Model Portfolio rmcduff:RMG1

What Great Global Recession of 2008?

The global economy in 2008 was NEVER as badly off as North American media portrayed it to be.

In 2008, global GDP increased by a respectable 3.8% over 2007. This data flies squarely in the face of those who were boldly tossing around the words "global depression".

It is true that mature cyclical economies such as Canada and the US showed GDP declines. However, it is equally true that China, Brazil and France either failed to receive notice of a global recession, or didn't experience anything more than a four month slowdown. Some of the preliminary data has already been revised for the better. I believe that it may ultimately be determined that neither Brazil nor France met the technical definition of economies in recession.

The statistics speak volumes. If the US, Canada and several other European countries (which in total account for about 35% of global output) showed a reduction in GDP, yet the global economy grew at such a solid rate, it stands to reason that the MAJORITY of countries posted positive GDP growth in 2008.

"Harrumph" goes the naysayers. "Of course China was in a recession". Their economy slowed from 13% GDP growth in 2008, to what looks to be just 9% this year. For China, that is a recession".

No. Calling China's 9% forecast rate of GDP growth in 2009 recessionary, is analogous to saying that Lance Armstrong, holding a commanding a 1 hour lead over all other riders in a Tour de France, and slowing down for a couple of minutes to battle some headwinds, is now going to lose the race. The headwinds also affect the peloton, not just Mr. Armstrong. He's likely still going to win the race by a landslide.

As the media becomes aware of the magnitude of their gaffe, the hyperbole is diminishing.

Now, rather than calling the reduction in global economic growth a "depression", the mass media has softened their tone. Now, it is just "the worst recession since the 1930's".

No. The 1980 recession made this slowdown seem like a cakewalk. Unemployment in the US peaked at 10.8%. US unemployment rates are a full 10% below that recorded level. This is by no means the worst recession since the 1930`s. It is not even close.

"Harrumph" goes the naysayers. "The unemployment rate is likely to rise, and will surpass that peak. Therefore, things are going to get worse".

Unlikely. Unemployment is a lagging indicator. And, North Americans are fixated upon US statistics, which accounts for just 20% of the global economy. Employment growth tracks GDP growth. As global growth was highly satisfactory in 2008, there is ample inferential evidence to suggest that globally, employment rose. Evidence is now starting to pile up which confirms the long held view of this author; the recession was primarily driven by a cyclical slowdown in the US. It spilled over into countries that derive significant trade with the US. The recession was neither global, nor was it severe. Regretfully, media, being concentrated in the US, took what was happening on a local basis, and reached an incorrect conclusion.

If there was NO global recession, the harrumphers proclaim, why did global equities fall lockstep with US equities?

Equity values will fall for a variety of reasons. One key reason was that the global growth rate abated. Equities do represent a call on future profit growth. A more slowly growing global economy inevitably results in a reduction of future expectations.

Equities on a global basis corrected, to reflect the reality that global GDP was no longer growing at 5.1% from 2007 and dropped to 3.8% in 2008.

In any event, a meaningful cyclical turnaround may soon be underway in North America. If true, it will be driven by consumer spending, based upon more disposable income due to lower commodity prices. While oil prices have recently increased, natural gas prices have continued to fall in 2008, which has helped reduce costs for both homeowners and manufacturers alike.

While the media remains fixated upon extricating themselves from an intransigent position, THE important macro story of 2008 was the ascension of Brazil into the world's economic elite.

In 2008, Brazilian GDP leapfrogged over Canada, and became the world's 10thth largest economy. Based upon reported growth rates in the first half of 2009, Brazil has since overtaken Spain, and now stands at 9th place globally. I believe that the Brazilian economy appears poised to overtake Russia in 2010. The economies of Italy and the UK could be smaller than Brazil by 2015. In 2020, I predict that Brazil may be the 5th largest on the planet.

Brazil is lumped into the BRIC (Brazil, Russia, India and China) group of emerging markets, and is therefore a bit more noteworthy than before. Goldman Sachs came up with the moniker. Nevertheless, despite the name recognition, North American investors still don't appear to have anything other than a passing interest in Brazil.

It is my opinion that inclusion into the group known as BRIC has actually HURT the image of Brazil with investors. Being lumped into a category of countries plagued by financial scandals, partial foreign exchange controls, bureaucratic governments, high levels of protectionism and kleptocratic businessmen (Russia and India); does little to enhance the status of Brazil.

This is moderately left of center, pro business country. It features low corporate taxes, a better national balance sheet than 9 of the top 10 economies globally and a superb macro outlook. My views are considerably more optimistic than consensus. When I work through Brazil's economy and prospects, I see a nation featuring China's growth potential, but without China's problematic lack of strategic natural resources.

The Brazilian economy has surprising parallels to Canada. Both nations have core competencies in agricultural output, automobiles and aerospace. However, rather than viewing Canada as a peer, I consider Brazil to be one of Canada's main competitors on the global stage. Key structural advantages, such as a motivated low cost workforce, lower corporate taxes and complete control over almost all aspects of the supply chain, have allowed Brazil's economy to dominate Canada in key industries. The proof is in the pudding. Canada's industrial output fell by about 1% in 2008, while Brazil's grew by 4%. In value added areas such as commercial passenger jet production, Canada fights with Brazil repeatedly. Several times in the past decade, Canada has filed trade disputes, claiming that Brazil exports goods globally at prices below that of Canadian exporters. Upon careful reflection, the WTO (World Trade Organization) generally indicates that Brazil is simply the lower cost producer. If you can read into the nature of the complaints, cries of foul play are actually a sort of offhanded compliment, in support of the Brazilian business model.

With only 2% of Brazilian GDP coming about via exports to the US, there appears to be limited economic correlation between Brazil and North America.

I consider Brazil to be the most balanced economy among the global top 10. The nation has a fast growing consumer market to sop up increasing industrial output. This might provide portfolio managers with some potential for a natural hedge, in an increasingly globally correlated marketplace. When I think of Brazil, I see the South American equivalent of Canada, minus Canada's uncomfortably high dependence upon the US for exports.

Canada generated approximately 29.3% of its GDP, or $459.1 billion US, through exports to foreign markets in 2008. Of this amount, a whopping 77.7%, or $356 billion, was exported to the US. US exports directly account for 22.8% of Canadian GDP. Canada has negligible export business with China. Brazil, on the other hand, reports that China is poised to overtake the US, as their largest trading partner and export market, by 2010.

Despite a strong economic showing for the better part of a decade, and accompanying equity buoyancy, I still consider Brazil to be relatively undervalued for investors.

The proof comes from a simple comparison of GDP to stock market valuations.

In 2008, Brazil's GDP was $1.67 trillion US, or roughly 2.4% of global GDP. In contrast, the market value of all Brazilian publicly traded shares was just $1.37 trillion, or 2% of the aggregate market value of global equities, at year end 2008.

In 2008, Canada's GDP was $1.56 trillion US, or 2.2% of global GDP. The aggregate market value of all publicly traded Canadian shares was $2.2 trillion, or 3.3% of the aggregate market value of global equities, at year end 2008.

In simplistic terms, the Brazilian economy is 7% larger than that of Canada. However, Brazil's stock market is just 62% the value of Canada's. I believe that in the years to come, this gap will diminish, and potentially reverse.

Brazilian equity undervaluation appears even more pronounced when the impact of foreign manager "herding" is considered.

At the end of 2008, 10 of the 439 publicly traded stocks on the Brazilian stock exchange accounted for more than half of the country's total public capitalization. Those who prefer to invest passively in Brazil, via ETF's, index products or mutual funds might find that various package offerings are largely identical. Most packages seem to feature the same ten large cap stocks, just in different weightings.

Ex these institutionally driven holdings, the average market cap for the remaining 429 companies was $1.58 billion US. Brazil is a now large cap economy, primarily run by companies selling for small cap valuations. Veritable cornucopias of intriguing companies exist, outside of the tightly clustered investment coverage herd.

Critics point out that Brazil has low GDP per capita, and that the consumer market is in its infancy.

I respond by indicating that the absolute size of the Brazilian middle class is larger than that of Canada. Brazil's economy in the past twenty four months has expanded by $139 billion. The magnitude of growth is such, that many companies appear well positioned to increase revenues significantly, without fighting each other for market share.

In contrast, Canadian GDP has grown by an anaemic .8% per annum for the past two years. This was about $20 billion of net increase. In such a weak economy, business must be wrestled away from competitors to gain market share. Absent a US led recovery, Canada's domestic economy appears to be very much a zero sum gain market.

Bears are quick to note that the Brazilian economic miracle needs to be tempered against an inflationary backdrop.

They report that Brazil's inflation rates are higher than that of Canada, and imply that Canada is therefore a safer place to invest. In reality, investors in Brazil have had far better success, adjusted for inflation, than have Canadians. Canadian GDP growth has LAGGED inflation by approximately 1.7% per year since 2007. In contrast, Brazil's inflation was only .3% higher than GDP growth for the same interval.

While inflation bears throw up a fearful talking point, their objections fail to pass even cursory scrutiny. Both countries are commodity exporters. A mild dose of inflation has helped their economies in the past, at the expense of import oriented nations. Brazilians and Canadians alike would prefer a global economy with rising input costs.

Finally, certain investors point out that the Brazilian equity market is dominated by just a handful of publicly traded companies. The worry about the marketplace effects, should just a couple of the top ten firms disappoint, on an earnings front.

This is valid, but becomes less worrisome providing that economic growth continues. I acknowledge the risk by seeking to hold an appropriate portfolio weight in Brazil. As the Brazilian economy is 2.4% of the global economy, and is growing 40% faster than the planet as a whole, I'm currently comfortable with about 3.5%-4% of my entire account allocated in Brazilian equities.

The macro case for Brazil might be augmented in the next decade, through the development of substantial offshore oil resources.

Petrobras, the largest oil company in Brazil, forecasts that oil output in Brazil will grow from 2.2 million bpd, to as much as 5.7 million bpd, by 2020. At $70 oil, and factoring in a multiplier of 2, oil development alone may add 2.5% to annual Brazilian GDP growth, for an entire decade. Output from the massive Tupi fields should initially commence at the end of 2010.

I consider the long term outlook for Brazilian equities to be very appealing.

And, I always put my money where my mouth is. Today, I complete the building of a portfolio position in Compania Brasileira de Distribucio (CBD-NYSE, $53.41). CBD is my choice to potentially benefit from rising consumer incomes in Brazil.

This is the largest grocery and general goods retailer in Brazil, holding about 13.2% of the entire Brazilian food market. The company operates both conventional grocery stores as well as the popular hyper mart formats. Half of CBD's 2008 revenue came from hyper marts, and the company increased its total number of hyper mart stores by 12% vs. 2007.

CBD's 2008 revenues were $9.62 billion US and EBITDA was $538 million. With a very recent acquisition of a white goods retailer, valued in the purchase at 5.6X 2008 EBITDA, 2009 revenues could touch $12 billion US. EBITDA could reach $780 million US.

The firm operates 1279 stores in Brazil. In the first half of 2009, sales were up 10.7%. Of particular interest, the revenue growth rate accelerated in Q2, which should have been the global trough in retailing. EBITDA was up 15.7% year over year. EBITDA margins (a key measure of operating profits) were 6.9% in the first half of the year. US and Canadian food retailers are generally pleased with margins half that level, and get absolutely ecstatic when margins surpass 5%. With $4.1 billion of total liabilities (I am more stringent in my definition than the street), and $6.1 billion of market cap, CBD has an enterprise value of $10.2 billion. This prices the company at roughly 13.2X my 2009 estimated EV/EBITDA ratio.

CBD only recently broke through the $5 billion market cap, which justifies inclusion into large cap accounts. In light of global market volatility, CBD's movement into the new cap weight may have slipped by the screens of some institutional managers.

Collectively, the top 3 food retailers, CBD (#1), Carrefour (#2), and Wal-Mart (#3) account for about 39% of the total Brazilian market. The next largest 2 food retailers account for less than 3% of the market. The top 3 firms appear to have organic growth potential, without having to continually embark upon food price wars experienced in the US and Canada. CBD has continued to maintain its fair share of the food market, despite a decade of competition with Wal-Mart.

I believe that a major improvement in the Brazilian economy will commence in 2011.

Individual investors are always on the hunt for future 10 baggers. This search becomes easier when powerful secular drivers exist. My forecast is that the Brazilian economy will soon have such tailwinds.

Initial revenues from new offshore oil production will start to trickle down to the consumer economy around 2011. Until then, the domestic economy of Brazil will show normalized levels of economic growth, plus a modest capital expenditure multiplier based upon the field development.

Tupi oil revenues, and the attendant economic multipliers, have yet to be felt by national economy. If oil prices remain at current levels, forecast rising output from Tupi could dramatically accelerate Brazil's growth rates.

As the largest retailer in the country, CBD is poised to obtain the lion's share of rising consumer incomes in Brazil. If the nation can produce 5% annual GDP growth rates through 2020, and if CBD can maintain its present market share of the food market, total revenues at CBD could increase from my forecast of $12 billion in 2009, to as much as $36 billion by 2020, a potential revenue increase of 300%. Such top line growth could produce EBITDA growth in the range of 500%.

Bears will respond with a hearty guffaw, at the thought of 5% annual GDP growth for a decade. If offshore oil output meets projections, I on the other hand, consider this very achievable.

I believe that that CBD's premium valuation, when compared to largest food retailers in Canada and the US, is fully warranted by the Brazilian retailer's superior top and bottom line growth rates. CBD has a balance sheet that is at least as strong as North American peers. CBD currently sells for a 41% premium to Wal-Mart (WMT-NYSE, $51.68). It also sells for a 49% premium to the largest retailer in Canada, Loblaws (L-TO, $32.86 Can). However, I scooped up shares on the cheap, during a time of investor distress. On April 24th 2009, RMG#1 initiated a position in CBD at a price of $31.31 per share. The portfolio averaged up throughout the period ending September 16th 2009, and now has a blended average cost base of $41.66 per share.

The blended average cost for RMG#1 is 10.1X my estimated EV/EBITDA ratio for CBD. This is a far more reasonable premium to Wal-Mart and Loblaws; in the range of 13% and 16% respectively.

I believe that that CBD deserves a valuation that is superior to the largest food retailers in Canada and the US, based upon top and bottom line growth rates. CBD has a balance sheet that is at least as strong as North American peers.

There are some great secular themes, crying out for investor participation, across the globe. Some, like growth in China, are well understood. Others, like the growth of Brazil, still appear to be overlooked. It is my opinion that Brazil is on the verge of larger scale investor acceptance. In addition to having purchased more shares of CBD for the large cap RMG#1 portfolio last week, I have purchased more shares personally.