Betting Beyond Buffett in Brazil

Warren Buffett, whose investment moves we follow with a close eye, has placed a seemingly unusual currency bet. Where did the Oracle of Omaha, known for his insistence on safety and value, put his money? Not on the euro, yen, or yuan, but on Brazil's star currency, the real.

Time out. Buffett's bearish stance on the U.S. dollar is well-known, but the real has doubled in value during the last five years--hardly the sort of trend that precedes most Berkshire purchases. Furthermore, Brazil's economic past is littered with crises. "It's quite likely that if you had told me 10 years ago that I would buy the Brazilian real, I would have thought you were crazy," Buffett is quoted as saying.

Has Brazil Turned a Corner?
Much has changed in 10 years. Investors were spooked when leftist president Luiz In�cio Lula da Silva took office in 2003. But he surprised everyone by extending the previous administration's cautious fiscal policies. Despite a bloated bureaucracy and unhurried pace of reform, Lula's government has since steered the economy on a course of steady, if not spectacular, growth. Two key drivers: lower interest rates and inflation, both of which are down dramatically from their previous high-teen levels.

Also reassuringly, Brazil has become more integrated into the world economy than ever before. Unlike its regional peer, Mexico (which distributes about four fifths of its exports to the United States), Brazil's global commerce is well-diversified. With a young workforce and comparative advantages in a range of industries, we expect trade will only expand.

The signs of economic progress are plain to see. One need only visit the country's crowded airports and shopping centers to sense that its people are doing better. Even some favelas--Brazil's notoriously poor slums--are packed with shiny new computers and home appliances.

We would be remiss, though, to ignore the serious ongoing risks. Persistent corruption, a stifling tax regime, and underinvestment in infrastructure are a drag on growth, while a heavy reliance on commodities exposes the economy to global price shocks. But if the country can dodge economic disaster, we think it has a good shot at consolidating reform. This would bode well for Brazil's resilience--and for investor returns.

Two of Brazil's Best Businesses
When we consider foreign investments at Morningstar, we first look for "earning assets"--solid business franchises with bright futures. Buffett himself usually favors this means of currency diversification over direct bets. In this piece we'll highlight two firms that are not only among Brazil's finest (both possess that universally attractive feature, an economic moat), but also offer foreign investors a way to gain leveraged exposure to the real.

In contrast to some of Brazil's biggest businesses, such as  Aracruz  and  Embraer (ERJ), the firms we present here collect almost all of their revenues in reais. We think that buying this sort of company could be a more advantageous way to stake a claim on a currency's future than owning it outright. If business earnings were to increase 10%, and the real were to appreciate similarly, U.S. investors would effectively see 21% profit growth. Moreover, these firms' foreign currency-denominated debt and input costs shrink when the local currency appreciates, further boosting earnings.

Although we caution that leverage of any kind works both ways, we think investors who are confident in the real's prospects relative to the dollar would do well to consider these companies. If the currency does poorly, the underlying strength of these businesses should help cushion the downside.

Our favorite firms can't always trade at bargain prices, and unfortunately that's the case at the moment with these two. Along with the overall market, both have appreciated in price under strong and rising expectations (local equities are up a stunning 350% since 2002). But successful investing is as much about patience as picking the right stocks. By holding out for deeper value, we'll maximize our return potential. In the meantime, we're keeping these quality names on our radar.

 AmBev 
Moat: Wide | Price/Fair Value Estimate Ratio*: 80.39/79 | 3 Stars
In a previous article that discussed Latin American firms with competitive advantages, we highlighted one of the world's premier beverage companies, Mexico-based  Femsa (FMX). It's tough to top such a strong performer, but by several measures Brazil's AmBev does just that.

AmBev is far and away one of the most profitable brewers in the world. Ruthless efficiency, vast scale, and powerful brands allow the firm to ring in operating margins a good 15 percentage points above those of industry rivals. These strengths form the basis for the firm's wide economic moat, in our opinion.

In addition to its absolute dominance of the Brazilian beer market (the world's fourth largest), AmBev has selectively expanded abroad and now holds successful stakes in Argentina's Quilmes and Canada's Labatt. The firm complements its brewing operations with carbonated soft drinks. It owns bottlers that fabricate and distribute  PepsiCo (PEP) products as well as proprietary brands. By possessing two classes of beverage products, the company is better able to leverage its distribution infrastructure. During the next five years, we expect revenue to increase at a robust 12% annual clip.

AmBev has many qualities we love, but the firm does not come without uncertainty. Sales are concentrated in Latin America, where economic and political risk is relatively high. Many of the firm's input costs, as well as about $3.5 billion of debt, are denominated in U.S. dollars. Should the real depreciate, these payments could become dangerously expensive. On the other hand, if Buffett's currency bet is right, AmBev's leveraged cost structure could entail handsome rewards.

 CPFL Energia 
Moat: Narrow | Price/Fair Value Estimate Ratio*: 62.70/63 | 3 Stars
In Brazil, sales of electricity-thirsty appliances and electronics goods surged by 16% in the last year alone. Manufacturers aren't the only ones smiling; the utilities that power these goods are, too. Of these, CPFL Energia is the best, in our opinion. Unlike some of its peers, CPFL's returns exceed its cost of capital--and we expect they will only strengthen.

Scale and natural monopoly status confer CPFL 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 of 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 entail power rationing in Brazil's hydro-dependent electricity market. Rationing would squeeze CPFL's margins, as revenue would fall while costs remained largely fixed. An economic downturn would lead to similar challenges. Despite these risks, we think CPFL's investor-oriented management, attractive service territories, and operating scale more than compensate.

Stock analyst Ann Gilpin also contributed to this article.

*Price/fair value ratios calculated using fair value estimates, closing prices, and cost of equity estimates as of Friday, Feb. 22, 2008.