Bailing Out Of Brazil - Part 2

Includes: BBD, EWW, EWZ, MELI, PBR
by: Bret Jensen


Brazil is the focus of much of the globe right now as it hosts the World Cup.

The main equity index in the country has rallied in line with our market this year in the run-up to this event.

However, there are several economic and other concerns that should keep investors from believing the rally is sustainable.

Most of the world - or least that part of the globe that finds watching just one score, six shots on goal and two yellow cards per game a delightful way to spend an afternoon - is transfixed on the World Cup. Given this, I thought it would be a good time to revisit the investment case for the host country, Brazil.

I have not penned anything on this country since September 2012 when I did an article entitled "Bailing out of Brazil" and outlined why I thought the country was a poor investment at that point of time for myriad reasons. It turned out to be a prescient call as the main country ETF index, the iShares MSCI Brazil Capped (NYSEARCA:EWZ) is down from the time of the article even after a recent rally in front of the World Cup. Meanwhile just about every other country index is up significantly since then.

I wish I could say that the situation in Brazil was improving and that it was evolving into a long term investable theme. Unfortunately, that is not the case. Industrial production has declined for three straight months, inflation is running at over 6% annually and interest rates have kicked up into the low double digits. Combined with no economic growth, Brazil is currently going through a bout of "stagflation" much like this country experienced in the late 70s under similar leadership.

Although the country has made good strides over the years reducing the illiteracy rates and improving education, both are far below the levels in other major developed countries. In addition, the country has one of worst infrastructures of any major country. A recent report ranked Brazil 65th out of 160 countries after falling some 20 places since its last report. Highways are in disrepair, navigating the customs process is tedious, electricity production can be spotty and agricultural commodities experience significant amounts of spoilage reaching ports and markets.

Even the World Cup itself has been rocked by significant cost overruns on building stadiums along with the appearance of corruption. Brazil's market ran up to the start of the start of the World Cup but has sold off recently although it is still up just under 8% for the year, in line with the U.S. equities.

It is hard to make a case for investing in Brazil at this time through the largest ETF index, iShares MSCI Brazil Capped, or via individual stocks. Banks like Brandesco (BBD) and Itau that occupy two of the top three holdings in this Brazil ETF sell for nearly two times book value. The problems ahead of them also seem challenging given the huge growth of consumer credit over the past decade especially given the dismal current economic environment. Both Moody's and the IMF have voiced concerns recently which have been captured in a solid piece in Forbes.

Petrobras (NYSE:PBR) is the fifth biggest holding in the ETF and has huge deep offshore fields with massive potential. Unfortunately it could require $250B or more to develop these resources. The government also owns nearly 50% of this entity and constantly forces the company to subsidize fuel prices for the population among other capital destruction initiatives.

A good portion of the other holdings is dependent on commodity prices and demand from China such as Vale (NYSE:VALE). The one world class manufacturer in the country, Embraer (NYSE:ERJ), is not in the top ten holdings of EWZ. The entire ETF goes for just over 14 times earnings, not cheap given the current economic challenges.

I also would be concerned around the prospects for MercadoLibre (NASDAQ:MELI) even after the recent large decline in its stock over the past eight months. The region's largest online retailer play gets some 50% of its sales from Brazil and still sells for over 30 times projected FY2015's earnings even after its pull back. Earnings this year are tracking to be lower than that of 2013 as well.

For those investors looking to diversify south of the border I prefer, and am invested in, Mexico through the iShares MSCI Mexico Capped (NYSEARCA:EWW). The new administration there has successfully passed education, telecom and energy reforms that should make the country more competitive and ignite faster growth over the long term.

The economy is growing and has lower inflation and interest rates than Brazil. Mexico will also benefit from an accelerating economy in the United States in the back half of 2014 after the economy contracted here in the first quarter. The ETF does go for 17 times earnings, a premium to Brazil's biggest ETF but reasonable given the different economic outlooks of the two countries.

I wish I could be more positive on the outlook on Brazil as the country has its day in the sun, but the economic situation there is murky at best. Maybe if a pro-business government emerges from the upcoming elections we can revisit this investment theme. In the meantime, it is only two months to the real football season, and drafting in fantasy leagues is just around the corner.

Disclosure: The author is long EWW. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.