Beware The Bubble In Brazil

Includes: BBD, CVX, PBR, RIG, VALE
by: Bret Jensen

One of the best things about living in Miami (besides the great weather, beautiful women, no state taxes and one the best defensive driving teaching crucibles in the world) is the perspective that it provides you into South America. What I am hearing lately is not good. My colleagues who travel to Sao Paolo regularly report it is twice as expensive to go out to dinner or entertain as it is Miami. In addition, new condo projects are being bought out in Miami again before construction begins by Argentines, Brazilians, Mexicans and Colombians (did the world learn nothing from the last housing crisis here?). Many have rent equivalent cap rates of 2%-4%. Commercial projects in numerous South American countries are attracting capital at lower and lower cap rates as well.

Of all South American economies, I am becoming most concerned about the largest country on the continent, Brazil. This country of almost 200mm is by far the biggest economic engine in South America and the recent data points suggest that it decelerating at a rapid pace.

Negative recent data points from Brazil.

  1. The unemployment rate recently ticked up for the second straight month.
  2. The new government is growing increasingly hostile to foreign investment judging from the recent $11B extortion attempt on Chevron (NYSE:CVX) and Transocean (NYSE:RIG) for a minor spill in deep water.
  3. The latest GDP reading came in at just 2.7%, less than half of the rate predicted by the government less than a year ago.
  4. January industrial production declined by 2.1%, its worst performance since the crisis in 2008.
  5. The slowdown in China, Brazil's largest trading partner, will negatively impact Brazil's export growth, especially commodity producers like Vale S.A. (NYSE:VALE).

Actions I believe investors who have positions in Brazil should take.

  • Avoid the banks like Itau Unibanco Banco Holding SA (NYSE:ITUB)and Banco Bradesco (NYSE:BBD). Although both appear to have reasonable valuations and strong growth prospects, they both are selling at multiples of book value (2.42 times b/v and 2.26 times b/v, respectfully). I think investors are well aware what banks selling at high book values can do when the economy goes south.
  • Avoid Petroleo Brasileiro (NYSE:PBR). Another firm with low valuations and huge offshore deposits. Unfortunately, the actions by the government against Chevron and Transocean will chill relations with foreign oil services firms the company needs to reach its offshore reserves that lie in very deep water as it lacks the technical expertise to do so on its own. The government is also meddling in a variety of other ways and the company has significantly missed earnings estimates for the past two quarters.
  • The country's other large commodity producer, Vale, is encountering some of the same government interference and is being pushed to expand production outside of just iron ore, mainly to create jobs regardless of whether it is good allocation for the company's capital. Given Vale's rock-bottom valuation and large dividend, it is a "hold" at this point in my opinion.

Disclosure: I am long CVX, RIG, VALE.