Tuesday, 17 July 2018

Brazilian samba

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The value of the Brazilian stock market has increased almost ten-fold in five years and is still growing, with a record 46 IPOs so far this year. For those who believe the trend is about to fade, it may be time to think again. Christopher Langner reports.

Brazil was always referred to as the “country of the future.” For Bovespa, the Brazilian stock market, that future is now. In just four years, Bovespa has made it from the sidelines into a pre-eminent listing venue and is quickly becoming one of the hottest targets for growth capital in the world.

It is staggering to consider how rapidly the exchange has grown. In July 2003, a mere US$3.7bn in stock trades were completed on Bovespa and the exchange had a total market capitalisation of US$161bn at the time. The total value of listings now stands at US$1.1trn, with monthly trading volume reaching a record US$45.4bn in July 2006.

A developing capital markets industry and the adoption of world-class corporate governance standards have been a significant driver behind that maturity. Ahead of the traditional summer slowdown in late July, a record-high 54 companies raised R$41.2bn, about US$22.4bn, through new stock listings. That compares with R$8.8bn (US$2.8bn) and 15 sales of equity in 2004.

“We are in a unique point in the history of our stock market,” says Carlos Antonio Magalhaes, technical vice-president of Apimec, a capital market professionals’ association in Brazil. “The huge world liquidity is also coming to our shores and our interest rates are at record lows.”

Domestic retail investors also are becoming more comfortable with the concept of ownership. A good example was the vast R$4.1bn (US$2bn) IPO of card processor Redecard in July, which drew a record 30,000 retail investors.

The advent of the Novo Mercado, a sub-segment of the Bovespa that imparted a higher standard of corporate governance, was a big reason behind the boost in investor confidence. Novo Mercado was created in 2000 to fight back a sharp decline in the number of listed companies and trading volume in the end of the 1990s. Among other requirements, companies listed in Novo Mercado sell only voting stock, with full tag-along rights, and have to float at least 25% of their shares.

A new law creating a clear framework of rules designed to protect minority shareholders in 2001 and later, the smooth handover of power to left-winged Luiz Inácio Lula da Silva, helped to reassure investors. The stability coupled with steady growth catered to foreign investors, but it also helped attract Brazilians into stocks, which partly explains the recent bout of activity.

According to the national investment-banks association Anbid, while fixed-income funds recorded net outflows of R$12.2bn in 2006, stock funds received R$8.4bn. Plus, local liquidity has never been so high. In 2006, open investment funds took in a net R$68.8bn, 213% more than the previous year.

The moderation of interest rates, which were historically maintained at high levels to fight inflation, helped draw investors to equities. The benchmark rate in Brazil currently stands at 11.5%, a historical low. And, despite a recent up-tick in inflation, market consensus is that the central bank will cut rates at least another 0.5% before stopping. The central bank started a long series of rate cuts in September 2005, when it lowered the benchmark from 19.75% to 19.5%.

Building blocks

Real estate is probably the sector that benefited most from the declining costs of borrowing. Just two years ago there was not a single company from the sector listed in Novo Mercado. Currently, the sector boasts the largest number of listed companies.

Cyrela, the first homebuilder to be listed in Novo Mercado, began trading in 2005. Since then, the number of real-estate related companies on the Novo Mercado has surpassed 25, with 15 initial public offerings from the sector this year alone. Results were mixed in all these IPOs.

Still, the fact that almost all of them managed to price within range suggests investors are betting that lower interest rates will unleash the huge contained housing demand in the country, currently estimated at 8 million units. “The key to this sector’s growth is the possibility that banks will move more heavily into mortgage lending because of the decline in interest rates,” says Antonio Milano,

chief executive of the brokerage arm of Banco Fator.

It is already beginning to happen. A total of R$8.5bn in mortgages had been extended out of money market funds during July 2007, the highest level since 1984 and 71.8% more than the same period in 2006, according to Abecip, a Brazilian mortgage lenders association. While still relatively small, the development of a mortgage market is in itself noteworthy in a country where consumers have historically funded home purchases in cash.

Brazilian law requires lenders to allocate 65% their money market holdings to mortgage lending. Home loans have a legally imposed cap interest rate of 12%. Until recently banks stuck to the legal limit but invested heavily in government securities to turn a profit. However, with interest rates at 11.5%, the argument for mortgage lending becomes stronger.

The need to extend credit pushed smaller lenders to list their shares. Faced with slimmer returns from investments in government securities, banks began specialising in certain credit niches, such as payroll deducted loans or financing for small and mid-cap companies. Without the assets provided by millions of checking account holders that bigger Brazilian financial institutions enjoy, the banks sold equity to expand their lending capabilities.

After mid-size lender Banco Pine listed in April, another five banks followed suit. Many more are expected to do so. Banco Pine shares priced at R$19, the bottom of an R$19–$24 indicative range, and recently traded at R$17.33.

Low financing costs, high valuations

Selling equity gives homebuilders and lenders the capacity to take on additional debt. Many of the homebuilders sold local debentures or global bonds not long after they listed shares. Mid-size lenders are expected to follow the same path.

The public listing also provides a valuable tool to value companies in the case of an acquisition, as Milano points out. “These sectors are expected to still see a lot of consolidation,” he said. He adds that acquisitions of niche lenders by mammoth banks such as Bradesco and Itau in the past were made at values that would have been much higher if the target was listed.

The prospect of being an acquirer, rather than the target, is one obvious motivation to go public. Most of the recently listed healthcare companies used IPO proceeds to step-up acquisitions in a highly fragmented sector with strong growth prospects. Diagnosticos da America, Medial Saude and Odontoprev all went on a buying spree after going public.

Cosan, the first ethanol producer to join Novo Mercado, also utilised its IPO to accelerate its consolidation of the sector. JBS-Friboi used the money and the rating upgrade it earned with the stock listing to buy Swift from the US, making it one of the biggest beef producers in the world. Springs Global, which listed in July, already was an aggressive buyer before going public and is now expected to make additional international moves.

The success of pioneers such as Cosan, Cyrela and JBS-Friboi, has attracted peers to the stock market. Although demand for the Friboi IPO was tepid, arguably because of overly aggressive banking, it was still enticing enough to prompt rivals Minerva and Marfrig into the equity market. The same applies to Acucar Guarani, which followed in the footsteps of Cosan.

Post-secondary education, a growing industry in a country in which less than 3% of the population makes it to college, also saw its participation in the Bovespa quickly expand after a successful debut by Anhanguera Educacional. In March, the company marketed a business plan familiar to international investors to raise R$445m on its IPO. Kroton Educacional and Estacio Participacoes both followed suit.

Roses and thorns

Eventually, however, some of these stocks could go sour, Apimec’s Magalhaes predicts. He says construction companies are known as bad dividend payers because they reinvest profits into new developments. Beef producers struggled with accounting problems in the past, though the new market leaders seem to have turned that page. Finally, Magalhaes warns, sugar companies have been held in the control of families for centuries and that they are hesitant to relinquish power.

A good example of that is Cosan, which recently raised US$1.05bn through a new financing vehicle. Cosan CEO and Chairman Rubens Ometto exchanged his 51% stake in Cosan SA, the Brazilian operating company, for super-voting shares in Cosan Ltd, the Bermuda-domiciled entity that listed on the NYSE in August.

Still, all of these sectors are expected to stage additional IPOs this year and in 2008 if markets stabilise. “There are still a lot of construction companies working to list their shares,” says Luiz Fernando Resende, president of boutique investment-bank LatinFinance and vice-president of Anbid, the Brazilian investment banks association.

Beef producer Bertin and Usina Santa Eliza, an ethanol producer, are also rumoured to be working toward IPOs. “We have been talking to investment-banks and they haven’t been able to meet all the requests for new IPOs,” says Banco Fator’s Milano. “If things calm down we can expect a lot of activity into next year.”

There may be additional motivations to invest in Brazilian equities. Barring any havoc-wreaking global crisis, Brazil is expected to become investment-grade within a year. The sovereign was recently upgraded to BB+ outlook positive by Standard and Poor’s just one notch into junk status. “If that materialises, you can easily expect Bovespa’s market value to surpass US$3trn by 2009,” predicts Resende.

Such a size will only make Bovespa’s own IPO ever more interesting. The Brazilian stock market is one step away from filing with local regulators to become a publicly quoted company, according to sources at the exchange. That would crown the new of age of the Brazilian equity market.

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