Six Ways to Profit as Brazil's Economy Takes Off

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In many ways, Brazil offers some of the best prospects among emerging markets and deserves to be a core holding in any international portfolio.

Brazil's economy had only a shallow recession and is now recovering nicely. Its market has been one of the best performing since Dec. 31, 2008, and both inflation and the budget deficit remain under control.

Yet one can be only moderately bullish – and I'll explain why.

If you rely on the numbers, Brazil appears to be in fine shape. Its gross domestic product (GDP) declined by just 0.3% in 2009, and is expected to rise by 5.8% in 2010. Its balance of payments deficit is less than 2% of GDP and its budget deficit, at less than 4% of GDP, is very moderate. Inflation is also moderate at 4.6%, and short-term interest rates at 8.5% are high enough to keep the inflation under control.

What's more Brazil is about to start benefiting from a gigantic oil find, the huge new Tupi oil fields, where oil was confirmed in 2007. These are located below heavy salt beds in deep offshore water, up to 7,000 meters down, much further than had been possible to drill until recently. These enormous discoveries appear to contain at least 60 billion barrels of oil, worth $4 trillion at today's prices. They are expected to come on stream starting in 2012 and will revolutionize Brazil's economy and its balance of payments.

While Brazil's stock market has zoomed up in the last year, it is currently selling at only 16.6 times earnings, well below its counterparts in both India and China and a reasonable valuation, given the growth prospects.

Unfortunately, there's an election late this year. While incumbent President Luis Inacio "Lula" da Silva can't run again, he wants to pass his power on to his party's nominee -former Chief Minister Dilma Rousseff. Rousseff was put in charge of devising a scheme to capture more of the Tupi oil revenue for the Brazilian government and, nominally, the Brazilian people.

A new state oil company, Petrosal, will be created to manage the new reserves.  Petroleo de Brasileiro SA (NYSE ADR: PBR), also known as Petrobras, will carry out production, with outside investors helping to supply the capital. Output will be shared between the investors and Petrosal. Petrosal will have half the votes on the operating consortium and veto rights over production and capital expenditures.  A new state fund will be set up to manage the revenue, which will be devoted to poverty relief, education and infrastructure.

Meanwhile, the current royalty system would remain, so that outside investors would pay both royalties and a production share. As one concession to reality, the concessions already granted would not be torn up.

There are two major problems with this system. First, it makes life much more difficult and less profitable for oil companies wanting to invest in the Tupi fields. Second, the oil revenue fund will be a huge pool of money for politicians to play with. Brazilian public spending is already 35% of GDP – a very high rate for such a poor country.

State bureaucrats have featherbedded contracts guaranteed to them under the 1988 constitution. So this slush fund will just fuel Brazilian corruption and divert yet more of the economy into the pockets of politicians, and to their friends and favored interest groups.

That makes Brazil dangerous from a long-term vantage point. If the state petroleum fund allows the already-outsized government to expand, Brazil will slip back to its 20th century state of forever being the "country of the future."

On the other hand, the petroleum fund could do enormous good if it is mostly channeled into tax cuts so that the state accounts for a smaller part of larger economy.

Six Ways to Play Brazil

We will know much more about Brazil's long-term prospects after the election, due in two rounds in October. In the meantime, rapid growth in China and India and expansive monetary policy in most of the developed world are causing a prolonged commodities boom, which can only be good for Brazil's economy.

So at least part of your international money should be invested here, despite the stated risks.

Brazil's prospects are simply too good to miss, even with the doubts attached. Here are what I believe to be the six best ways to capitalize on Brazil's promise, and the global trends that are feeding it:

  • The iShares MSCI Brazil Index (NYSE: EWZ) exchange-traded fund (ETF) is more than $9 billion in size, and is currently trading at a Price/Earnings (P/E) ratio of about 14. It has a dividend yield of 4%.
  • Fibria Celulose SA (NYSE ADR: FBR) is the result of a 2009 merger between Aracruz and Votorantim Celulose e Papel (VCP), a pulp-and-paper manufacture with capacity of 6 million tons of pulp. Pulp is one of the commodities not enjoying bull-market conditions right now, but the stock yields about 5% and has a prospective P/E of 20.
  • Itau Unibanco Banco Holding SA (NYSE ADR: ITUB) resulted from the merger of two large banks, Itau and Unibanco, and is now the largest bank in Brazil. It has a P/E ratio of 16 and dividend yield of 0.4%.  It's highly rated, but it deserves to be. The prospects for ITUB are considerably better than for U.S. banks, because Brazil's interest rates have dropped in the past year but are still well above inflation. That means lending can be expanded on a sound basis.
  • Petroleo de Brasileiro SA (NYSE ADR: PBR), or Petrobras, is one of the few emerging-market oil companies with access to modern technology and a willingness to work with Western oil majors. Trading at about 12.5 times 2009 earnings, with a 2.8% yield, there would appear to be room for some upside, given its long-term prospects.
  • Companhia de Saneamento Basico (NYSE ADR: SBS), or Sabesp, is a water-and-sewage system provider for Sao Paulo. Now that's a growth business, and is one that's not dependent on commodity prices or rapid Brazilian economic growth. It has a P/E ratio of just 5.5 and yields 5%. It looks like a bargain to me; it has growth almost built-in.
  • Vale SA (NYSE ADR: VALE) is one of the new world blue chips, with a market capitalization of almost $144 billion. It's the world's largest producer of iron ore and it has ancillary operations in gold, nickel, copper and other metals. Vale should benefit from Chinese iron ore re-pricing this month (the price in the Chinese market gets re-set annually, and was very low in 2009-10.) However, it may be a little rich at these levels. It is trading at 16 times projected 2010 earnings, with a 1.9% yield.

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  1. Ben Franklin | March 5, 2010

    Yes I believe in Brazil as having a newness to growth,or should I say freshness,and because of this could get excited themselves from growth more than USA,and put their chi force into it as a kind of Brazilian pride-like is shown at the national games,americas sence of pride and the USA has lost alot of freshness due to exporting Businesses and jobs to china,the moral in the USA is low and sluggish-selling America out is trending ever more daily,and this can only work against the morale of the people,ever how much it is-this factor is not present in Brazil,so they have a fresher Morale Ben

  2. Ben Franklin | March 5, 2010

    Brazil is fresh,lively and the morale is high,they should do well,and achieve some aspiration levels,we cant here Ben

  3. Tradermark | March 7, 2010

    BRF is a broader way to play Brazil

    its a more consumer driven ETF than EWZ

  4. Jacqueline Rocha | November 12, 2010

    come mai falam sempre que o Brasil va bem e vejo sempre tanta gente que imigram em outros paeses em cerca de trabalho,e eu sou uma desses milhoes de gente que imigraram . amo meu Brasil morro de saudades de tudo Familia tudo tudo mas tenho medo de tornar porque ai nao consigui um trabalho e eu tenho 44 anos hoje penso que com a minha idade hoje e agora pior nao encontrerei ninguem que de trabalho a 1 mulher de 44 anos e triste mas e a realidade

  5. Jacqueline Rocha | November 12, 2010

    come mai falam sempre que o Brasil va bem e vejo sempre tanta gente que imigram em outros paeses em cerca de trabalho,e eu sou uma desses milhoes de gente que imigraram . amo meu Brasil morro de saudades de tudo Familia tudo tudo mas tenho medo de tornar porque ai nao consigui um trabalho e eu tenho 44 anos hoje penso que com a minha idade hoje e agora pior nao encontrerei ninguem que de trabalho a 1 mulher de 44 anos e triste mas e a realidade sou em Italia da tantos anos morro de saudades do meu pais da minha familia……………….

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