Though the current context remains uncertain, one positive development is the recent progress of the vaccine rollout in many countries (mainly developed economies). That is why—in conjunction with extensive monetary and fiscal stimulus measures—global equities have managed to capture the majority of investment flows so far this year. In other words, in anticipation of a strong economic recovery, investors are abandoning monetary and government funds and turning to equities, hoping to capitalise on the improved corporate earnings prospects for the coming months. As such, we closed April with substantial positive returns in most equity markets worldwide.
Among Latin American equities, it is worth noting the commodities and energy sectors, which performed better in relative and absolute terms in 2020, in the last 12 months, and in the last semester. This is what investors have been looking for within Latin American equities, gaining exposure to these two sectors, which already account for 35% of the benchmark index (MSCI EM Latin America).
Our portfolio intentionally has no exposure to commodities or energy, because these are sectors where it is difficult to find companies capable of generating long-term value. This is the main reason that EDM Latin American Equity (R$ class) closed April with a return of -7.67% YTD, currently underperforming relative to the benchmark index, the MSCI EM Latin America (-3.11%).
As we have mentioned before, our approach is not based on companies that are overly dependent on macroeconomic factors, commodity prices, and sector trends; neither is it a choice between a “value” or “growth” style. At EDM, we remain focused on “micro”: we hone our investments by selecting interesting businesses that are financially sound, well managed, and attractive in terms of valuation. It is important not to be discouraged by today’s headwinds, but to continue looking to the future with optimism, since we believe there are countless opportunities in Latin America.
As an example, we would like to discuss Petz, which was recently added to EDM Latin American Equity. It is a leading seller of pet food and all necessary pet accessories in Brazil. It also offers pet-related services, such as grooming, veterinary consultations, kennels, adoption services, etc. Its brand positioning is very good.
It is a multi-channel (brick-and-mortar and online) and multi-format (through different establishments depending on location and demand), niche business in a market with room to continue growing organically in the future: the expected annualised rate over a five-year period is +17%. In this context, we estimate that its sales and EPS will grow +35% and +59%, respectively (also at a 5-yr. annualised rate). It is possible that the company will play a pivotal role in the future consolidation of the Brazilian market, which is highly fragmented, with the two largest companies accounting for only 10%.
Clearly, Petz is a company with high, stable margins (EBITDA margin at 18% and EBIT margin at 10%) that has resistant, predictable sales. Its management team has an excellent track record in business management strategy, giving Petz considerable financial strength and indicating that it is capable of funding its healthy growth with its own operating cash (net debt/EBITDA = 0.1x). Last but not least, it is a profitable business; we expect its ROCE to reach 14% in three years, much higher than the cost of capital, thus generating tremendous value.
Delving into an analysis of the portfolio’s main parameters, we continue to feel comfortable with the structure of EDM Latin American Equity. It currently consists of 25 companies, from which we expect to obtain an aggregate profit growth rate of +21.7% in 2021 and +22.4% in 2022, exceeding +18% in the next five years. Though it may seem high, it is in fact conservative and lower than what the consensus of market analysts expects. In addition, given the quality of its management and positioning in each market, it will emerge stronger from the crisis, gaining market share in its respective business segments.
For the portfolio as a whole, the return on equity (ROE) is 16.5%, which is much higher than the cost of equity (Ke) of the selected businesses. It is, therefore, a set of companies that generate value for shareholders.
Moreover, the net debt/EBITDA ratio is less than 1x. In other words, these are growing businesses that are both profitable and financially sound.
In terms of valuation, it is an interesting moment. The fund’s P/E ratio is 15.6x the expected earnings for 2021 and 12.8x those for 2022. Its P/EG ratio (the P/E ratio divided by the expected annual earnings growth rate at five years) stands at 0.86 and 0.70 for 2021 and 2022. We also estimate that its upside potential will remain attractive since, at current prices, the portfolio trades at approximately 25% below what we consider to be its fair valuation in terms of NPV (net present value). At current prices, we calculate an average annual IRR on investment of 15%, meaning the fund could double its capital in five years. And no less significant, the dividend yield could reach 3%.
Given the foregoing, we think that, in the medium and long term, EDM Latin American Equity will be able to capitalise on the value of the companies in the portfolio, which are clearly well managed and financially sound, in addition to having high growth prospects and currently trading below what we would consider “fair value” or “target value”, offering a sufficient safety margin for conservative investors.
Financial Analyst & Fund Manager – Partner