How and Why Investors Should Tap Resource-Rich Brazil

Editor’s Note: Unlike many emerging economies, Brazil is becoming an investor’s hotspot because of its rising middle class and wealth of soft commodities. A special report jointly developed by U.K. affiliate MoneyWeek Magazine and our experts here at Money Morning explores the factors fueling Brazil’s long-term potential. For more information on MoneyWeek, please click here.

Several years ago, investment bank Goldman Sachs Group Inc. (GS) devised the new idea that four big countries – Brazil, Russia, India and China – would together soon become so important to the global economy that they could be viewed as a single, cohesive market – much as we think of Europe or Latin America as being a single economic entity.

Goldman Sach’s marketing minds dubbed the member countries as “The BRICS” [pronounced “bricks”], an acronym comprised of the first letters of each country’s name. And the investment-banking giant boldly predicted that this economic bloc would grow in both importance and magnitude. Now just 15% the size of the world’s six most advanced economies [including the United States and Japan], Goldman predicted that the BRICS would grow to become even larger than the six leaders in no fewer than four decades.

The obvious conclusion was that long-term investors should focus on the BRICs. And Goldman’s logic was sound.

Global Demand

“Chindia” is developing a gargantuan appetite for the natural resources – energy, metals and foodstuffs – that it needs from the rest of the world.

Brazil and Russia, by contrast, are among the handful of countries best situated to supply those increasingly valuable natural resources [For a related article on Russia’s global growth aspirations in today’s issue of Money Morning, please click here].
Russia is a huge exporter of oil and natural gas, nickel and platinum-group metals. Brazil is the world’s biggest supplier of such internationally-traded agricultural products as sugar, soybeans, coffee, corn, orange juice, beef and poultry.

Both still have enormous resources that can be developed to meet Asia’s growing demands.

And neither faces shortages of energy, food or water.

The Case For Brazil

Last year Brazil’s main stock market index rose 71% – even faster than India’s – suggesting that international investors are awakening to the potential of the South American giant.

Much of that interest was focused on Brazil’s two biggest stocks – Vale (RIO) and Petrobras S.A. (PZE). Vale is the world’s biggest exporter of iron ore; Petrobras has just made the world’s second-largest oil/gas discovery in 20 years, deep beneath the waters fo the Atlantic Ocean.

But it’s renewable resources, not minerals, that are increasingly attracting investor interest.

Brazil has two things much of the rest of the world is lacking – a plentiful supply of fertile land and a huge amount of fresh water, thanks largely to the Amazon basin. These factors have combined to make Brazil the world’s largest supplier of a huge range of soft commodities – from sugar and coffee, to beef and chicken

Jim Slater, the well-known British investor, says Brazil is “insulated against the world’s main shortages – fresh water, agricultural commodities and energy.” And he should know: After making a fortune in the mining, base metals and minerals “super-cycle,” Slater is now targeting agri-business as the next big global profit opportunity.

Brazil contains nearly one-fifth of the world’s fresh water, available to expand agricultural production and carbon-free electricity generation. Hydropower already provides 80% of the country’s electricity needs, and two big new dams are being built on the Amazon River at a cost of $10 billion.

Because Brazil is able to produce alcohol fuel from sugarcane, without subsidies, for prices competitive with petrol, the country has been dubbed “the Saudi-Arabia of ethanol.”

“No country is better-positioned to benefit from the agricultural boom than Brazil, with its large and fertile land mass, absence of any desertification, and ample supply of fresh water,” said David Fuller, a London-based analyst.

Other commentators point to the nation’s economic growth rate [around 5% a year], a foreign trade surplus [running at about $40 billion a year], large foreign reserves, a strong currency and a buoyant stock market as key points of attraction for potential investors.

Last year Brazil attracted $37 billion in foreign direct investment in factories and business operations – twice as much as India. It ranked third in the world in terms of the amount of investment capital raised via equity issues, outpaced only by the United States and China. And its international bonds are expected to be granted investment-grade status within two years.

Brazil has a flourishing middle class of 20 million – as much as five times bigger than India’s … depending how you define “middle class” – as well as political stability, a favorable environment for foreign investment, and an economy that’s a strong jobs-creation machine [5 million new jobs since 2000].

The favorable international-business environment of the past few years – combined with sound government policies, disciplined finances and liberalized trade rules – has delivered low inflation and a general decline in market interest rates.

One result is the emergence from poverty of a new lower-middle class, so the nation’s notorious income inequality has been declining.

What are the negatives?

Despite the gains the government has made, problems remain. The public sector is bloated and corrupt, packed with jobs-for-life bureaucrats who have fat pensions to dream about upon retirement.

The taxes that underwrite this waste gobble up about a third of the national output – a proportion much higher than in other emerging markets and out of proportion to the low quality of services provided.

Brazil  also has some serious infrastructure problems, including power-supply shortages. The regulatory environment is not sufficiently clear to attract private investment.

Labor laws are highly restrictive, with welfare and other compulsory contributions adding 60% to 100% to employers’ payrolls.

The stock market is very sensitive to flows of foreign capital, therefore exposed to adverse money shifts that may be triggered by developments unconnected with conditions in Brazil itself, such as the U.S. subprime crisis.

Finally, remember that although Goldman Sachs Group’s BRIC study projected good per capita growth rates for the Brazilian economy over the coming decades, it suggested the three other nations in the group would grow even faster.

How to Invest in Brazil’s Strengths

Just as China is the dominant economy in Asia, Brazil is the dominating force in South America. But that doesn’t mean it’s alone, nor does it mean the country is the sole source/beneficiary of the continient’s economic growth. 

So investors who want to invest in Brazil should equally consider investing in South America as a whole.

As with any investment, research is necessary to sidestep potential pitfalls. Money Morning Contributing Editor Horacio R. Marquez, an emerging-markets specialist and Argentine native, highlighted three catalysts of Latin America’s economic growth:

  1. The price of commodities/global growth: Continued growth in China, India and other emerging markets can only further stoke the already-high demand for commodities. For example, China’s consumption of iron ore is one of the top reasons why the share price of Vale more than doubled last year.
  1. The "second wave" of profits: This refers to the countries’ ability to keep driving their economies by increasing the size of their own consumer markets, and then building demand among those consumers.
  1. The health of the U.S. economy: If anything tugs at South America’s growth, it’s the region’s economic ties with its trading partners, especially the United States. It wasn’t a coincidence that when the U.S. greenback declined last year, the Brazilian real dropped in virtual lockstep. A wild card here is how the subprime fallout plays out in Europe, another key sales destination for South American exports. 

Investors can dodge this potential trap by avoiding currency trades, and eschewing the shares of Latin American companies whose primary customer is the United States.
Instead, investors should focus on Latin America’s wealth of commodities [which are in demand in nearly every world market], and companies that profit from the region’s growing middle class.
Here’s a breakdown of the continent’s strongest sectors, as well as their potential profit plays:

  • Energy: Latin America’s appetite for energy is nothing short of ravenous. As of now, three-fourths of the country’s electricity comes from hydroelectric power. That figure will be higher in 2012, when the region’s largest hydroelectric project, the Santo Antonio Dam, will begin producing electricity. Santo Antonio is the first of three Amazon River dams the government hopes will decrease Brazil’s need for fossil fuels. Until then, however, Brazil’s state-controlled oil-and-gas company, Petroleo Brasilero SA (PBR) will continue to meet the demand.
  • Food/Retail: As South America’s population and middle class expand inland from its coastal metropolises, the food and retail sectors are some of the first to profit. One company that’s been profiting from this population-and-development trend is the Companhia de Bebidas das Americas, also known as AmBev (ABV), a $45 billion Brazil-based beverage powerhouse that produces, sells and distributes beer, draft beer, malt, soft drinks, sport drinks, iced tea and water throughout Latin American and the Caribbean. Similar, though smaller, the Companhia Brasileira De Distribuicao (CBD) is a food retailer with more than 550 supermarkets, home appliance stores and convenience stores throughout Brazil.
  • Mining: South America is stuffed with metals. And with commodity prices soaring, this is a good market to be in. As mentioned earlier, Vale is making a killing feeding China’s appetite for iron ore. It’s the second-largest mining company in the world, and the largest producer of iron ore and nickel. The Phoenix, Ariz.-based mining giant Southern Copper Corp. (PCU) heavily taps South America’s rich copper mines. Though based in the United States, this company has all of its mining, refining and smelting operations in Mexico and Peru. With this stock, however, investors are subject to the volatility of the U.S. market, which doesn’t look very promising in the first half of the year.
  • Banking/Real Estate: According to Money Morning’s Marquez, "when the [Brazilian] economy expands, [banks] do fantastically well." And the same goes for real estate. Some of the first banks to profit from the growth of the middle class are Banco Bradesco SA (BBD), Uniao de Bancos Brasileiros SA (UBB) - also known as Unibanco - and Banco Itau Holding Financeira SA (ITU). "Buy them and go to sleep," Money Morning’s Marquez said.  But white-knuckle speculators may want to roll the dice on Gafisa SA (GFA), a homebuilder based in Sao Paulo, Brazil.
  • ETFs: Investors who are wary of investing directly in foreign companies have a few exchange-traded funds to choose from. The iShares Standard & Poor’s Latin America 40 Index (ILF), which tracks highly liquid securities in Mexico, Brazil, Argentina and Chile, ended 2007 with a 44% gain. There’s also iShares MSCI Brazil Index Fund (EWZ), a capitalization-weighted index that aims to capture 85% of the total market capitalization in Brazil. It invests in a sample of securities and is reviewed quarterly. Last year, it gained a healthy 72%.

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