Buying Brazil (Part VI): Assessing Country Risk

by: Nicholas Pardini

<< return to part V

In this final part of my article series on investing in Brazil, I address the risks investors need to be aware of when buying stocks there. Brazil has a lot going for it right now. With a stable democratic government and religious freedom, Brazil lacks many of the other risks faced by other major emerging markets such as religious strife, terrorism, authoritarian overpopulation, civil unrest, or human rights issues. However, investors need to factor in risks such as inflation, populist driven government intervention, corruption, and high income inequality that come with the territory when investing in Brazil.

Currency Risk:

Like the rest of Latin America, Brazil does not have the best history of a free floating, stable currency. Inflation and capital controls are rampant throughout Latin America. At 6.5%, Brazil's inflation rate is at its highest since 2005. However, the Brazilian central bank is countering this by raising rates to 11.75%. High real yields can encourage local investors to actually put money in the bank versus stocks. The country has a two percent tax on foreign investment in stocks and bonds to slow currency appreciation as well. Similar to how investors are reacting to the US dollar, the best way for investors to hedge this is to buy companies that sell raw materials such as Petrobras (NYSE:PBR) and Vale (NYSE:VALE) .

Government Intervention and Corruption:

The recent left wing coalition led by President Dilma Rouseff and her predecessors has a record of government intervention in private industry. The government owns a controlling stake in leading oil producer Petrobras (PBR) and miner Vale (VALE). They often use Petrobras' capital and profits to finance social programs or build infrastructure projects that do not help the business. Vale recently fired its CEO and replaced him with somebody more friendly towards the Brazilian government threatened by politicians due to a lack of investment in the local economy.

Although the government is scaling back on regulation, price controls are still prevalent in fuel, telecommunications, and the airline industry. Combined with moderately high inflation, these regulations hurt margins for local companies. Like the rest of Latin America corruption is high in Brazil as many politicians use state funds to pay for lavish lifestyles. The country is ranked 75th out 180 countries in the corruption indexes and permit rights for infrastructure projects are often decided by paying off the right politician versus the economic benefits of country.

Income Inequality:

Out of all the BRIC countries, Brazil struggles more than any of them with the issue of income inequality. Brazil has the tenth highest gini coefficent in the world at 57, and 31% of the population lives below the global poverty line. Armed guards for wealthy individuals and foreigners are common, and favela slums have grown along with the middle class. This disparity of wealth leads to higher crime rates and large, drug war torn, favela slums that are uncontrollable by the police. With the benefits of economic growth limited to the wealthy, the growth of the Brazilian consumer society is severely restricted.

In addition to the economic loss caused by high crime rates, income inequality encourages populist voting patterns which elected officials respond with protectionism, stifling high taxes (tax revenue 39% of GDP vs. 28% of US), price controls, inflation financed government spending, nationalization of private industry, and other anti-capitalist policies. Solving the wealth disparity is a real problem in Brazil, but it may come at the expense of economic growth.

Despite these concerns, I still believe that Brazil, along with Chile, is one of the two best emerging markets for investors. Unlike the societal demographic and structural problems that exist in China and India, Brazil's issues can be solved with efforts to clean up the government and additional economic development. Another strength of Brazil is status as an exporter of minerals, agricultural commodities, and oil which will keep the real strong and provide growth to the economy outside of the consumer society.

As a conclusion, I believe the best opportunities to invest in Brazil are through Ambev (ABV), Petrobras (with tight stops), Cozan (NYSE:CZZ), Sabesp (NYSE:SBS), and/or the iShares Brazilian ETF (NYSEARCA:EWZ) in order to profit off the growth in the largest economic power in Latin America.

I hope you readers learned something from this series, as I move on to research other emerging markets.

Disclosure: I am long ABV, PBR.