Description

If you look at my history, I have done my share of VIC recommendations with a lot of numbers and accounting analysis.  This will not be one of those, though it has plenty of numbers for you to analyze.  What I am going to present here is mainly qualitative, an idea that I own significantly that I hope piques your interest to want to learn more about.

If you follow Berkshire as we all do, you are certainly familiar by now with Warren Buffett’s favorite deal partner Jorge Paulo Lemann, Brazil’s wealthiest man.  I don’t think we have heard the last of their partnership deals.  Cristiane Correa’s book Dream Big is a must read to understand this investment idea or just to understand a unique and very provocative business culture.  The Garantia culture, now known through the GGG partnership’s acquisitions of Budweiser, Heinz, Burger King and now Kraft, is not a place I would like to work, but if I could invest with them side-by-side that would seem very interesting.

There is an investment which is run under this business model where you can invest side-by-side on essentially the same terms.  BTG Pactual is the largest Latin American investment bank, #1 on Brazil’s league tables in just about everything from M&A to equity underwriting and asset management.  Let me emphasize, BTG Pactual is not GGG, it is not Budweiser or Heinz-Kraft.  The relationship is that these are all diaspora of the Garantia culture – call it a “Lemann cub” if you will. 

Everybody hated Brazil before the election last October and the market and currency have been a bad place to be even since then.  Now more than everybody seems to hate Brazil.  Brazil if you recall – it has been a while – was the B in BRICs and even just two years ago was the focus of catalysts from building for the World Cup and the Olympics. 

In the last two years we have seen growth slow from expectations of mid single digits to a recession now.  The run-up to the World Cup produced protests and failure in promised infrastructure investment.  In the World Cup itself Brazil suffered one of the great humiliations in the history of the event.  Then we had an election in October where the incumbent despised by the business community and international investors was re-elected in a close race.  Since then the market went to new lows, the biggest oil company flirted with insolvency, and the country is now seen as a political basket case.  Any of you complaining about not finding any cheap stocks should spend a little time poking around Brazil (though be warned – don’t believe any ratio you find by a screen).  It is the seventh largest economy in the world.

So we have a market near 10 year lows (in U.S. dollars) that everybody hates, and we can buy the country’s largest investment bank and invest alongside the Garantia partnership culture.  Sounds a little bit interesting, no?

Let me cover some history here briefly.  BTG Pactual is not run by Jorge Paulo Lemann nor GGG.  In the 1980s, Luiz Cezar Fernandes, one of Lemann’s original partners, defected from Garantia and founded a new bank called Pactual.  By 2006 it was the largest investment bank in Brazil and Brazil was the B in BRICs.  So what did they do?  What any good value investor would have done.  Cashed out.  Management sold to UBS for $3.1 billion.  Nice.

A few years later, the same team defected from UBS and put the band back together, starting a new bank called BTG (thought to mean “back to the game” or possibly “better than Goldman”).   In 2009, UBS kinda needed cash more than they needed Brazil, so Brazilian management bought back Pactual for less than they had gotten for it three years before.  These guys are opportunistic to say the least.

This is not your Chuck Prince when the music’s playing you’ve gotta dance culture.

Let me describe how you get rich under the BTG culture, which management proudly describes as a meritocracy. 

1) get hired as a young, inexperienced, bright and very hungry individual;

2) work your ass off to become a partner with the opportunity to accumulate stock at book value;

3) Zero based budgeting – cost control is a religion

4) buy equity at book value from retiring partners – that’s the key to Lemann’s economic model – a partnership culture where new partners have the opportunity to buy at book value and retiring or fired partners must sell to them at book value;  

5) Continue working your ass off.

6) Compound the hell out of book value.  Growth and high return on capital is essential to this business model working.

If you have read Dream Big or followed Jorge Lemann’s career, you will know that this model has worked for them for decades.  Kids don’t try this at home, but it seems to really work when adopted fully by a certain type of person.  It seems to really work for BTG Pactual.

What is absent from the history of this seemingly high-risk culture is things going broke, and we are talking more than a few decades in a country now considered very high risk – interest rates in Brazil are over 10%.

Brazil had a big bankruptcy in 2013, but that was not these guys.  Mr. Batista was Brazil’s Bernie Ebbers/Jeff Skilling – every hot market has one of those and they crash and burn.  This guy named every one of his companies ending in X to signify compounding.  That is not the Garantia style – they have much more class than that.  BTG’s exposure to this huge bankruptcy was minimal.

Likewise, if there was a body to float to the surface from the recent scare in Petrobras we would know it by now.  BTG had little exposure there either.

While you’re reading Dream Big, also read the last chapter of Michael Lewis’s The Big Short where he told us why investment banks in the U.S. are probably a heads I win kind of, tails I lose big model.  BTG partners - and I have had long conversations with several of them - have a different mindset.  They ARE the old partnership model Michael Lewis describes.  The individuals I met, one an up and coming late 30s investment banker and the other just below the CFO with the company for 17 years had one thing in common.  The vast majority of their net worth – north of 90% - is in the stock.  That is the core of the Lemann culture.  When these people retire at a relatively young age they will sell that stock at book value to new and hungry partners. 

A partner has every financial incentive imaginable to do two things until then.  Compound book value and absolutely not go broke.  There are things you will not do if you are smart and you have 95% of your net worth in the equity of your employer.  Chuck Prince and Dick Fuld are still rich.  They would not be under this model.  Those I have met are fully aware of that risk.  For this to go broke these guys would have to be dumb, and they’re not dumb.     

This is a beast you have to feed.  The business model requires growth, which is achieved both organically and with aggressive acquisitions.  Over the last several years BTG Pactual has been expanding organically throughout Latin America, becoming a regional powerhouse.  On the acquisition front, last summer they announced the acquisition of BSI, a Swiss private bank.  On the surface it is hard to see how this acquisition adds value, but with an understanding of BTG’s culture it is quite easy.  As the U.S. food industry has discovered, the Brazilians like to buy bloated cost structures.  They didn’t buy Budweiser or Heinz because they thought they were run well, they bought them because they saw a huge amount of costs to eliminate.  It would not take a leap of faith to think that a Swiss private bank might not be the leanest organization on the face of the earth.  BSI has been described to me by a source outside of BTG as an organization with 17 layers of vice presidents.  I suspect BSI is not going to know what hit them and this deal will wind up not only being highly accretive, but also being the platform for future acquisitions.

I am presenting this as an interesting qualitative idea to do your own financial work on.  I have owned it for over a year now, and gutted out the last two quarters when Brazil was in trouble.  Pactual seems to have skated through this with minimal damage.  Earnings are down this year, and are of lower quality (they realized some “cookie jar” investment gains from private equity investments – though that certainly does count for growth in book value which is the long-term goal here), but the bank didn’t come remotely close to blowing up.  The fourth and first quarter while Brazil was going through catharsis were a big test.

The way I look at valuation is that in 2013 they earned 3.07 and in 2014 they earned 3.77, both high teens return on equity.  Book value is 21 a share.  At 31 I am paying about 1.5x book value and a single digit earnings multiple for a business compounding in the high teens with the culture I described above.  I think the odds in my favor.

[The views expressed are those of the author and do not necessarily represent the views of any other person. The information herein is obtained from public sources believed to be accurate, reliable and current as of the date of writing.  The author will not undertake to supplement, update or revise such information at a later date.  The author may hold a position in the securities discussed.]

Catalyst

Investor perception of Brazil improves

Long-term compounding of book value per share

Visibility on BSI acquisition integration