IPO Boom And Growth In Brazil Could Send Stocks Higher

Includes: EEM, EWZ, GGB, ITUB, PBR
by: Efficient Alpha

Bank of America (NYSE:BAC) and BTG Pactual, the two largest stock underwriters in Brazil, believe that equity issuances could double this year to $16 billion. This is after IPO activity plummeted 32% last year to a seven-year low of $8.21 billion as a weak economy and global risk drove six companies to withdraw or postpone issuance plans.

A bounce in share issuance, along with an improving economy, could bring foreign investors back to the market. This could drive share prices higher and support the local currency, driving further gains for dollar-based investors.

Last Year's Loser Could be This Year's Turnaround Story

Economic growth in the country has stalled recently, and many investors have started to question the country's emerging credentials. Growth last year plummeted to under 1% after 2.7% in 2011 and 7.5% in 2010. Dollar investors were hit by a double whammy last year, as poor economic performance was compounded by a 9.5% drop in the value of the Brazilian Real. The iShares MSCI Brazil Fund (NYSEARCA:EWZ) lost 8.8% last year, underperforming the broader iShares MSCI Emerging Markets Fund (NYSEARCA:EEM) by 21.7%.

A rebound in commodity-hungry China and domestic spending leading up to the World Cup in 2014 and the Summer Olympics in 2016 should help the country beat 3% this year and 4.5% in 2014. The improvement in the economy may lead the central bank to raise rates, which would help support the Real and bring foreign investors back into the market. This should send stocks higher on improving fundamentals and investor sentiment.

Next year's possible increase in share issuance could lead to a virtuous cycle for the markets. As the outlook improves, more companies will come to market and help support the chorus of optimism. As more investors return, inflows increase to boost capital and the value of the Real. This would also increase returns for foreign investors when converting to dollar terms and further support the growth theory.

Core-Satellite Approach to the Market

I usually recommend a core-satellite approach to investors for the emerging market portion of their portfolio. This involves using a diversified fund to provide core exposure to the general market and selecting a small group of individual names to provide excess returns. The core investment might comprise between 60% to 80% of the total country allocation with individual names consisting of 5% to 10% of the investment. This helps to decrease the volatility around one company but still deliver returns that beat the general market.

The iShares MSCI Brazil Fund remains the most popular outlet for overall exposure to the market with 12.5 million shares traded on a daily basis. The fund holds assets in 84 companies with diversified sector exposure to financials (27.5%), materials (19.2%), energy (16.5%) and consumer staples (14.6%). The fund trades relatively cheaply at 13 times trailing earnings and pays a 2.8% dividend yield.

Shares of Petrobras (NYSE:PBR) have underperformed the iShares country fund by about 20% over the last year as state controls on gas prices forced the company to sell at a loss in the domestic market. A recent decision to lower operating costs by $15.4 billion over the three years to 2016 should help to improve margins at the $124.4 billion oil company. The government has agreed to increase the price Petrobras can charge for domestic gas next year. Increases in June of 2012 were the first allowed since 2006, so a second round of increases in less than a year may signal the government's willingness to work with the company.

Shares of steel makers should benefit from the coming increase in infrastructure spending. Gerdau S.A. (NYSE:GGB), the $11.2 billion iron and steel company, produces and sells its products principally in the domestic market, but also generates revenue throughout Latin America and the United States. The company reported a 9% increase in second quarter profit over the same period last year even as it saw construction growth of only 5% in Brazil for 2012. Revenues grew by 10.7% over the same quarter last year. The shares pay a 2.1% dividend yield and trade for 18 times trailing earnings.

Itau Unibanco (NYSE:ITUB) saw a decrease of 0.1% in loan delinquencies to 5.1% over the last quarter, though the rate was higher than last year's 4.7%. Overall economic growth has improved recently, growing 0.4% in the second quarter against the first and on track for 1.5% growth over the year. Economic activity is forecast to pick up next year and should help to further moderate default rates. Further, a slight increase in inflationary expectations should keep the central bank from lowering rates further and will probably even start to raise rates in 2013. This will help to improve profitability through fees and the spread on products.

The banks may not be out of the woods yet, but I think you can slowly allocate into the quality names. Itau trades at 11.9 times trailing earnings and pays a 0.5% dividend yield. Despite a difficult environment, management is able to earn a 19.5% return-on-equity.

The cancelation of the IPO for Vix Logistica SA last week confirmed that investor sentiment is still weak, and demand for issues during the first quarter may be lackluster. Still, an improving global macro environment and a significantly undervalued Real should help to support growth this year. With a few positive headlines, many of the planned IPOs will come to the market, and momentum could build quickly. Investors may want to start increasing their allocation now before sentiment turns.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.