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.

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come mai falam sempre que o Brasil va bem e vejo sempre tanta gente que imigram …

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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About the Author

Martin Hutchinson is the Global Investing Specialist for Money Map Press. A British-born investment banker with more than 30 years of experience, Martin has worked on both Wall Street and Fleet Street. He is now the editor of the Permanent Wealth Investor, where he focuses on "Alpha Bulldog" stocks that pay high dividends covered by earnings. In his Merchant Banker Alert, Martin uncovers the fastest-growing companies in the fastest-growing economies and brings those ideas back home to you. For more information about these services, call our VIP Services group at 855.509.6600 or 410.622.3004.

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