BRIC Investor Warning: Thursday Could Be An Inflection Point

Includes: FXI, GGB, MTL, SID, VEDL
by: Efficient Alpha

By Joseph Hogue, CFA

Thursday promises to be a heavy day in terms of emerging market economic releases. While global headlines will follow Europe's second round of three-year liquidity program on Wednesday and the EU leader summit starting Thursday, data out of individual countries could significantly affect the stocks focused heavily on their economic health.

All four of the BRIC nations report manufacturing purchasing manager indexes (PMI) on Thursday. HSBC (HBC) reports monthly on the economic activity within the manufacturing sectors of individual countries through data gathered from management interviews. Detailed reports for each country are available on the company's website. While the PMI report is important for the developed world, it is even more so for emerging countries many of which still rely on strong manufacturing exports to drive the economy.

The key number to watch for in the releases is 50.0, this is the demarcation between expansion and contraction. While the consensus estimate is factored into stock prices well in advance of the release, surprise readings and trends can significantly move prices on the day of the release and following.

China's report on Thursday is, by far, the most important and arguably the most important release of the week. With little help from sluggish U.S. growth and only fear out of Europe, the Chinese PMI reports have been used as a strong indicator for the global economy over the last few years. China's manufacturing index has been falling steadily from 55.0 around the beginning of 2011 and now stands dangerously above the point of economic contraction. Expectations are for a slight increase from January's 50.5 reading to 50.8 in February. With the general downward momentum in the economy, if February's report does not surprise to the downside then the March report may continue the trend. A reading below 50 for the Chinese index could bring back the risk-off trade in global equities.

The iShares FTSE China 25 Fund (NYSEARCA:FXI) consists of the largest companies in the China equity market that are available to international investors. Financials dominate the index with a weighting of 52.9% while telecommunications and oil & gas represent 18.0% and 15.0% respectively. The fund has returned approximately 11.8% since the beginning of the year and pays a dividend yield of almost two percent. The shares underperformed the general market and other emerging market funds on Monday and could see further losses during the weak if the PMI report disappoints.

Russian manufacturing slowed for a second month in January as exports fell, largely as a result of an increasingly strong ruble. The index fell from 51.6 in December to 50.8 in January. The ruble appreciated along with most emerging currencies in January and further extended gains in February, putting pressure on export prices. Domestic demand continues to be extremely strong in Russia and the economy is expected to continue its momentum through the upcoming presidential elections.

Mechel OAO (NYSE:MTL) is a mining and steel company operating in the Russian Federation and internationally. The company operates in four segments: mining, steel, ferroalloys, and power. The company has been under pressure with other coal miners as cheap natural gas and lowered global growth puts pressure on earnings. The stock has fallen from highs around $30 last year to just over $11, though they have rebounded strongly from lows of $8 a share since the beginning of the year. While long-term value remains in-tact, a weak PMI report from either Russia or China could weigh heavily on the shares. The shares trade for approximately 7.2 times trailing earnings and pay a dividend yield of 2.2 percent.

Brazil's PMI rose to 50.6 in January after seven months of negative readings. The sector expanded for the first time since May and momentum may continue this month as the central bank aggressively cuts interest rates to spur growth. Expectations are for an increase to 51.0 in the index. Equities in Brazil may shrug off a favorable PMI number if the reading out of China comes in below expectations. The South American powerhouse is economically tethered to China, even more so than other BRIC peers.

Companhia Siderurgica Nacional (NYSE:SID) is an integrated steel producer in Brazil and Latin America. The company sells steel products as a input to various manufacturing industries including automotive, home appliance, and construction. Weak exports to developed markets have brought shares down over the last year but are well off the lows of late last year. Despite an almost 30% jump in shares, the company still trades for 7.7 times trailing earnings and pays an attractive dividend yield of 6.3 percent.

A hedge against weakness in the Brazilian report may come from Gerdau (NYSE:GGB), another Brazilian steel producer. Cost pressures and a week global market weighed on fourth quarter profit and are the impetus behind a recent strategy to spinoff some assets. The shares are expensive relative to SID, trading at around 15.0 times trailing earnings and only pay a dividend yield of 1.8 percent.

India's factory output has been strong since the central bank ended its restrictive monetary policy in December. Lagging investment is still hampering the economy, though the manufacturing PMI showed an impressive rebound in January. January's reading of 57.5 was the best since May 2011 and easily beat December's 54.2 report. Expectations for February's report are for a slight moderation to 56.0 though the risk is to a surprise to the upside on momentum.

Sterlite Industries (BATS:SLT) operates as a non-ferrous metals and mining company in India and internationally. The company processes copper and copper byproducts in addition to other industrial metals and chemicals. Power generation accounts for a small portion of revenues mainly from thermal and wind power plants. The stock has bounced with other emerging market shares but still trades for an expensive 29 times trailing earnings.

Look for the China report to overshadow all others, but individual country reports could still provide an opportunity to hedge or make incremental profits. While a weak reading on the reports may drive prices downward, valuations for many of the shares are fairly low and may provide an entry point to long-term holdings.

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