New wealth from commodities is fueling growth and expanding the consumer economy. And that presents great opportunities for investors
by David Bogoslaw
businessweek.com
The Brazilian economy is barely recognizable to those who knew it more than five years ago. In those days it was plagued by mountains of debt and boom-and-bust cycles. Now everything is different. Indeed, 2008 is quickly shaping up to be the Year of Brazil.
The economy is ready to burst at the seams—but this time the growth looks sustainable. And foreign investors are taking notice in a big way. Should you join them?
First, it’s worth looking at some telling figures. Brazil’s gross domestic product increased 4.5%, to $1.3 trillion, in 2007, and grew by 5.8% in the first quarter of 2008. The country’s benchmark stock index, the Bovespa, is up 5.9% thus far in 2008.
Brazil is on the right side of the global commodities boom. It has enjoyed a 65% price hike for the high-grade iron ore it sells to steelmakers around the world. In the midst of a staggering increase in world energy prices, Brazil stands ready to capitalize on newly discovered offshore oil deposits that may be part of one of the biggest oil fields in the world. Major credit-rating agencies have given their stamp of approval on its government debt by upgrading the country’s sovereign rating from junk.
What makes the story even more compelling is how Latin America’s biggest economy has largely kept a lid on inflation, even as central banks around the globe continue to battle it. The reason: Brazil’s self-sufficiency in many of the commodities whose price run-ups are causing consumer prices to soar worldwide.
Not Playing Politics
Still, there has been concern about consumer prices, which climbed more than expected to an annualized rate of 5.04% in April, prompting the central bank on June 4 to raise interest rates to 12.25% from 11.75%.
“Brazil’s central bank has gained a lot of credibility by not allowing politics to interfere with the rate cycle. It’s one of the few central banks that’s ahead of the game and not playing catch-up,” says Will Landers, who manages the $970 million BlackRock Latin America Fund (MDLTX) and the $1.5 billion BlackRock Global Emerging Markets Fund (MDDCX).
Continued strength in Brazil’s currency, the real, “demonstrates the market’s confidence that the government is on top of inflation,” says Julian Thompson, portfolio manager of the $730 million Threadneedle Emerging Markets Fund (IDEAX) in London, roughly 21% of which is invested in Brazil.
None of this will come as much of a surprise to money managers or investors who have been looking for opportunities to diversify their portfolios away from assets based in the world’s industrially advanced countries. The giant emerging markets Brazil, Russia, India, and China (BRIC) have gained popularity as investors watch their economies expand at a sometimes dizzying pace.
But not all BRICs are created equal. With oil and metals price going through the roof in the past year, savvy investors are starting to distinguish the growth prospects of commodity-producing countries like Brazil and Russia from those of Asian countries that have no choice but to pay up for these resources to build their electricity grids, roads, bridges, and overall manufacturing capabilities.
The Glow from Petrobras
At the lead of Brazil’s economic boom is Petrobras (PBR), the state-owned energy giant whose oil production is projected to grow 12% this year and 10% in 2009, says Thompson. Petrobras stock has jumped 16.4% thus far in 2008 on a stock-split-adjusted basis.
The potential from exploration in the oil reservoir off the coast of Rio de Janeiro suggests high production growth for Petrobras in the next 10 years, he says. Reserve estimates for the Tupi oil field range from 5 billion barrels to 30 billion barrels—even Petrobras admits it doesn’t know how big it is—and production isn’t expected to come online for another four to five years.
Brazil has seen the need to become self-sufficient in oil since struggling with a hefty trade deficit amid hyper-inflation in the 1990s. “When Brazil had balance-of-payments problems, Petrobras continued to invest in exploration, even when oil prices were low,” he says. “There was a strategic imperative to reduce the dependence on foreign oil, while other countries had less pressure” to do so.
Brazil has other high-demand commodities up its sleeve, too. The global steel market shows no signs of slowing, as long as developing countries continue to expand their infrastructure. Future price hikes by iron ore producer Companhia Vale do Rio Doce (RIO) are underpinned by strong demand in China and India and the difficulty of bringing on new supply to meet demand, says Thompson. “Iron ore looks like an extremely attractive commodity for us over the next five years at least,” he says.
Ferrying Ore to China
And to get a bigger chunk of China’s market, CVRD is building a small fleet of mega-freighters able to carry a lot more iron ore to China, serving the small customers that until now haven’t been able to afford to sign long-term contracts with the company, says Landers at BlackRock. The company is targeting a 50% boost in sales to China starting next year.
Even so, CVRD is trying to diversify its business, adding nickel production by acquiring Canada’s Inco two years ago, and planning to expand into copper and other materials as well.
But Brazil is turning out to be much more than simply a bet on continuing spikes in commodities prices. A strengthening consumer sector—willing to take on debt to finance purchases of an array of goods—is also catching the eye of money managers.
Fund managers see a wide range of sectors to invest in, from banks to telecom providers to real estate developers, all bound to gain from growing consumption among Brazil’s growing middle class.
“This is like the U.S. in the 1950s. It’s a different generation [of wealth creation],” says Terrence Gray, who manages emerging market portfolios with $3 billion in total assets at DWS Scudder. He says he’s confident commodities will stay stronger for longer, which will help support consumer growth trends.
Real Progress for the Real
Consumption growth is tied to improving economic circumstances that stem from Brazil’s replacing its trade deficit with a large current-account surplus. That has strengthened the currency, which is up more than 19% against the dollar in the past year; has reduced Brazil’s debt load; and has helped lower interest rates, making credit more widely available to businesses and individuals.
Wider access to credit has fueled the mortgage market, enabling many Brazilians to buy their own homes for the first time. The mortgage market is still only 2% of GDP but could grow to at least 10% of GDP by 2013, predicts BlackRock’s Landers.
Commercial banks like Banco Bradesco (BBD) are a great way to tap into the expanding consumer economy with none of the exposure to risky credit derivatives that landed U.S. banks in so much trouble, fund managers say. Bradesco’s loan portfolio grew by 38.5% in the first quarter of 2008, according to Threadneedle’s Thompson.
More affordable credit is also helping drive a boom in real estate development and retail spending.
A Sea Change
Confidence in the Brazilian central bank’s ability to fight inflation, along with a number of structural improvements, have led to a sea change in the way the government debt is viewed. Standard & Poor’s Rating Services upgraded the country’s long-term foreign currency sovereign debt to investment-grade on Apr. 30, and Fitch Ratings following suit a month later.
“The investment-grade [rating] makes a big difference to the ability of financial stocks to raise capital more cheaply abroad,” says Thompson. “As the cost of credit comes down, there’s a direct impact on companies’ [profit and loss statements] and their ability to maintain growth.”
A case in point is Cyrela Brazil RLY AD, a property developer in São Paulo and Rio de Janeiro, whose pre-construction sales of multifamily homes surged 95% in 2007 from the prior year. Cyrela doesn’t start building new properties until it has pre-sold them to home buyers, so the strength of the pre-sales suggests how much revenue will be flowing into the company’s P&L this year.
Companies such as Cyrela can expand their business only to the extent that the country’s financial markets strengthen, especially the mortgage market, says Thompson. “For that to happen, you need to see a much more stable lending environment. Otherwise, the banks won’t open up their balance sheets to that kind of risk,” he says.
On a Shopping Spree
Retailers such as Lojas Renner and Lojas Americanas are seeing revenue rise—not just from growing consumer demand but also from partnerships with banks to distribute financial services such as auto loans and insurance products, says Landers.
America Latina Logistica, one of the country’s two major railway networks, is a way to play the growing agriculture industry. “[The company] transports hard and soft commodities across the country to the ports,” says Gray at DWS Scudder. “That network is going to need to expand. It will have to add more [rail]cars. That’s the main conduit for trade in Brazil.”
Any way you slice it, Brazil is likely to keep growing for many years to come. Even if the commodity plays have become too rich for some investors, the budding consumer economy offers less pricey ways to get in on the action. Given how many of these stocks don’t trade on U.S.-based exchanges, your best bet may be to buy a piece of an emerging markets mutual fund heavily weighted toward Brazil. In addition to the Threadneedle and BlackRock funds mentioned earlier, investors may want to take a look at the DWS Latin America Equity Fund (SLAFX) and the Fidelity Latin America Fund (FLATX).
North Coast Investment Research 