Is Brazil 'Investment-Grade' for Individual Investors?

by: Martin Hutchinson

Brazil is a lot like a person who gets a new job, pays off some of his debts, and has his credit score upgraded.

In pretty short order, all the charge-card companies boost his credit limits, cut the interest rates he’s paying on his outstanding balances, offer him new credit lines - and even make him eligible for various “rewards” programs that give him all sorts of freebies for spending money.

Brazil finds itself in that situation because uber-debt-rater Standard & Poor’s just boosted the country’s credit rating to “investment grade” in recent weeks, moving its rating from BB+ to BBB-. Why should we care? After all, isn’t Brazilian debt bought mostly by institutional investors? That’s true. But with the increased debt rating, Brazilian shares also should benefit - provided the government doesn’t embark on a big spending binge.

Brazil was included in the “BRIC” (Brazil, Russia, India, China) group of rapidly growing emerging economies that was created by Goldman Sachs Group Inc. (NYSE:GS) back in 2003. At that time, it really didn’t deserve the distinction. Long-term growth since the 1970s had averaged less than 2% per capita, and the country had narrowly avoided bankruptcy only the year before. Long-term interest rates were above 20% (around 15% in real terms), which hardly encouraged companies to make capital-spending commitments that might grow the economy. Most alarming, a left-wing socialist named Luis Inacio Lula da Silva had just been elected president.

Brazil got lucky. First, Lula proved to be surprisingly moderate, not much to the left economically of previous Brazilian governments, perfectly willing to welcome foreign investment, generally friendly to the United States and not at all like his socialist neighbor, Venezuelan President Hugo Chavez. Second - and probably even more importantly - 2003 was the year in which energy and commodity prices began the long climb that has brought them to their current (astronomical) record levels. Third, since Brazil was not an oil exporter, there was no single source of new wealth that the government could just seize. Instead, revenue flowed to mining companies, the oil company Petroleo Brasileiro SA (usually referred to as just Petrobras) (NYSE:PBR), and numerous agri-business operations that benefited from the rise in agricultural prices.

Most startlingly, Brazil’s ethanol program, which had been a hopeless boondoggle for a generation since it started during the oil crisis of 1979-82, suddenly became the envy of the world. Rising oil prices made Brazilian sugarcane the world’s cheapest and most economically and ecologically efficient source of newly fashionable ethanol. At a $20 per barrel oil price, the ethanol-from-sugar program was a typical example of misguided Third World government planning; at $120, it is a bonanza.

Brazil’s debt position has improved in three ways:

  • The amount of outstanding debt has been reduced through modest repayments.
  • Its ratio of debt to gross domestic product [GDP] has dropped sharply, as GDP in dollar terms has shot up with the revaluation of the Brazilian real against the dollar.
  • And Brazil’s interest costs have dropped along with the country’s improving creditworthiness and with the generally low level of global interest rates.

With more income, a stronger currency and lower debt, it’s not surprising that Brazil’s credit rating has improved. As with an individual consumer on whom the credit card gods suddenly smile, what happens next depends on what use is made of the improved position. If a person reverts to their earlier spendthrift ways, they will quickly max out the new credit limits, actually making their position even worse than before.

Fortunately, the Brazilian government appears to have learned the difficult lessons of the last 25 years, and is remaining both careful in its spending and welcoming to foreign investment. That will bring down Brazil’s debt costs further, as will recent favorable developments like the discovery by Petrobras of about 36 billion barrels of oil in an offshore Brazilian oilfield.

Now, don’t get carried away. This isn’t China - with its 10% annual growth rate, apparently repeatable ad infinitum. Brazil had such growth rates for a brief period in the 1970s, but they disappeared around 1980 in a blizzard of unpaid debt. Brazil’s growth rate is currently around 5% - but it looks far more balanced and stable than it did in the 1970s. Brazil’s improving credit position is likely to make growth persist, and future political risk appears minimal. When Lula goes, a politician of the center-right could well replace him.

Another good sign for Brazil - there are more than 30 Brazilian companies with full American Depository Receipt [ADR] listings on the New York Stock Exchange, plus 40-50 more that are traded in the over-the-counter market. Here are a few attractive examples to consider:

  • Banco Itau Holding Financeira SA, referred to usually as Banco Itau (ITU), has a Price/Earnings ratio of 14 and dividend yield of 2.4%. Brazilian banks earn very high returns, primarily from domestic market lending in reals. Including Banco Itau, there are three large ones listed on the Big Board in New York; the other two are Banco Bradesco SA (NYSE:BBD) and Uniao Bancos Brasile SA (Unibanco) (UBB). However, Itau is the cheapest of the three, though only slightly.
  • Companhia Vale do Rio Doce, now referred to only as Vale (NYSE:RIO), is one of the true global blue chips, with a market capitalization of almost $200 billion. An iron-ore company with ancillary operations in gold, nickel, copper and other metals, its shares trade at a reasonably valued 13 times earnings, though its dividend yield is only 1.2%.

  • Petrobras (PBR) is one of the few emerging market oil companies with access to modern technology - and the willingness to work with the oil majors. Its shares are up 168% in the past year, but the stock’s P/E still is only 16. It has a 1.3% yield. The possible upside: It finds another gigantic offshore oilfield. The possible downside: Oil drops back to $50 a barrel. If the world’s monetary authorities get serious about imposing higher interest rates to fight inflation, PBR and RIO would probably suffer as commodities prices fall back to earth.
  • Companhia de Saneamento Basico (Sabesp) (NYSE:SBS) is the water and sewage system provider for Sao Paulo. Now that’s a growth business, and not dependent on commodity prices. With a P/E of only 9.2 and a yield of 2.7%, this is one stock I have to say I love.
  • TNE (NYSE:TNE) There are a bunch of Brazilian cell phone companies, but TNE appears to be the cheapest. It’s concentrated in the populous southeast and northeast regions of Brazil, with a P/E ratio of only 7 and yield of 4.25%.
  • Telecomunicacoes de Sao Paulo SA, or Telesp (NYSE:TSP) provides the fixed line telephone system for Sao Paulo. Before you sneer, consider this: the company has a dividend yield of 9.8% and a P/E ratio of 10 (which means the dividend is only just covered). And it’s majority owned by Spain’s Telefonica.

  • Voturantim Cellulose (VCP) is a pulp and paper company, with a P/E ratio of 14 and a dividend yield of 2.8%. Trees grow fast in the tropics and VCP definitely benefits from that!