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Stock Strategist

Bargain-Hunting in Brazil

We highlight four of our top candidates for future purchases.

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In the midst of last year's market meltdown, we suggested that Warren Buffett's advice to "be greedy when others are fearful" would apply just as well to Brazil as anywhere else. While we claim no special foresight, we think the subsequent 50% rise in Brazilian equities speaks to the value of this approach. But with investor fear on the wane, the question now is whether "being greedy" remains a sensible policy.

In the case of at least one Brazil-oriented firm (highlighted below), we think it does. In general, however, market fear has diminished to the point where we are now more cautious. But if and when fear reasserts itself, Brazil will make a great hunting ground, in our opinion. Below we highlight four of our top candidates for future purchases.

What might renew investor fright (and, consequently, spur another dip in stock prices)? We're on the lookout for three possible catalysts. The first is lower-than-expected economic output. While there's no question the Brazilian economy is decelerating, predictions vary as to the pace. The government's forecast of 1% growth in 2009 may prove optimistic; private estimates peg the likely rate closer to zero. Should economic growth fall short of official expectations, less-patient investors might head for the exits.

A second possible catalyst is the growing mismatch between Brazilian government expenditures and tax revenues (the former is holding steady while the latter is falling). With an election set for next year, a sudden tightening of state purse strings seems doubtful. This mismatch will erode Brazil's budgetary surplus, which could worry investors and temporarily weigh on asset prices.

Finally, Brazilian stocks remain broadly exposed to international investor sentiment, which, as we've seen in recent months, can be fickle. Should another flight to safety sweep global markets, cool-headed investors could be handed a new buying opportunity.

Brazil's Transformation
Past observers of Brazil could scarcely have imagined the country's recent turnaround. Though serious problems linger, market reforms have brought stability and expansion to a once-stagnant economy. Inflation--the country's historical Achilles' heel--has fallen fivefold, and President Lula's government seems determined to keep it low, even at the expense of near-term growth. Another historical weakness has been currency volatility. But with $200 billion in accumulated reserves, Brazil's current scope for stabilizing the real is unprecedented. Moreover, the country can now borrow in its own currency, which should help take the bite out of unfavorable exchange-rate swings.

In addition to prudent policy, Brazil possesses some fundamental advantages. Vast natural endowments, a young population, a relatively sound banking system, and a diversified economy are some of the structural features that we believe will propel Brazil's economy in the years and decades ahead.

We acknowledge that substantial risks--both external and internal--cloud Brazil's future. But on balance we think the country's long-term prospects are too bright to ignore.

 

This Pick Is Still 5 Stars
 NII Holdings (NIHD)
While Brazilian equities have appreciated considerably in recent months, it's not too late to pick up NII Holdings on the cheap. This U.S.-based wireless provider has significant exposure to Brazil. NII has directed its operations toward a profitable niche: corporate customers who demand instant connectivity. NII targets its push-to-talk wireless service at business customers such as building contractors and security firms that need instant communications to conduct their businesses. At $58, NII's monthly average revenue per user is by far the highest in Latin America. Strong revenue generation has enabled the company to consistently deliver attractive operating margins and returns on investment.

We think NII's solid customer base and reputation in the Latin American market should allow the firm to maintain its subscriber growth over the next couple of years, but competition is a threat worth monitoring in the long run.

Brazilian Stocks for Your Radar Screen
 Brazilian Petroleum Corporation (PBR)
Brazil's future economic expansion will demand energy. And while competition is entering the market, Petrobras' home-court advantage and extensive reserves should make it the go-to source for years to come. We also like that the company derives most of its operating profit from upstream operations--a link in the supply chain that offers strong long-term profit potential (OPEC uses its heft to influence global oil supplies, promoting the health of nearly all upstream producers). In addition to its incumbent position and potential for serious production growth, Petrobras has significant deep-water expertise. Given Brazil's vast undersea deposits, we think this know-how constitutes an important competitive advantage.

Several caveats--including state meddling in energy markets and the government's majority ownership stake--temper our enthusiasm. On balance, however, we think this energy titan would be worth investors' consideration if the stock fell below our Consider Buying price.

 Embraer (ERJ)
We think low-cost jet maker Embraer has a leg up over its one serious rival, Bombardier. Demand for regional jets is trending toward larger aircraft. As Bombardier races to bring larger models on line, we expect Embraer will capture incremental share with its market-ready planes, some of which seat up to 118 passengers. Meanwhile, high barriers to entry should keep prospective market entrants in the hangar.

Although Embraer's maintenance and repair business should help take the sting out of a cyclical downturn in aerospace markets, the firm's bread and butter will remain new aircraft orders. And in today's low-credit, low-growth economic environment, new orders are facing serious head winds. Still, we're confident in the firm's long-term staying power and profitability, and at the right price think it would make an attractive holding for internationally minded investors.

 CPFL Energia (CPL)
Scale and natural monopoly status confer CPFL, Brazil's largest private power distributor, a sustainable competitive advantage. The firm's difficult-to-replicate distribution networks, which are concentrated in the economically vibrant southern states of Sao Paulo and Rio Grande do Sul, represent a sizable barrier to entry. We expect that CPFL will build further scale as it acquires local utilities in the fragmented Brazilian market. Rising per-capita consumption (currently one fifth U.S. levels) will also help drive CPFL's top line. Operating costs, meanwhile, should remain in check, as Brazil's reformed regulatory system rewards efficiency.

On the downside, a widespread drought could necessitate power rationing in Brazil's hydro-dependent electricity market. Rationing would squeeze CPFL's margins, as revenues would fall while costs would remain largely fixed. Today's economic downturn has created similar challenges. However, we think CPFL's investor-oriented management, attractive service territories, and operating scale bode well for long-term investors.

 Companhia Vale Do Rio Doce (VALE)
As the world's largest iron ore supplier, Vale wields considerable bargaining power. The company's clout has been evidenced by massive negotiated price increases with key customers. Vale's top-line strength, together with its low-cost Brazil-based operations, supports strong operating margins by commodity producer standards.

Going forward, we think Vale's greatest challenge will be managing industry cyclicality. Although pricing power and operational advantages should provide a downside cushion, a prolonged slump could slice Vale's margins and stall its expansion. The situation could be made worse by Brazil's regulatory instability. As is often the case in emerging economies, changes in fiscal, monetary, and international trade policies are common and could hurt Vale's business. Risks aside, we consider Vale an excellent vehicle for investors seeking to stake a claim on long-term global economic growth.

Ryan McLean does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.