far superior opportunities for investors than its commodity markets.

What most investors don’t realize, he says, is that commodity exports are a small serving of the Brazilian stew: Exports account for 9.7% of Brazil’s gross domestic product, with sales to China accounting for 1.2%. Brazil’s iron ore, oil, tobacco, grain and wood pulp exports are a fraction of the economic story.

“There’s a growing middle class in Brazil which is contributing to the growth of the secondary markets and the credit markets,” says Hadid.

Brazil’s middle class has grown by 24% in the last four years, moving 20 million people out of poverty, according to BRZ’s research. Now that these people can afford cars, houses and other consumer goods, they are taking out loans and pouring money back into the local economy, adding to the continued development of the secondary credit markets.

BRZ believes it is poised to take advantage of these opportunities. The firm manages two long/short strategies, six private equity funds, five credit managed accounts, one long-only equity strategy, and two macro funds, and is planning on launching an infrastructure fund for U.S. investors in 2011. The bulk of the firm’s assets are in its private equity division, which oversees $1.45 billion. Its credit managed accounts oversee $450 million and its macro funds manage $14 million.

The two hedge funds, BRZ Long Short Advanced and BRZ Fund SPC Equity Market Neutral, have had mixed results in 2010. The Advanced fund, a $288 million equity long/short and market neutral fund for local Brazilian investors, is up 6.69% through October. It was up 14.92% in 2009 and 18.66% in 2008. It has produced a net annualized return of 14.32% since its inception in April 2007. The equity fund, a Cayman-domiciled long/short strategy that manages $7.9 million, was down 27 basis points for the year through October. It returned 19.93% in 2009 and was up was up 4.6% in its first year, having launched in September 2008. It has produced a net annualized return of 13.43%.

The firm’s long-only funds, the BRZ Fund SPC Equity Long Only Fund and the BRZ Valor FIA, have had more impressive years. SPC is up 11.85% this year through October. Last year, the $1.8 million strategy shot up 211.86% after a fall of 55.66% in 2008. Valor, which manages $180 million, was up 11.94% for the year through October. It returned 127.97% in 2009 following a 36.78% drop in 2008.

Hadid joined BRZ in May 2010, having previously worked at the firm’s private equity division, GP Investments, as chief financial officer and head of investor relations. From 2002 to 2006, he was the chief investment officer of a Brazilian family office, and from 2000 to 2002, he managed the international fund of funds at Banco Matrix. AR staff writer Suzy Kenly interviewed Hadid to discuss the opportunities in Brazil, the plusses and minuses of hosting the Olympics and World Cup, and why there’s more to the country than just iron, oil and pulp.

How will big events like the Olympics and the World Cup help Brazil?

These milestones represent dates for Brazilians. We have to focus on fixing up hotels, roads, and transportation by 2014 for the World Cup and 2016 for the Olympics. We must organize it ourselves.

I hope that these events will help build up surrounding regions and sectors that are not just related to the World Cup or the Olympics.

Such as? What other sectors do you hope will improve?

For example, Brazil is planning to double airport capacity in the next four years, which, if you have ever flown in and out of the country, you will realize is badly needed. And previous World Cups have shown that air traffic typically jumps 40% in the month of the event.

You also see impacts in other sectors. Demand for construction steel is projected to rise 8% in the three years leading up to these events from World Cup and Olympic demand alone—leaving aside any GDP growth—which translates into approximately two million tons of steel. Energy consumption also typically goes up 10% during the Olympic Games, which is why you saw some investors investing in Light, the Rio energy distributor, after Rio de Janeiro won its bid for the 2016 games.

On the flipside, what are potential negatives of these large events?

If we just focus on the events and the surrounding areas of the stadiums and not the country as a whole, that would be very negative. We could spend our money wrong and waste this opportunity. We have to use this opportunity to focus on the whole country.

There are some nations where there were investments around the stadiums but the rest of the country was forgotten. Brazil should use the World Cup and the Olympics to plan the future and its surroundings.

Please can you elaborate on infrastructure and why there are such incredible opportunities?

For years, very little money was invested to transportation across the country. And Brazil is a large country—the size of the continental U.S. With any growing country, you need energy, you need more airports, you need more roads, you need ports.

As the economy grows, so too does the interconnection between the regions in Brazil, which brings forth and an abundance of opportunities in infrastructure-related sectors, including energy, transportation, ports, railroads, airports and toll roads.

Take railroads. Only about 30% of Brazil’s transportation is done via railroad, which is low compared to other countries of the same size. There has been some new construction in recent years, but not enough to meet its needs.

While most railroads are still owned by the government, some are private. The largest railroad is ALL (America Latina Logistica). It underwent a privatization process in the 90’s. We bought into ALL via one of our private equity funds, and in 2004, it went public. It is now one of the largest railroad companies in the world.

You’re more interested in the infrastructure and consumer stories than in commodities. Why?

We are looking at the way Brazil grows. A lot of people first think of Brazil’s connectedness to China, and our import/export relationship. But Brazil has a huge domestic market.

For example, Dasa is the largest healthcare diagnostics company in Latin America and fourth largest in the world. Braskem, a petrochemical company which makes the resins used in plastics for consumer goods, is the fifth largest such company in the world. And Banco Itaú is one of the world’s strongest private banks for consumer credit.

Credit is a terrific story, as the past few years, inflation has gone down, which has led to consumer credit becoming more readily available in banks. There are now a lot of people using credit in the consumer markets.

So you believe inflation has been tackled?

Interest rates are 10.75% with inflation at 5.4%. For U.S. standards, it seems like a high inflation rate, but for Brazilian standards, it’s very low.

We’ve discussed Brazil and China’s relationship. Many investors are predicting a bubble in China. If such a bubble were to burst, how would this impact Brazil?

It will have an impact on Brazil but not too severe. A lot of people say that if one emerging market goes down, the rest will follow. People think that Brazil has a strong relationship with China. We do have a relationship with them, but it’s not that significant. Only 9.7% of Brazilian GDP in 2009 was derived from exports, and the total sales to China equaled 1.2% of Brazilian GDP that year.

The bubble in China bursting will affect iron ore and steel production, but again, Brazil’s domestic market is very strong. There will be some investors taking out money from China and Brazil, but the domestic economy in Brazil will hold through.

Can you elaborate on the growing middle class and what opportunities the developing credit markets offer investors?

In the past eight years, 30 million people have moved from poverty to the middle class. Previously, these people didn’t have money to spend, and were unable to plan ahead to purchase larger items, such as cars or houses. Now these people, who previously didn’t have formal jobs, are employed. They can purchase things in installments and can go to a bank and request a loan.

With more and more people entering the market and spending money, the economy is going to grow through the various cycles. The economy is growing so fast, the demand for new labor in different areas of the market is creating a shortage of workers in the labor market.

One example of how the credit markets are developing is the airlines. Almost everyone can buy an airline ticket for the same cost as a bus fare by purchasing one in 12 installments.

Now we have 20-year mortgages. Two decades years ago, it wasn’t possible to get a five year loan from a bank. People would have to pay for their houses in cash.

And while the government has been efficient in providing healthy mortgages and credit, the private sector still has a lot of room to grow. Brazil’s only secondary market is the high-grade market, where large companies can issue debentures with maturities of an average length of five years, although there are some that can reach ten years. But the mortgage and high yield market is still incredibly underdeveloped.

When will this be fully developed?

We have to have a strong secondary market with more participants competing. Then consumers can choose the best lender comparing borrowing rates and terms.

Although you’re not as keen on commodities, do you invest in them at all?

Yes. Earlier this year, for example, we saw China increasing demand for iron ore, so iron ore was a good opportunity. We invested in Vale, a mining corporation and producer of iron ore, pellets and nickel. We are also invested in Suzano, a pulp and paper producer, and in several oil and gas companies, including OGX and HRT.

There are some excellent commodity companies. We just don’t like the stereotype that being invested in Brazil is solely being invested in commodities. For several years, Brazil was viewed as just an exporter of commodities, particularly to China. This has changed. Now it’s about the domestic story in Brazil, which is what international investors are beginning to ask about.

When did Brazil change from a sole commodity play to a domestic story?

I would say the change began in 1994 after the stabilization plan (Plano Real). Once Plano Real was introduced, there were various cycles seen only in a mature economy. Inflation was under control, and the consumer could buy goods.

However, there was big trouble in 1999 when there was a devaluation of the currency, and there were a lot of concerns about how Brazil would survive. But after that, you saw an inflation targeting policy, as well as a new anchor for the monetary policy. This in turn created a macro economic backdrop to help the micro economy evolve.

If you take the mentality of Brazil before 2000, it was mainly to invest abroad and invest very little in local businesses. Since 2000, we have seen entrepreneurs invest in their businesses with lots of young people coming out of university wanting to create their own companies or design their own products.

From 1994 to 2003, there were 53 IPOs in Brazil. From 2004 to 2010, there were 203.

And now, the country has returned to normalcy. Interest rates have come down, inflation is under control.

What are some good positions that have boosted your long/short fund’s performance recently?

So far this year, we have played the telecom sector particularly well. There has been a lot of consolidation. In July of this year, for example, the Spanish telecom company Telefônica made a bid for full control of the Brazilian mobile company Vivo, which it had previously shared control of with Portugal Telecom. In addition to Vivo, Telefônica also owns Telesp, a fixed-line phone operator in Sao Paulo state. It has stated its intention to merge both of these companies early next year, which we believe will unlock major synergies. Telefônica has already done this with its assets in other countries, including Spain, and we are positive for the results for Vivo. To hedge our long in Vivo, we have used a basket of other telecom operators and utilities companies.

Financials have also worked well for us. Here we like Banco Itau. We were able to enter the position in mid-May when Bank of America sold its stake to repay TARP. It allowed us an attractive entry point into a stock that we are bullish on. Given the growth in consumer credit, Itau has the potential to grow its loan portfolio over 20% in 2010. And the synergies from Itau’s acquisition of Unibanco are just beginning to show up in the 2010 results. Here we are using other banks with less attractive valuations to hedge our long position in Itau. Again, on the short side we are looking for names that we think are overvalued, not necessarily bad companies.

Some of our short ideas have been AmBev, the fifth largest brewery in the world, Natura, a manufacturer and marketer of skin care, solar filters, cosmetics, perfume and hair care products, and Petrobras, an energy company. In the case of all of these shorts, we feel these stocks are overvalued.

Does Brazil make it difficult to short stocks?

In the equity markets, it is possible to short and this activity is well regulated by the Comissao de Valores Mobiliarios (CVM), the Brazilian version of the SEC. The only thing you cannot do is short without owning it. If you want to short, you have to borrow the stock and then you have to sell it. It is a very regulated and institutionalized market. Almost all of the stocks listed are able to be shorted. There are good prices for shorting, especially for mid-and-large size companies.

We also have a futures market, unlike China and India. You can short interest rates, currencies and indices.

Both hedge funds and mutual funds are regulated by the Brazilian SEC, and both charge a management and performance fee. You have daily NAV. With 90 days, you can go to the public website of the Brazilian SEC and see the portfolio of each manger. You can see all of the longs and shorts.

We have absolutely no problem sharing our positions with our investors.

I can see why this is appealing to investors. What is the downside of such transparency?

Because our public equity portfolios are focused on the more liquid mid and large-cap spectrum of the Brazilian equity market, our portfolio could be liquidated within a few days if need be. There is little risk of other traders being able to influence the price of these securities. Where this could be more problematic is for funds with a high small-cap exposure. Because of the low liquidity of Brazilian small-cap stocks in can take months to build, and even longer to close positions. But even then, I think this transparency is a given. Brazilian managers know that they will have to provide it and everyone has to abide by the same rules. I think it would be a bigger shock for a foreign asset manager trying to enter this market, but not for Brazilian managers who expect these high levels of transparency.

How much of your money is from outside Brazil and how much from local investors?

Very little of our money comes from outside Brazil. Our parent company, GP Investments, which is the largest Latin American private equity firm, has 100% of its investors from outside. We, on the other hand, have focused on Brazilian investors.

However, now we are speaking with more U.S.-based investors, and are fundraising offshore.

Why are you pushing now for U.S. assets?

Before having the offshore funds set up we received a number of reverse inquiries from U.S. investors looking for exposure to Brazil. We set up the offshore equity vehicles in 2008, but given the crisis most investors closed their wallets.

Now that we have a track record, we are speaking with U.S. and Asian investors whose appetite for Brazil has returned.

How many of your funds are offshore (i.e., for U.S. investors)?

Two funds are offshore, one long-only equity fund and a long/short market neutral equity fund. And we’ll have an infrastructure private equity offshore fund next year.

Brazilian pensions can allocate up to 10% of their money into hedge funds, up from 3% due to legislation that passed last year. Have they allocate much outside of the country or primarily in local Brazilian managers?

They’ve been able to allocate to Brazil hedge funds for a long time although long short equity investing is still pretty new for them. They haven’t yet diversified a lot out of Brazil, however. Most countries outside Brazil aren’t doing so well and Brazil is hot at the moment. There will come a time when pensions diversify outside of the country, but not yet.

What is the number one concern U.S. investors have when it comes to investing in Brazil and South America?

In my view the biggest concern for offshore investors is the currency risk they take. Remember they convert dollars to reais when investing in Brazil. And in all economies, there will be volatility. Depending on the time frame, the FX rate can affect investors. Whenever you invest in another country you cannot take for granted the currency’s fluctuations.

You mention fluctuating currency markets. Can you provide some numbers to prove Brazil’s fluctuations?

It’s not a concern, but rather a good piece of advice for people investing in Brazil. Don’t take for granted the currency because it fluctuates. As an investor in Brazil, you should take on a five to 10 year horizon. It’s a small piece of sand on an entire beach. These are the things you have to remember about investing in Brazil or any other emerging market.

But I don’t think Brazil is as volatile as Venezuela, where politics play such a big role in the economy. The government in Venezuela is more closely tied to the economy. You don’t know when the government could seize your assets and sell it.

I think institutions are very strong in Brazil. And one thing Brazil has learned is stability, especially in inflationary times. The Congress, executive and legal branches are independent, and we have already impeached a president (Fernando Collor in 1992).

For example, on October 31, 2010, when Dilma Rousseff of the Workers Party won the election, the Brazilian stock market reacted favorably, with the Bovespa index gaining 1.3%, and the currency also rising, trading at 1.696 reais to the dollar. It was a very different story from 2002, however, when after the election, markets fell dramatically, and there was a general fear of what the newly elected PT government would mean for investors.

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