The seemingly endless negative headlines about the impact of the Covid-19 pandemic on global health systems, economies and markets runs the risk of making us all despondent. The humanitarian and economic cost associated with this crisis is extreme, but it may be helpful to remember that when it comes to investing the future is always uncertain, cycles are inevitable, and the greatest long-term rewards are often secured during a crisis. One just doesn’t realise it at the time. We have studied past crises to inform our response to this crisis and future crises. Our in-depth research shows that although crises are all different, they do tend to share similar underlying mechanics. An example is Brazil’s economic crisis of 2015. At the time, an economic recovery in Brazil seemed highly unlikely. The case for investing in Brazilian equities was difficult. However, investors who stayed the course were greatly rewarded.
Brazil’s economic history is characterised by extreme volatility, and the 2015 crisis was particularly severe.
The country has contended with many challenges over the decades – hyperinflation, political turbulence, military dictatorship, staggering inequality, and aggressive commodity boom and bust cycles, to name a few. The 2015 crisis had a deep and protracted economic impact and is similar to the world’s current crisis in many aspects.
In the run-up to the crisis and through 2017, Brazil’s economy (and by default the banks that operate within it) was staring down the proverbial barrel of a gun due to several factors that would have made even the most battle-hardened investor gulp:
- Political infighting, corruption and a left-leaning presidency, which ultimately ended up in the impeachment of President Dilma Rousseff and the arrest and conviction of two former presidents.
- The largest corporate fraud in Latin American history in the form of the Odebrecht scandal, which involved multiple parties and countries.
- Falling commodity prices and a current account deficit that widened to a peak of 4.5% in April 2015.
- Extreme currency weakness due to a terms of trade shock and concern around the country’s fiscal sustainability. (The Brazilian real depreciated 76% against the US dollar from the beginning of 2014 to its weakest point in early 2016.)
- Increased tax rates as the country sought to offset fiscal pressures.
- Surging inflation that peaked at 10.7% and, as a result, higher interest rates. (Real rates peaked at roughly 9%.)
- All three ratings agencies (Standard & Poor’s, Moody’s and Fitch) downgraded the country’s sovereign debt status to junk with a negative outlook between September 2015 and January 2016.
- The onset of the Zika virus in late 2015 which, while less severe than the current health crisis, came at a time when the country could ill-afford it.
These factors resulted in the Brazilian economy experiencing its most severe economic contraction on record, with real GDP shrinking by 3.5% in 2015 and another 3.3% in 2016. Unemployment soared to new highs, peaking at 12.8% in 2017. The impact on the banks was as expected: loan books contracted, provisions for losses rose sharply as did delinquencies (and later bankruptcies), and earnings contracted.
Figure 1: Brazil endured an extremely difficult macro environment between 2014 and 2017.
Source: FactSet (15 April 2020)
The markets reacted strongly to news headlines in 2015.
Figure 2: Reading the headlines, an investor could easily have run for the hills.
Source: Denker Capital research
The Bovespa Index (Brazil’s flagship equity index) fell 13.3% in local currency and a staggering 42.8% in US dollars in 2015, underperforming the MSCI World Index by 13.0% and 41.4% respectively.
Two of Brazil’s flagship banks, which are also two of our preferred holdings in the Denker Global Financial Fund, Itau Unibanco (Itau) and Banco Bradesco (Bradesco), fell 40.8% and 52.9% respectively over the year in US dollars. Valuations reached levels not seen in either the global financial crisis or the dotcom crash. Scary stuff indeed.
Investors who took advantage of the lower prices and attractive valuations on offer, enjoyed very generous returns after Brazil’s fortunes changed in early 2016.
The turn-around was sparked by political developments that brought a new, reform-orientated administration. The two scenarios below show the investment returns for the two-, three- and four-year periods after investing in the Bovespa Index, Itau or Bradesco relative to the MSCI World Index during the crisis.
Scenario A: Investing mid-way through the crisis (at the end of August 2015)
This date may seem arbitrary, but at the time the future was still very uncertain and the range of possible economic outcomes was wide – much like where we find ourselves today. Valuations, while still relatively far from reaching their lowest points, were attractive. At that point, the Bovespa Index was trading at a 24.6% discount to its long-term historical average, while the banks were at an average discount of 45.5% to their historic averages.
Despite these seemingly attractive valuations, the Bovespa Index still fell another 21.5% to its trough. Bradesco fell another 25.4% and Itau another 14.0% to reach their respective lows. Drastic price moves such as these can easily lead investors to doubt themselves. Holding on, or indeed investing more, would certainly have required a healthy dose of mental and emotional fortitude.
Figure 3a below shows the subsequent returns earned after investing in August 2015. It would’ve paid off handsomely to stay the course. Returns generated over all periods, in both Brazilian real and US dollars, were strong and outperformed the MSCI World Index by a wide margin.
Figure 3a: Investing mid-way through the crisis generated strong, market-beating returns.
Source: FactSet
Returns are cumulative total returns. Valuation as measured by price to latest reported book value. Historical average valuation range is from 2001 to investment date (31 August 2015).
Scenario B: Investing at the bottom (January 2016)
While we make no claims to be able to ‘call the bottom’ in any market and have little faith in anyone’s ability to do so consistently, it is nevertheless interesting (and admittedly enticing) to look at prospective returns from the point of maximum pessimism in January 2016. At the time, valuation of the Bovespa Index was 33.9% below its long-term average, and valuations for the two banks were on average 53.6% below their long-term averages.
As shown in Figure 3b below, the subsequent returns were nothing short of spectacular in scenario B – on an absolute basis as well as compared to the MSCI World Index. Like in Scenario A, buying while Brazilian assets were significantly out of favour generated very strong long-term returns and returned multiples of what the MSCI World Index generated (in both currency measures).
Figure 3b: Investing at the bottom of the crisis delivered even stronger returns that materially outperformed global markets.
Source: FactSet
Returns are cumulative total returns. Valuation as measured by price to latest reported book value. Historical average valuation range is from 2001 to investment date (31 January 2016).
The Brazilian example is a timely reminder that investing during a crisis is emotionally uncomfortable but can be rewarding.
So, why is this information helpful today?
As is widely quoted in financial writing: history does tend to rhyme. The Brazilian example is a good reminder that it’s often well worth it to stay the course, and indeed to capitalise on opportunities that might arise.
‘History provides a crucial insight regarding market crises: They are inevitable, painful and ultimately surmountable.’ Shelby M.C. Davis
The headlines and investor emotions today are similar to those seen during past crises (especially relating to global financial stocks).
Figure 4: Today, headlines are once again daunting.
Source: Denker Capital research
While the impact of Covid-19 is out of our control, we do have control over our investment decisions.
It is clear that we are headed for a severe economic contraction globally, but the range of potential outcomes is wide, and uncertainty is high. We have no special insight as to when or how this crisis may end, and nor do we have any control over it. We also do not know how much more discomfort it will cause before things start to improve.
We are, however, definitely seeing good buying opportunities for businesses that we rate very highly, based on their attractive valuations relative to our assessments of their intrinsic value. We firmly believe this bodes well for prospective returns for patient investors in the Denker Global Financial Fund. We have taken advantage of these opportunities in a thoughtful and considered manner and intend to continue doing so if further opportunities arise.
Investors can invest in the Denker Global Financial Fund in US dollars, British pounds or euros. Please contact us at investorrelations@denkercapital.com for more information.
To view the latest fund fact sheet (or minimum disclosure document), please click here.
Barry de Kock
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