Keeping a Cool Head in Brazil

Brazil's president Lula could not have been further off base when he confidently declared earlier this year that "Bush's crisis" would not affect his country. In the months since, credit has dried up, commodity prices have collapsed, and the real (Brazil's currency) has tanked. After years of double-digit gains, the Bovespa stock index is down by nearly half from its peak. Panicked investors are dumping shares in even the best of businesses.

But is Brazil's future really so bleak? While the economic outlook has certainly dimmed, we remain cautiously optimistic. Buying stocks in today's environment takes courage--and doubly so in a volatile emerging market. Ultimately, though, we think Warren Buffett's advice to "be fearful when others are greedy, and greedy when others are fearful" will prove as rewarding in Brazil as anywhere.

In this piece, we highlight three Brazil-oriented businesses we think would make attractive long-term holdings. But first, let's explore some of the factors behind investors' fear.

Not As Bad As It Seems, Perhaps?
Brazil's economic challenges are serious, but in our view, they are surmountable. The recent fall in commodity prices is a key concern. For some Latin American countries, like oil-dependent Venezuela and economically mismanaged Argentina (discussed in my previous article), sustained low prices could be disastrous. But for Brazil, the region's most-diversified market, the story is less grim. While commodity exports still amount to a hefty 9% of output, growth in services and manufacturing makes Brazil's economy less dependent on raw materials than at any time in history. And when commodities markets eventually recover, the country's natural comparative advantages should once again serve it well.

A second challenge is a lack of financing. Just as Brazilian consumers and businesses were beginning to benefit from an unprecedented ability to borrow, credit markets evaporated. Although credit scarcity will stunt growth, it isn't really new; Brazilian firms have long contended with tight financing and some of the world's highest interest rates. We think this history of financial adversity, and the adaptability it fostered, will make today's credit crunch less of a shock in Brazil than elsewhere.

The depreciation of the Brazilian real is a third worry, as a weaker currency means more expensive imports and higher interest payments on dollar-denominated debt. But Brazil now holds foreign-exchange reserves on the order of $200 billion, and it recently arranged to tap billions more from the U.S. Federal Reserve. This cushion should bring stability to the real. Moreover, Brazil can now borrow in its own currency, which should help take the bite out of unfavorable exchange-rate swings.

There's an old joke: "Brazil is the country of the future� and always will be." Yet in recent years, it has progressed farther and faster than any skeptic had predicted. While Brazil's near term will be tough, we think valuations for some companies imply overly pessimistic expectations. Investors with a cool head and a stomach for volatility stand to profit from others' panic.

Three of Our Favorite Brazil-Oriented Firms
 NII Holdings 
Morningstar Rating: 5 Stars | Fair Value Uncertainty: High | Moat Rating: Narrow
Headquartered in the United States, NII Holdings has a strong position as a wireless provider serving the Latin American business market. While most wireless operators in the region are focusing on the fast-growing prepaid retail segment, 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, at 20% and 27%, respectively.

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.

 CVRD (RIO)
Morningstar Rating: 5 Stars | Fair Value Uncertainty: High | Moat Rating: Narrow
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 phenomenal operating margins by commodity producer standards.

Going forward, we think Vale's greatest challenge will be managing industry cyclicality. Though pricing power and operational advantages should provide a downside cushion, a prolonged slump could slice Vale's margins and stall its ambitious expansion program. The situation could be made even worse by Brazil's regulatory instability. As is often the case in emerging economies, significant changes in fiscal, monetary, and international trade policies are quite 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.

 AmBev 
Morningstar Rating: 3 Stars | Fair Value Uncertainty: High | Moat Rating: Wide
While Brazilian brewer AmBev is not currently as cheap as our first two picks, we would like to reiterate our positive take on this firm's competitive position and prospects. Simply put, as long as people drink beer, we think AmBev will make a lot of money.

AmBev is far and away one of the world's most profitable beverage makers. Ruthless efficiency, vast scale, and powerful brands allow the firm to ring in operating margins a good 15 percentage points above 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. 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 revenues to increase at robust double-digit rates.

AmBev has many qualities we love, but it does not come without uncertainty. Many of the firm's input costs, as well as about $3.5 billion of debt, are denominated in U.S. dollars. Should the Brazilian real depreciate further, these payments could become dangerously expensive. On the other hand, if the real strengthens, AmBev's leveraged cost structure could entail handsome