Finding Solid Value in Brazil

Uncertainty drove global equity markets in 2011. Brazil’s stock market wasn’t immune to concerns about the EU’s ongoing sovereign-debt crisis, weak economic growth or the long-run ability of the US to tend to its internal affairs.

Although Brazil’s economy continues to develop and domestic demand has increased substantially, the nation still depends heavily on international trade. Accordingly, economic growth in Brazil slowed dramatically in the second half of the year, catching some overly bullish investors by surprise.

The mood as 2012 dawned was downbeat, and though the global “risk- on” trade has lifted Brazilian stocks, investor sentiment hasn’t improved much. This dour outlook gives savvy investors an opportunity to pick up shares of high-quality, dividend-paying companies at a discount.

Brazil has emerged as one of the best emerging markets, due to China and India’s insatiable demand for natural resources, but domestic factors should drive growth in 2012. The local economy had picked up steam even before fiscal and monetary authorities enacted simulative policies.

The government has announced plans to implement a new tax relief scheme and committed to increasing public expenditures. Policymakers also approved a 14 percent increase to the minimum wage. According to official forecasts, these initiatives should boost gross domestic product (GDP) by 2 percentage points.

The government has also resorted to protectionism, raising the duty on imported vehicles by 30 percent and imposing new taxes on imported shoes, apparel and furniture. The Central Bank of Brazil is loosening policy, as real interest rates are approaching 4 percent, a historically low level.

Bank lending and retail sales have been strong. Since mid-2011, state-owned banks have posted average monthly loan growth of 2.3 percent. The CEO of one state-owned bank recently forecast that lending at his institution would surge by 40 percent in 2012.

Although rising prices may become a problem down the road, recent data suggest that inflation won’t be a major issue in 2012. At almost 6 percent, the inflation rate remains above the official target of 4.5 percent. But it’s still a far cry from the 17 percent increase in consumer prices that took place in 2003. Expect inflation to remain above 5 percent in 2012, particularly in light of Brazil’s strong credit growth.

But even as Brazilian consumers lever up during this period of relative economic strength, the nation’s net public debt as a percentage of GDP peaked at about 63 percent in 2003. Public debt stands at about 37 percent of GDP and in 2012 should approach the recent low of 35 percent.

The Brazilian real has also strengthened, which is a boon for US-based investors, despite the effect it may have on Brazilian exports. Less than a decade ago, one US dollar was worth four reals; at the time of writing, the exchange rate had narrowed to 1.73 reals. If the global economy holds itself together, the exchange rate should narrow to 1.60 reals by the end of 2013.

Brazil’s stock market, as represented by the Bovespa Index, has lagged global equities since the beginning of 2011 and is relatively cheap. The Bovespa currently trades at less than 11 times earnings and 1.45 times book value while offering a dividend yield of 3.5 percent. The S&P 500 Index trades at 14 times earnings and 2.2 times book value while offering a dividend yield of 2 percent.

However, the case for investing in Brazil isn’t based on explosive GDP expansion and gangbusters earnings growth. Rather, steady and solid are the watchwords for Brazil in the “new normal.”

That being said, this emerging market’s GDP growth could surprise to the upside in 2012 if the global economy finds its footing. Barring another global financial meltdown or recession, Itau Unibanco Holding (Sao Paulo: ITUB4)(NYSE:ITUB), Telefonica Brasil (Sao Paulo: VIVT4)(NYSE:VIV) and Petroleo Brasileiro (Sao Paulo: PET4)(PBR A) will continue to build wealth for investors.

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