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International stocks often have the glamour of a walk down the Champs Élysées and the mystery of Zorro. Sure, we know that Greek debt is being refinanced, and German bonds are safe, and China's currency is not properly valued. And we know that Brazil, Russia, India, and China have overall economic growth rates much higher than those in Europe and the United States.

But just as the fastest growing stocks in the United States are not always the best investments, the fastest growing economies might not have the best investments. In the United States most investors use the P/E ratio, combined with earnings growth, to evaluate the suitability of a given investment. But determining the P/E ratio of a fund or ETF investing in international stocks can be difficult.

In this article I use a statistical sampling method to estimate the P/E ratio of the iShares Brazil Index Fund (NYSEARCA:EWZ), and this method suggests that these stocks trade at a discount to American stocks.

When studying a characteristic of a population, it is often impractical to examine every member of the population. A survey of a group within that population is therefore used to examine given characteristics of the group as a whole. Normally done for opinion polls on different issues, consumer preferences, or thoughts on political candidates, there is no intrinsic reason why the same statistical methods cannot be used on stocks.

In this case, I examined every position in EWZ greater than 1.00% of its portfolio. This provided 20 issues, 7 of which I was unable to find listed on U.S. exchanges. The remaining 13 issues accounted for 63.2% of the value of EWZ's holdings. However, 6 of these issues were preferred issues, a surprising finding that led me to compute the following statistics both including and excluding the preferred issues.

I used Zacks Investment Research to obtain trailing twelve months (TTM) and 2011 estimated earnings for each of the stocks listed on American exchanges. I then calculated the weighted average P/E using the closing price as of August 19, 2011 and the percentage holdings of EWZ as reported by iShares. Counting only the 7 regular stock positions amounting to 29% of the total holdings of EWZ led to a TTM P/E of 9.0 with a standard error of 1.8. Using Zacks' estimates of 2011 earnings gave a P/E of 7.6 ± 1.0.

This estimate gave me pause, however, as using 7 issues to determine the overall P/E of an ETF can be risky, even if those issues accounted for 29% of holdings. To obtain a larger data set I decided to include the preferred issues in my estimates by using the common stock P/E for those issues. With those data included, the TTM P/E is 9.0 ± 1.3 and the P/E based on estimated 2011 earnings is 8.0 ± 1.0. These numbers agree well with the data from only common stock, and are based on a much larger 63% of the total holdings of EWZ.

In order to validate this method, I used the same basic computation to calculate an estimated P/E of the S&P 500 using only the top 10 stocks in the index. The prices are closing prices from August 19, 2011 and the earnings figures were obtained from Zacks. The top 10 stocks account for 20% of the market capitalization of the S&P 500, and have a trailing twelve months P/E of 12.2 ± 0.6 and a P/E based on 2011 earnings of 11.3 ± 0.6. This matches very well the current TTM P/E of the S&P 500 of 12.4 based on the last twelve months earnings (90.91) obtained from Standard & Poor's.

Since we've established that Brazilian stocks are undervalued, how can U.S. investors profit? One can of course invest in the iShares Brazil Index Fund (EWZ), or perhaps the Market Vectors Brazil Small-Cap ETF (NYSEARCA:BRF). Or one could invest in individual stocks, such as the 13 stocks used in the calculations above. The largest is Petrobras (NYSE:PBR), one of the largest integrated oil and gas companies in the world that trades at a P/E of 6.7. Vale (NYSE:VALE) is a metals and mining company that mines and produces iron ore, as well as other metals and minerals such as manganese, copper, phosphates, potash, and some platinum group metals. It trades at a P/E of 6.3 and only about 6% above its 52 week low.

Itau Unibanco Holding (NYSE:ITUB) is the largest bank in Brazil, providing commercial, consumer, and investment banking. It trades at a P/E of 9.6 and is also 6% higher than its 52-week low. Banco Bradesco (NYSE:BBD) is the third largest bank in Brazil, and is primarily a commercial bank providing both banking and insurance services. It trades at a P/E of 9.5, and is only 4% above its 52-week low. Ambev, known formally as Companhia de Bebidas das Américas (ABV), is a subsidiary of Anheuser-Busch InBev and is the biggest brewery in South America. It trades at a P/E of 21.5 and is just 5% under its 52-week high and 57% above its 52-week low.

Other possibilities are BRF Brasil Foods (NYSE:BRFS), a food company that focuses on the production and sale of poultry, pork, beef, and dairy products that trades at a P/E of 25.3, or either of the steel companies Gerdau (NYSE:GGB), or Companhia Siderurgica Nacional (NYSE:SID), trading at P/Es of 10.4 and 9.0, respectively. These represent just a sampling of the many Brazilian stocks that trade on American exchanges that may be good investments.

This article has shown a simple method to estimate the P/E of Brazilian stocks using publicly available information. This method provides an estimate for the weighted average P/E of the iShares Brazil Index Fund of just 9.0. This is significantly less than the 12.4 P/E of the S&P 500, suggesting that Brazilian stocks are attractively valued.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: Assessing EWZ: Brazilian Stocks Appear Undervalued