EWZ: Not Ideal, But Don't Write It Off Either

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Brazilian equities have underperformed both global stocks and their EM counterparts quite significantly this year.EWZ is the largest Brazilian-themed ETF around, but the next largest offering - FLBR -...

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How Does EWZ Compare To The Next Largest Peer?","collect":0,"end_time":0,"defaultTopTitle":"seekingalpha.com","property":[],"viewcount":null,"language":"en","relate_stocks":{"BK4588":"碎股","BK4585":"ETF&股票定投概念","EWZ":"巴西ETF-iShares MSCI"},"translate_title":"EWZ：不理想，但也不要一笔勾销","themeId":null,"isJumpTheme":false,"ttsUrl":null,"symbols_score_info":{"EWZ":0.9},"content_text":"Brazilian equities have underperformed both global stocks and their EM counterparts quite significantly this year.EWZ is the largest Brazilian-themed ETF around, but the next largest offering - FLBR - is gaining interest and with good reason.Trading volumes in the Brazilian equity markets have come off quite significantly as the Central Bank's ongoing rate stance has made fixed income more attractive.EWZ could face additional pressure in this rate environment given its high exposure to banks that are likely to face asset quality deterioration and lower loan growth.However, EWZ shouldn't be entirely dismissed, given the compelling valuation and risk-reward backdrop.LeoPatrizi/E+ via Getty Images  Introduction The iShares MSCI Brazil ETF (NYSEARCA:EWZ) a 24-year-old product that focuses on large-and-mid-cap companies from Brazil has experienced a disappointing 2024 so far. In a year where global stocks have generated healthy gains of +17%, and emerging markets haven't been too far behind either, EWZ has lagged significantly and has eroded investor wealth by over -16%. YCharts Could EWZ be due a bounce back, and is it the most ideal vehicle to play Brazilian equities? Well, here's what we think. How Does EWZ Compare To The Next Largest Peer? It's fair to say that investors who look for diversified access to Brazilian equities typically plump for EWZ, and its pull is reflected in the size of its AUM (over $3.8bn), which is around 23x greater than the next biggest alternative- the Franklin FTSE Brazil ETF (FLBR). Admittedly, FLBR has a much shorter listing history of only around 7 years, but it's worth noting that it has been attracting a greater chunk of funds since its inception. Despite underperforming EWZ by close to 300bps (since FLBR's inception), note that its AUM has surged by a tremendous amount, even as the larger product's AUM has shrunk by -43% during the same period. YCharts We'd like to think this shift is largely driven by FLBR's compelling cost efficiency; note that the younger ETF can be picked up at an expense ratio of just 0.19%, which equates to only one-third the ratio of EWZ (0.59%). What also helps FLBR's cause is that across the last 5 years, it has yielded a superior figure of 7.36% which is over 70bps more than EWZ's average yield. However, it appears as though EWZ has been stepping up its dividend game, with the most recent semi-annual hike growing by +21% YoY, whereas FLBR's semi-annual hike saw a contraction of -54% YoY. As a result, we have a scenario where EWZ's yield is leading FLBR for the first time since H1-23. YCharts Investors may also want to note that EWZ appears to be slightly riskier, with a rolling volatility profile that is around 50bps higher. YCharts Given the higher risk taken, EWZ should generate an excess return threshold that justifies that, but it comes up short. This is captured by the 3-year and 5-year Sharpe ratios where it lags FLBR. YCharts Given all that we've written so far, one can understand why EWZ has been witnessing AUM erosion, even as FLBR's AUM has been growing.  Brazilian Equities - Yes Or No?  While we are not necessarily entirely against it, taking a punt on Brazilian equities right now feels like a somewhat tricky proposition. The problem isn't necessarily with growth dynamics per se. In fact, the key industry and services segments have proven to be quite resilient (the latest available data for Q2 showed 1.8% growth for industry and 1% for services) and played an important role in prompting Q2 GDP to surprise to the upside (1.4% sequential growth). As a result, we've also seen the finance ministry lift its FY24 growth expectations from previous levels of 2.5% to 3.2% (for context, GDP growth in Q3 had come in at 2.9%). However, also consider that inflation risks have started creeping up now, with inflation as of mid-October rising to 4.47% (driven mainly by electricity costs), up from 4.12% previously. Last month, we saw the Finance Ministry posit an FY inflation target of only 4.25%, but this looks quite unlikely. For context, the official target is a figure of 3% with a tolerance band of 150bps. In light of higher inflation risks, it is difficult to see the central bank moving away from its recent rate-hiking stance. To highlight, in September, we already saw the Selic being lifted by 25bps to levels of 10.75%, but even back then the central bank had signaled that more hikes were in the cards. Essentially, we don't believe it is unreasonable to expect the benchmark rate to be trending above the 11% level by the end of this year. A higher interest rate outlook will continue to damage interest in Brazilian equities as interest continues to shift toward the fixed-income space. It's worth noting that average daily trading volumes in the Brazilian equity bourses are already down by -42% from previous peaks and are currently hovering at a figure of less than 19bn BRL on a YTD basis. It's also worth pondering what a higher rate threshold could do for the asset quality of Brazilian banks, given the additional debt burden on borrowers. This is quite pertinent given that EWZ's largest sector exposure is towards the financial sector, which accounts for 36% of the total portfolio. Already, this year, bankruptcy filings for small and midsize Brazilian companies have hit record highs, and it is difficult to see how this will come down. Note that the NPA ratio of Brazilian banks as of H1 stood at 3.2%, but this is expected to increase to levels closer to 4% by the end of the year. With a worsening asset quality position, we expect banks to tighten lending standards, which will inevitably reduce the pace of loan growth. Over the last few months, credit growth has been trending at a pace of 14% on average, but this is expected to dip to 9-10% by the end of the year. When these banks can't grow their asset base relative to historical standards, this could make the Price to Book Value multiples look unappealing. CEIC Closing Thoughts - Valuation and Technical Commentary As noted previously, we don't feel as though EWZ should be the preferred vehicle to play Brazilian equities, and there are also some concerns with the interest rate conditions there, but if you're looking for silver linings, we'd point you to the valuation and technical sub-plots. As a mean-reversion candidate within the emerging market universe, EWZ comes across as finely positioned as its current relative strength ratio versus its EM peers is now at levels from where we've traditionally seen a bounce. Crucially, the current ratio is 23% off its long-term mean and offers scope to normalize. YCharts EWZ's mean-reversion case is bolstered further by its compelling valuation and earnings trade-off. Note that EWZ's holdings are poised to deliver healthy long-term earnings growth of 13% which is roughly only 100bps lower than the earnings potential of emerging markets. Yet, EWZ's holdings can be picked up at a weighted average P/E of less than 8x, which translates to a 37% discount versus the corresponding multiple of EMs. Morningstar Meanwhile, also take a look at EWZ's monthly chart below, which shows how the price is now not too far away from revisiting a range where traditionally we've seen signs of bottom formation.  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