Hunting for Value in Brazil

Andrés is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Brazil is one of the most exciting economic growth stories in the last decade. The country has an expanding middle class, abundant natural resources and solid political institutions. In the last year however, the economy has decelerated notoriously, and Brazilian stocks have delivered disappointing returns. Now that valuations are cheap, and the economy may be about to rebound in 2013, it seems like the right time to consider a position in Brazilian stocks.

The Sun Will Rise Again

Brazil is no longer growing at a 6% or 7% annually like it used to; analysts are forecasting an uninspiring increase of 1.5% in GDP for 2012. But the government is reducing taxes and cutting interest rates, which should provide some impulse to the economy in the middle term, so a rebound to 4% growth is expected for next year.

On the other hand, the government has implemented a series of interventionist measures to reduce interest rates on corporate loans, electric utility bills and telecommunications costs.  Sectors like energy and commodities have always been under the attention of Brazilian authorities, and are now seeing increased scrutiny from the government.

These new regulations have a contained impact on individual sectors of the economy, and the government is trying to compensate interventionist measures with more market oriented policies like a reduction in payroll taxes. Still, investors should watch regulatory risks closely, especially in some sensible sectors.

The bottom line is that the Brazilian economy is fundamentally strong from a long term perspective, and valuations are attractive due to the current slowdown. This could be a great time to go bargain hunting in Brazil.

The Best Way to Invest in Brazil

The most popular ETF to invest in Brazil is iShares MSCI Brazil Index (NYSEMKT: EWZ), which has more than $9 billion in assets under management and pays a juicy dividend yield of 2.77%. This level of dividend yield is particularly high for emerging market stocks, which tend to reinvest heavily for growth as opposed to distributing big dividends. There is clearly a lot of value among Brazilian stocks.

The problem with EWZ is that it has too much exposure to big companies in sectors like energy and commodities, particularly Petrobras (NYSE: PBR) and Vale (NYSE: VALE), which together represent nearly 30% of the fund.

A better alternative to bet on the rise of the Brazilian consumer could be Market Vectors Brazil Small-Cap (NYSEMKT: BRF), which focuses in small capitalization Brazilian companies. This ETF is much smaller than EWZ with assets under management of nearly $5,550 million, but it provides higher exposure to the consumer and industrial sectors, which stand to benefit enormously from Brazil's economic development in the long term. This ETF carries a 2.5% dividend yield and provides exposure to many local companies which are not listed in the US markets.

Big Companies with Big Potential.

Oil giant Petrobras has discovered several fields with enormous potential in Brazil's shores since 2007. The company is expected to invest more than $200 billion in offshore projects that could easily triple its current production over the following years.  But not only are these projects highly expensive and uncertain, the Brazilian government is a major partner in Petrobras and also guides regulatory policies that can affect the company's profitability and strategic decisions. Investing in Petrobras means a partnership with the Brazilian government, for better or for worse.

Vale is a big global player in iron ore and other metals, and the company has had a series of disputes with Brazilian authorities regarding taxes and other issues. In addition to that, concerns about the health of the Chinese economy and iron ore prices have been another negative for the company over the last years. But pessimism has probably gone too far, as Vale is currently trading at a P/E of 7.6 and yields a 3.6% in dividends. Once the economy starts showing positive signs, Vale is well positioned to deliver solid gains.

Itaú Unibanco (NYSE: ITUB) is the biggest Brazilian bank and has a diversified exposure to different regions of the country and various business areas.  Itaú has a leadership position in segments like credit cards and corporate lending, coupled with ambitious plans to expand in Latin America. Macroeconomic headwinds and rising regulatory risks have taken their toll on Itaú shares, and they are now trading at a forward P/E ratio below 5, which sounds excessively cheap for a healthy bank with plenty of growth opportunities.

Shopping in Brazil

A decelerating economy and increasing government intervention are creating important uncertainties for investors in Brazilian stocks. But the valuations are really attractive, and the Brazilian economy should do better in 2013. If you can handle the risks, chances are Brazilian stocks will deliver some exciting returns in the middle term.

acardenal has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Motley Fool newsletter services recommend Petroleo Brasileiro S.A. (ADR). Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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