CHAPTER 10

Brazil

THE GIRL FROM IPANEMA . . . GOT CARJACKED!

Brazil. What comes to mind is Rio, Copacabana, the statue of Christ the Redeemer on Corcovado Hill, Carnaval. What comes to mind is a vibrant population that seems to revel in the joy of life. Then, I talk to people who have been to Brazil. The country is booming, but massive social problems still prevail. Residents of Rio worry more about being kidnapped or carjacked then they do about the economic miracle. That is the reality on the ground.

The largest country both in terms of land area and population in South America, it has become the economic miracle of this century. Rich in natural resources, the country has been a favorite of emerging markets investors for the past two decades. But the sailing has been far from smooth in this economy prone to massive booms, busts, and hyperinflation. But, the country seems to have turned a corner, and done so under a socialist president, something few thought would happen. In the 1980s and early 1990s, Brazil saw rates in excess of 300 percent annual inflation.

When Luiz Inacio Lula da Silva took power in the 2002 election, people around the world were stunned. He had run twice before, unsuccessfully. He was seen by many as ultra-left politically, someone who clawed his way through factory jobs, someone with little formal education, and someone who made his name organizing labor unions. He was once jailed for a month, charged with organizing labor rallies in the 1970s, a time when Brazil was under military rule. By the time he left office in 2010, Lula was hailed as the most popular politician in Brazil’s history.

His policies and progressive thinking strengthened the country’s currency, opened the floodgates for economic growth and energy independence, and brought a sense of pride to a country that had lost its way in the 1990s.

In 2001, Argentina, Brazil’s neighbor, defaulted on its foreign debt to the International Monetary Fund (IMF), which bailed the country out of economic crisis in the 1990s. Brazil, on the other hand, which had been the largest emerging market IMF debtor nation up to that point, paid off its debt to the IMF in full in 2005. In 2008, Brazil became a creditor nation—one that is owed more than it owes, a stunning reversal. Partly in recognition of its progress, Brazil was awarded the 2016 Summer Olympic Games, a first for a South American country.

Lula’s plan was to implement his policies of investing money in education, social programs, pension reform, and welfare for the poor and working class. Focus on exports has led this resource-rich country into the twenty-first century at the top of the list of Tier 1 emerging markets. But, while on the surface everything appears rosy, a look below reveals issues that may derail economic expansion and may even lead the country into recession in the years ahead.

Lula’s plan for Brazil’s recovery was implemented through heavy government spending and, while that allowed millions of families to rise out of poverty, the country’s recovery also owed much to its strong export sector, a sector very dependent on commodities prices and the commodities boom that has prevailed for much of the past decade. As that boom fades or as global economies slow, Brazil will face lower export revenue at a time when government spending is on the rise. Skyscrapers are popping up everywhere, money is being spent for the upcoming Olympics, but the country still suffers from inadequate tax revenue, a low savings rate, and massive poverty outside the biggest cities. Inflation is starting to rise again on the back of a 10-year boom, and interest rates are rising in an effort to cool growth. The higher rates and economic growth are attracting lots of short-term capital playing the risk trade, borrowing in dollars and investing in reals. This, in turn, is causing sharp appreciation in the real, which traded at 2.17 to the U.S. dollar in 2006 and now trades almost 30 percent higher at 1.64 to US$1.00. It’s made Brazilians big spenders overseas but is showing signs of hurting their export sector.

Brazil is now a Tier 1 emerging market, however, last year a major battle broke out in one of Rio’s slums, something akin to a war. The military was called in and by the end of the skirmish, more that 42 lay dead. Events like this are not uncommon in emerging markets that suffer from massive economic inequality. Socially, it still suffers from instability beneath the surface that could lead to government heavy handedness. But, there is little doubt that Brazil will ever revert to a military dictatorship or hyperinflation. More likely, the country will suffer lower growth than the current 8 percent as world economies cool and commodities demand falters. But, growth in other emerging markets and the continued long-term trend in commodity prices bode very well for the country’s long-term outlook. In 2008/2009 Brazil saw economic contraction as the world suffered from the recession in the United States. However, growth in this emerging market was the first to rebound, a testament to its resiliency compared to days past.

Few people realize that Brazil is a major player in several world markets. It produces more than 80 percent of the orange juice consumed worldwide. It has the largest cattle population of any country in the world. It has huge oil reserves and is a net exporter of oil. It is also a major producer of sugar cane and coffee. Brazil’s problem has never been that it was not rich, rather that the wealth was concentrated amongst a very small upper class. This inequality continues today, but as I mentioned earlier, the Lula government took steps that are directly benefiting the lower classes, such as increasing the minimum wage and reforming the pension system.

Brazil is a major trader on the world market and especially in the South American region. The country is almost as big in size as the United States and borders every country in South America, save Chile and Ecuador. It is home to the world’s largest rainforest and the biggest river (the Amazon is nearly twice the size of the Nile although it is slightly shorter in length). Its biggest trading partner is actually not in the Americas; it is China. China’s need for natural resources plays into the hands of the Brazilian economy and that should be a trend that continues for many years to come.

Infrastructure in Brazil is quite impressive, as well. The country has more than one million miles of roadways (paved and unpaved) putting it behind only the United States, China, and India and well ahead of any European nation and Russia. The country also has the second highest number of airports in the world, albeit the majority are landing strips. It’s a country well equipped to lead growth in the Americas for many years to come as long as it can refrain from fiscal irresponsibility, which has plagued its past.

Investor Friendly . . . to a Point

Investing in Brazil is quite easy. Unlike in many emerging markets, there is plenty to choose from depending on your tastes. The three most popular investment classes in the country are banks, oil, and natural resources. All three are quite volatile and can provide extremely good returns if you can time your investment. The Bovespa is the main stock exchange in Brazil, located in Sao Paulo, the country’s financial capital. It’s a major world exchange with a market capitalization exceeding US$1.5 trillion.

There are dozens of companies that trade as American depositary receipts (ADR) on U.S. exchanges such as the NYSE and NASDAQ. You can get a full list of ADRs for any country on this site: www.adr.com.

The two most popular companies for investment in Brazil are oil giant Petrobras (PBR:NYSE) and Vale SA (VALE:NASDAQ), the mining giant. Petrobras is South America’s largest company by market capitalization and sales, and by far the largest company in Brazil. Vale is the second largest company in Brazil. The two combined tend to drive the Bovespa’s price movement on any given day. This is an important point to note if you are considering investing in Brazil through an exchange-traded fund like the Ishares Brazil (EWZ:NYSE) or through a closed-end fund like the Brazil Real Fund (BZF:NYSE), which trades the currency. EWZ’s two largest components are Petrobras and Vale, which make up close to 30 percent of the holdings, leading to more than average volatility because of narrow concentration. The Brazil Real Fund, managed by Wisdom Tree (www.wisdomtree.com/etfs/fund-details-currency.asp?etfid=63), gives you the ability to diversify your currency into the Brazilian real, which has returned over 36 percent since the fund’s inception in 2008 as the real has steadily appreciated against the U.S. dollar.

If you’re looking for alternative investment classes consider Banco Bradesco (BBD:NYSE), one of Brazil’s largest private banks, with a huge retail presence. With interest rates over 10 percent in Brazil, the banking sector has been able to attract a ton of foreign investment and inflows allowing it to lend robustly. However, as we have seen in the United States, banks are not the smartest lenders in the world. Banco Bradesco shares tend to outperform U.S. counterparts in the good times, but fall as hard, or even harder, when corrections occur.

Other options for investing in Brazil that are attractive are companies in the home-building sector like Gafisa (GFA:NYSE) and Rossi Residential.

Resource Is King

Brazil’s two largest companies, Petrobras and Vale, are world players. Petrobras is a semiprivate company controlled by the government and also by shareholders. It is hugely profitable and an aggressive explorer in many countries, but particularly off the coast of Brazil. The company is one of the technological leaders when it comes to exploration because it dares to drill deeper than any other company. One of the company’s former petroleum geologists, Dr. Marcio Mello, and I have met several times. He has presented extensively about his work in the private sector as president of HRT Petroleum, an exploration company based in Rio. But, what intrigued me the most about our conversations was what he has to say about Petrobras, his former company . . . and when he said it. Our first meeting was at a conference a few years back when he was explaining to a stunned audience about how Petrobras’ drilling technology has taken it to depths of almost 23,000 feet (80 percent of the height of Mt. Everest) below the ocean’s subsalt surface, the layer well below the ocean’s surface. Estimates range from 30 billion to as many as 70 billion barrels of oil in this part of the subocean surface. The higher-end estimates would put the finds on par with those of the North Sea fields off the coasts of the United Kingdom and Norway.

Petrobras has a distinct advantage in drilling for oil off the Brazilian coast and that advantage is the lack of stringent environmental regulations such as those in force in the Gulf of Mexico. One of the major advantages that all emerging markets have over developed markets is their more lenient regulatory burden, a result of playing catch-up to developed economies at any cost. Pollution, environmental damage, and human rights abuses are part and parcel of the emerging markets story.

Over the past decade, Petrobras has shown that it can play with the big boys like Exxon Mobil, Chevron, Royal Dutch Shell, and British Petroleum on the world stage. The company has reported staggering profits measured in the tens of billions of dollars, all the while ramping up production. The company has the distinct advantage of government support in raising capital to fund the massive costs associated with deepwater drilling. Oil prices, which have hovered well above $70 per barrel on the world markets, have also aided in the quest for greater profits. But, in order for that profit growth to continue, oil prices need to remain high as deepwater drilling is not only expensive but also a slow process in the early stages. Fortunately, Petrobras’ growth is almost assured thanks to growth in emerging markets like India and China, which are ramping up consumption of oil in per capital terms. China, which will surpass the United States in total oil consumption this decade, still lags in per capita consumption, as do all emerging countries. Table 10.1 offers a selected look at world oil consumption. (Please see the Appendix for a complete world oil consumption chart).

Table 10.1 Selected World Oil Consumption Rankings (barrels per day—2010)

Source: www.cia.gov/library/publications/the-world-factbook/rankorder/2174rank.html.

The oil consumption chart from 2009 shows that China’s oil consumption is 8.2 million barrels per day while the United States consumes over 18.69 million barrels per day, and India a scant 2.98 million barrels per day. These numbers are slightly higher for each country in 2011, but the purpose is to show you the huge gap that exists in oil consumption globally. With China and India growing at over 6 percent per year and massive numbers of middle class oil consumers being added daily, the future for oil looks very bright. Brazil’s Petrobras will continue to be a major player for a long time to come.

During oil price sell-offs, which occur with regularity and during emerging markets sell-offs, companies like Petrobras experience corrections that are more magnified than they should be considering the long-term potential. That is the fun in investing as far as I am concerned. It is the opportunity to make money when others are selling because of fear or panic. You have to take advantage of these pricing opportunities to trade and to accumulate shares of companies like Petrobras. This is a rare occasion where it makes perfect sense to accumulate an emerging markets company for the longer haul. Oil companies like Petrobras are here to stay and will flourish as the world’s demand for oil grows. Sure, there is a lot of talk about alternative energy and that is the long-term path that we all must follow. But, consider this. Based on current trends in alternative energy, sources of non-fossil-fuel consumption worldwide make up about 10 percent of energy consumed today and in the best possible case will make up 20 percent or thereabouts in 20 years from now based on studies put forth by various proponents of alternative fuel consumption. The price of oil will have quite a bit to do with how this alternative energy cycle pans out. If oil prices decrease, it will take longer to switch as there is less incentive, especially among emerging market nations that care more about growth than they do about pollution or renewable energy.

The Sweet Spot in Resources

Vale (VALE:NASDAQ) is by far the largest mining company in South America and one of the top five in the world. Vale is also the largest producer in the world of iron ore pellets and the second largest miner of nickel.

This and other mining activities puts Vale in the commodities sweet spot vis-à-vis China and other Asian emerging markets as what it mines is necessary for construction, especially steel for buildings and infrastructure. One major issue, one that Vale has overcome so far by being a lower cost producer, is proximity to China and status as a ship-borne miner. Its biggest market is much easier to reach by the major Australian miners that are the company’s largest competitors in the iron ore business.

Vale was a state-owned “public” enterprise until 1997 when it was privatized by the government. In 2006 the company acquired Canada’s second largest mining company, Inco, a major nickel miner, for a staggering US$19 billion, $17.7 billion of which was paid in cash. This made headlines because it made Vale number two in nickel behind Russian miner Norilsk and also because it was the largest acquisition ever made by a Brazilian company.

Vale is hugely profitable with revenue exceeding US$50 billion and profits of more than US$15 billion projected for 2011/2012. Its future looks quite bright, as well, as the emerging markets growth story for Asia and to some extent Latin and South America is still quite young and demand for its iron ore as China industrializes and builds out its rural regions will remain robust for some time to come.

If there is a common thread for most of these emerging markets stories, it is Chinese and Asian demand. Almost every mining company in South America and Australia has profited on the back of Asia and looks to that region and nowhere else for growth.

I wanted to mention another company as an interesting opportunity based purely on Brazil’s strong secular internal growth. The country is growing its GDP at 6 percent plus clip and that means a strong flow of funds to the retail sector and consumer. As in any market, the consumer’s biggest purchase once reaching the middle class is a home. Brazil is no different. Gafisa (GFA:NYSE) is a speculative way to play the Brazilian residential growth. With US$2.3 billion in sales, Gafisa boasts some large U.S. institutional investors, such as property baron Sam Zell, all looking to play one of the strongest secular growth stories in the world today. But, beware, if Brazil’s economy continues to overheat as it did in mid to late 2011, Gafisa will be hard pressed to make a lot of money in a tightening interest rate environment.

Strengths

Brazil has massive reserves of oil and natural resources. It is a democratic country with transparent political and economic systems (for an emerging market). It is a strong and welcome player on the world stage and will play host to the upcoming Olympics in 2016 and World Cup Soccer in 2014. Brazil boasts a huge tourism industry. It is a creditor nation with exports greater than imports. It is energy independent, has a huge population, second only to the United States in the Americas, and a functioning and transparent stock exchange. Brazil has enjoyed strong sustained growth during the past five years, entering recession only once for two quarters during the U.S. financial crisis.

Weaknesses

While transparent, the government has been known to hide spending on social programs under other categories of spending or not declare them altogether. There is a history of out-of-control government spending, something that has been brought under control for now. Brazil has a history of extremely high inflation, well into the triple digits on an annual basis, as recently as the 1990s. Its strong currency is putting pressure on exports. Massive poverty still exists in the country, and is especially evident in the slums of Rio.

Opportunities

China is a massive importer of Brazilian natural resources. Investment into high-tech/medical tech/biotech could make Brazil the Silicon Valley of South America. An exporter of energy, Brazil is still exploring within its shores and could emerge a top global player over the next two decades if its deepwater drilling program pans out. It has a chance to be a model for emerging market growth in Latin/South America as a major populated country. Sao Paulo is emerging as South America’s financial capital. If the rest of the Americas grows, Brazil, with its current stability, currency, and strong export sector, will benefit.

Threats

An overheating economy could cause interest rates to soar to combat inflation, which would bring growth to a dead stop. Political transparency could be better in terms of disclosing where the government is spending money. If it turns out the government is indeed funneling money to far left social programs, it could torpedo the ruling party. Global economic contraction, especially in China, could hurt Brazil the most of any emerging market as it is reliant on exports and natural resources for a good chunk of its growth.