Opinion – From Grain to Grain: Discover the factor that most explains the recent rise in the Ibovespa

Most argue that the strong appreciation in the last thirty days of the Ibovespa was explained by the expressive inflow of foreigners into Brazil. Undoubtedly, the buyer movement helps. However, it would be naive to think that the foreign investor is buying without any reason in view. I explain below which factor most explains the change in the Ibovespa level.

I carry out company valuation and teach about it for the last twenty years. I started working in this area in 2002 at a large national resource manager. At that time, I was responsible for analyzing and giving recommendations on the public service concessions sector.

I remember that at that time, there was a huge room where the balance sheets and income statements of companies were archived. We had to type everything into Excel. It is now much easier, as everything is digitized.

But let’s get back to the topic.

The evaluation of any business can be explained by four basic factors: revenue growth, margin evolution, the need for investments and, finally, the discount rate, which signals the risk of the business.

Considering these factors, a company should be worth more when growth and margins rise and when investment needs and interest rates fall, considering other parameters constant.

Obviously, these are not the only elements of an assessment, but they are the key factors.

Of these four factors, the discount rate was the one that most changed expectations in the last thirty days. To discount cash flows or dividends to present value, the long-term interest rate is used and not the Selic rate.

The graph above presents the Brazilian yield curve in three different periods. The top line in blue was the yield curve on July 19th. The green curve is for Friday and the orange curve for a week.

Note that long-term interest in Brazil was around 13.5% per year and dropped to 12% per year on August 19th.

We can build a simplified model. I assumed a hypothetical flow that grows at a rate of 8% per year for the next five years and then 6% per year in perpetuity. Therefore, 2% real growth, that is, above expected inflation.

This is a growth rate similar to that of GDP. I remind you that the usually publicized rate of GDP growth is a real growth rate, that is, above inflation.

The discount rate is composed of two elements: the risk-free rate extracted from the yield curves in the graph above and the risk premium for investing in the stock market. Usually, an average rate of 5% or 6% per year is used for this premium.

The figure above depicts this simplified model.

With this model and the interest rate in force for a month, the Ibovespa’s fair price is 98,500 points.

If we just change the interest rate to 12% per year like last Friday, the new Ibovespa fair value rises to 112,200 points.

At this point, I imagine that you ask me: Michael, where is the Ibovespa going now for me to position myself?

I answer you with a question: where do you believe the four factors I mentioned above will evolve in the coming months?

The answer to where the market is going lies in its perspective on the evolving assumptions of the four key factors I mentioned.

Michael Viriato is an investment advisor and founding partner of Investor’s House

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