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Experts Divided on Brazil

Banks and retailers have joined commodity giants in the spotlight, but have they come too far too fast?

Karin Anderson, 08/11/2010

Brazil looms large in many emerging-markets portfolios. The average emerging-markets stock fund had a 16% stake in Brazilian equities as of Aug. 4, 2010, making it the largest country weighting. (The typical Latin America fund devoted roughly 71% of assets to the country.) In some cases, this exposure reflects the popularity of Brazil's commodity giants: energy firm Petroleo Brasileiro PBR (Petrobras) and materials titan Vale VALE.

But there's much more to Brazil than its diverse natural resources. The country's middle class has flourished in recent years thanks to low interest rates and easier access to credit. Growing income levels could set the stage for more robust retail sales, industrial spending, and housing demand. Reflecting these trends, the MSCI Brazil Index, though still heavy in the energy and materials sectors, has shifted away from those areas more toward financial services and consumer-related industries in recent years. And exposure to telecom firms fell to roughly one fourth of its former weight.

Domestic-oriented stocks were big drivers in Brazil's huge 128% rally in 2009. But the market has taken a breather in 2010: The index shed nearly 3% for the year to date through Aug. 4, 2010. While worries about a global economic slowdown has dinged commodity plays, domestically oriented stocks have also come under pressure given the risks of rising interest rates and a slowdown in foreign investment.

So, what's the outlook from here? Is the expansion of domestic-oriented sectors the sign of a new dawn for Brazil's market, or have Brazil's stocks become too popular for their own good? Not surprisingly, fund managers disagree on that important question.PAGEBREAK

Can the Carnivale Continue?
When you compare Brazil's investing climate with those of the other large developing countries, there is a lot to like. In addition to being a large, diverse economy, it's considered to be one of the more stable markets from a political standpoint. It also suffered less during the financial crisis of late 2007 through early 2009 and recovered much faster. And from a regional standpoint, its securities exchange operator, BM&FBovespa, boasts Latin America's most liquid stock market and has the most stringent listing requirements. (This promotes better behavior on the part of listing firms.)

In recent years, Brazil's banks have attracted many fund managers. Howard Appleby, who comanages foreign large-blend mutual fund Harbor International HIINX, said he likes the big Brazilian banks Bradesco BBD and Itau Unibanco ITUB because they weren't exposed to the contagion during the financial crisis because they had less leverage. For the longer term, he believes that they offer a great growth opportunity given the country's low savings rates. Similarly, Roger Edgley, who runs foreign small/mid-growth fund Wasatch International Growth WAIGX, likes commercial bank Banco Daycoval because consumer credit penetration is still very low.

Plays on the growing demand for infrastructure and housing have also been quite common. Will Landers of BlackRock Latin America MDLTX has focused on homebuilders such as Cyrela Brazil Realty and PDG Realty. He doesn't expect the upcoming interest-rate-tightening cycle to result in a significant slowdown but rather an adjustment to bring inflation expectations back to the target level. And global real estate fund manager Sam Lieber has really kicked it up a notch when it comes to Brazilian exposure. At last count, he devoted about one third of Alpine International Real Estate EGLRX to real estate operating firms such as BR Malls Participacoes and homebuilders such as Gafisa. Lieber believes that the country's middle class is growing quickly enough for suburban retail landlords to make up for the higher costs of borrowing.

Meanwhile, T. Rowe Price Latin America's PRLAX Jose Costa Buck has emphasized consumer-oriented companies that should benefit from a robust domestic economy, including credit card service provider Redecard and clothing manufacturer Lojas Renner. That said, a slowdown in government stimulus programs and investment inflows will create short-term headwinds, he said. Similarly, Justin Leverenz of Oppenheimer Developing Markets ODMAX has confidence in the capital allocation skills of the management team behind retail chain operator Lojas Americanas, which he sees benefiting from consolidation in the region's fragmented retail industry.

Or Will These Stocks Get Kicked Capoeira Style?
Toward the end of last year, and even more recently, some managers have found the entire market too rich. For example, Ruchir Sharma of Morgan Stanley Institutional Emerging Markets MGEMX attributed last year's frothy market to a lot of good news, including Petrobras' oil discoveries, Rio de Janeiro's winning Olympic bid, and the fact that more than half of the country's population is now middle class.

Earlier this year, Adam Kutas of Fidelity Latin America FLATX found valuations of Brazilian banks to be exceptionally high. And given the fact that they are transitioning from corporate to retail businesses, he's found them difficult to value as they take on this risk. Kutas also believes that the banks will face unreasonably high expectations this year in terms of loan growth, and so he's lightened up on large banks Itau Unibanco and Bank Bradesco. Similarly, Jim Gendelman of Marsico International Opportunities MIOFX sold out of Itau Unibanco earlier this year because he was no longer comfortable with its valuation or the regulatory environment for the country's banks.

Thomas White, who runs foreign large-value fund Thomas White International TWWDX, currently has a 4% stake in Brazil but has noted several signs that indicate a slowdown for consumer-oriented fare is on the horizon. He believes that continued interest-rate increases by the central bank could restrict credit growth. And unlike China and India, Brazil's savings rate is low, which has kept borrowing costs relatively high.

Conclusão
Investors who want to target Brazil can choose among a handful of Latin America stock funds and Brazil-focused options in both the mutual fund and exchange-traded fund formats. But making such narrowly focused plays can backfire. Many investors will find they can get ample exposure to the country through diversified emerging-markets funds or even broad international funds. Lately, several prominent foreign funds have sported even exposure between Brazilian commodity- and consumer-linked businesses.

Keep in mind that Brazil's more diversified equity market won't spare it if commodity-oriented stocks are pummeled. And although the country's political climate has been stable in recent years, investors will be watching the October presidential election closely. Neither of the front-runners are expected to institute major policy changes, but it remains to be seen how the new president will handle fiscal policies geared to bring down real interest rates as well as social policies that can keep the country's middle class growing at a steady clip. The latter includes the overall trend in wage increases and reforms that will boost its citizens' savings rates.

Karin Anderson is a mutual fund analyst with Morningstar.

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