• Many frontier markets are trading on multi-year low valuations as their battered economies limp from wounds inflicted by the pandemic and lockdowns, political upheaval, and the ravages of high inflation. This is in stark contrast to large parts of developed capital markets which are expensive on typical measures

• Brazil embodies many of these challenges but is also showing some green shoots and tentative signs that more settled economic conditions will prevail in the medium-term

• In June we visited Latin America to investigate several capital cycles and grapple with a range of challenging governance issues; we engaged with 50 corporates – some we know well and others that are new to Hosking Partners

The weight of Latin America in the benchmark is 1% as of the end of Q2 2023, half what it was when Hosking Partners launched. Our exposure peaked at 2.9% in October 2016 and resides at 2.3% presently, and we have work ongoing to interrogate the merits of counter-cyclical investments to modestly increase our exposure to the region.

It is hard to imagine a more toxic cocktail of circumstances for emerging and developing economies (EMDEs) than those that followed the outbreak of Covid-19. Export demand dwindled as lockdowns took their toll and the total debt of EMDEs ballooned to a 50-year high as they struggled to simultaneously fund a paused economy and deal with a humanitarian catastrophe. All the while foreign capital took flight, leaving 2023 investment 8% lower than what the World Bank expected when cutting its forecasts back in the halcyon days of early 2020. (1) The inflation shock and associated increase in the foreign exchange value of the dollar that followed were like a match to a tinderbox and they have effectively left one in five EMDEs locked out of global debt markets versus one in fifteen in 2019. China’s lackluster economic rebound and the impacts of the Russo-Ukrainian War on food and energy availability and prices have, in general, added to the woes of frontier markets.

The outlook for EMDEs is intrinsically linked to the outlook for the global economy, and rarely are opinions so divided on what lies around the corner. Times like these are exciting because periods of uncertainty and ignorance have the potential to deliver high expected investment returns, not least because of an absence of competition from sophisticated, but conventional, investors. Associated mental models are the lifework of Professor Richard Zeckhauser, the Kennedy School’s Professor of Political Economy. Hosking Partners’ history with Richard stretches back to 2007 when Jeremy first attended his course and we have returned to school regularly ever since, with our next generation of multi-counsellors attending class late last year.

Our gaze has fallen on EMDEs specifically because the general level of uncertainty described above is compounded by idiosyncratic risks which have resulted in extremely low valuations. Brazil is a prime example, the Ibovespa is trading on a multiple of earnings last visited in the depths of the Great Financial Crisis. Richard terms such situations ‘unknown, unknowable and unique’ or ‘UUUs’ for short; it’s in these situations that some of the most impressive investment returns can be found. Many generalists shy away from UUUs in emerging markets because they fear local investors have an informational advantage that outweighs the valuation opportunity they perceive from their desk in London or New York. Of course, that can be true, but UUUs exist when the margin of safety is extremely wide. Richard puts it eloquently, ‘Do not engage in the heuristic reasoning that just because you do not know the risk, others do. Think carefully, and assess whether they are likely to know more than you. When the odds are extremely favorable, sometimes it pays to gamble on the unknown, even though there is some chance that people on the other side may know more than you.’ (2)

As expected, the set up in Brazil is intimidating for investors. The country has recently emerged from one of the closest elections in memory in which President Lula, having spent two years in prison, was victorious. Violent protests in Brasilia accompanied the departure of his predecessor President Bolsonaro. Lula has inherited a bruised economy. The Brazilian federal funds rate, the Selic, is at a multi-year high of 13.75%, significantly in advance of inflation which dropped to a three-year low of 3.2% in June (vs. 10.1% a year earlier). Commentators expect Governor Neto to cut rates at August’s central bank meeting but, as a Bolsonaro loyalist, elevated tension between him and Lula is a source of anxiety for many. Beholden to a center-right Congress and prisoner to one of the lowest approval ratings of any incoming President, Lula has positively surprised many local economists with fiscally responsible proposals (so far). We think there are other signs to suggest the future may hold more positive surprises for EMDEs in general. High real rates are cited as the driving force behind a rally in EM high-yield hard-currency bonds, long-awaited by local fixed-income investors (although there has been a dearth of issuance). A rally in local debt markets, never explainable by any one theory, is often a prelude to better performance in frontier equity markets, in our experience. Observations along these lines in Sri Lanka has prompted additions to our existing holdings (the largest being John Keells) as well as initial positions in several new ones including Tokyo Cement, which has appreciated over 100% year-to-date.

When an UUU is identified, the best use of an investor’s time is focusing on ‘the knowable’; the industries and companies that constitute the opportunity set. With that in mind in June Steve Chambers departed our new offices on Charles II Street for a month of travel through Mexico, Chile and Brazil (where most of the time was spent), engaging with 50 companies in total. The insights one takes in whilst in the field are – for reasons that are not entirely clear – immeasurably more valuable than what one derives through Zoom calls. Perhaps one explanation applicable to this trip is simply trust. Governance in Latin America is more complex than it is in more familiar markets; it was not long ago that most of Latin America was under some form of dictatorship and many companies are still in the grip of those families that benefited from the first wave of privatization (sometimes this is obvious on the shareholder register, sometimes it is not). Trust between these parties, the government of the day and minority investors is, unfortunately, often lacking, and interrelations are complex. Our meetings were a chance to get to the bottom of the relationship between the executive, controlling shareholders and the government, to work out the likely implications for capital allocation decisions. After all, at its heart the capital cycle approach is a window into the psychology of those allocating capital in industry.

Visits to our long-term investments in Petrobras and Cemex have prompted renewed enthusiasm, the former encapsulating the opportunity we perceive in both Brazil and oil (and the reflexivity between the two). Petrobras’ new (Lula-appointed) CEO, Jean Paul Prates, has signaled they will invest more in renewables than they have historically, and the dividend will be capped. This is a particular worry since Petrobras’ balance sheet has, at times, served as the government’s piggie bank. That said, he has given reassurances that capital expenditure will not rise above 15% of sales over 5 years. Funneling investment away from oil and into renewables has clear risks and, in addition, if Lula’s economic policies fail then parafiscal interventions, in the form of increased fuel subsidies for consumers, may follow. The shares were last this cheap on EV/sales (LTM) in 2002 (Lula’s first election) and have only been significantly cheaper, in the last 30 years, in 1995 (hyperinflation & devaluation). They will always trade at a ‘governance discount’ to oil producers in more reliable jurisdictions, but the margin of safety seems compelling in our view.

Brazil’s premium listing class, Novo Mercado, requires governance standards on a par with the best seen in developed markets. Amongst the requirements are a single share class and the abolition of shareholder voting agreements (so-called ‘one share one vote’), a minimum free float requirement of 25% and a minimum dividend payout ratio of 25%. The growing popularity of this class is a step in the right direction.

We initiated a new investment in a Novo Mercado-listed truck leasing company, Vamos. Founded (and 68% owned) by the Simoes family, who also founded car hire company Movida (which competes against Localiza, another holding in the Hosking Partners portfolio). They have used their scale to establish a national business with a 30% buying advantage, an economy of scale they share with customers to offer trucks and associated servicing at a price which significantly undercuts the total costs associated with owning and maintaining an equivalent vehicle. It is a young business and the runway for growth seems long; the key question for us is whether their scale and their first-mover advantage will prove sufficiently durable as capital inevitably attempts to muscle in and erode their returns. They have 80% share of an industry that represents just 1.5% of the trucking fleet in Brazil and expect to grow at a revenue CAGR of 35% between now and 2025. The business has derated substantially since its IPO in 2019 (symptomatic, we believe, of the macroeconomic backdrop) from 6.5x EV/sales to 3.5x despite managing a revenue CAGR of 46% over that period. Today’s valuation is at a significant discount to similar businesses that we know well.

Based on current plans the Hosking Partners team will have journeyed to six of the seven continents by the end of the year. In aggregate, we will meet and engage with hundreds of companies – both prospects and portfolio holdings – in our remit as global generalists. Jeremy and Chris will revisit Japan in the autumn, following a stop in Hong Kong where Omar will join for a busy week of meetings in another market that looks to be pricing in extremely pessimistic outcomes, as discussed in our article 'Three-Body Problem'. This sort of face-to-face engagement helps us get a tactile sense of how long-term, intangible issues are affecting capital cycles across our unconstrained investment universe.