Sunday, March 25, 2012

One of the plays for this trend is the Brazil Small Cap ETF

U.S. stock mutual funds have seen outflows for 17 consecutive weeks as investors have finally figured out that putting money blindly in a domestically-oriented mutual fund “because stocks always go up in the long run” is a bad idea.
For many individual investors, it has been a huge disappointment to see the 10-year investable trailing annualized return for the S&P 500 come in at a negative 1.64% per year, as measured by the largest index fund — the Vanguard 500 (MUTF: VFINX).
Those withdrawals are completely understandable, as are the inflows into emerging market mutual funds. This is not limited to the U.S. alone. Bloomberg just reported that globally “mutual fund investors poured $35 billion into [emerging markets] this year, even as they pulled $28 billion from the U.S., Europe and Japan.”
One place where they have been putting serious money — and we have previously suggested doing the same — is Brazil. While the Brazilian benchmark index, the Bovespa, is about 10% or so from the all-time highs at 73,900 set in 2008, Brazilian small caps are already making all-time highs in 2010.
The Market Vectors Brazil Small-Cap ETF (NYSE: BRF), which we have consistently recommended since emerging market equities made a low in May, has advanced a stunning 123.85% since its introduction in 2009, while the Bovespa has advanced 33.07% in that time frame. For comparison, since BRF’s introduction, the S&P 500 has advanced 19.07%. No wonder mutual fund investors globally are leaving developed markets for emerging markets at large — and Brazil in particular.

Brazil Small Caps Are Driven by Domestic Demand

The massive outperformance of Brazilian small caps is due to the fact that they are dom! esticall y-oriented and not captive to any external shocks. The Brazilian large-cap Bovespa index is also dominated by several companies that have special situations and as such do not reflect the reality of real Brazil. The largest company by market capitalization in South America — Petrobras (NYSE: PBR) — is a good example of this skew.
Although publicly-traded, Petrobras is controlled by the Brazilian government much the same way that Gazprom (OTC: OGZPY) is controlled by the Russian government; they are both considered national treasures. Since Petrobras controls the largest and deepest oil finds the world has seen in decades, investors are naturally both interested and intrigued by the complicated financing and technical maneuver of getting those oil reserves out. And this week I have some news on this front.
Although controlled by the Brazilian government, Petrobras is paying Brazil $42.5 billion in new stock for the right to develop five billion barrels of offshore oil reserves. It originally sounded like taking $42.5 billion from your right pocket and putting it in your left pocket, but it actually it is quite a bit different as a lot of money is coming from external sources via complicated financing through both new debt and equity.
Now, that works out to an average of $8.51 a barrel for the oil in stock. This may sound like a good deal with oil in the $70s, but no one is really sure how much it would cost to extract the oil that is miles under sea water and layers of rock. The company will have a secondary offering of stock to partially finance the $224 billion offshore development plan. Naturally, this uncertainty weighed on the shares and has put pressure on the headline Bovespa index as well as the Brazil iShare ETF (NYSE: EWZ), where the company is the largest holding.
I think this oil will be worth a lot one day and that all this PBR share volatility will be worth the wait, but in the meantime if! you are looking for performance with less uncertainly, you probably need to focus on the BRF and other Brazilian large caps.
One such Brazilian large cap with assured growth is CPLF Energia (NYSE: CPL), a sizeable electrical utility that is growing nicely, has a 29% return on equity and 7.5% dividend yield. GDP growth of 6% or so in Brazil translates in strong electricity growth, which also tends to increase per capita electricity usage as people’s incomes rise. The other beneficiaries of a strong economy are of course the banks — Banco Bradesco (NYSE: BBD), Banco Itau (NYSE: ITUB) and Banco Santander Brazil (NYSE: BSBR), which is independent from the problematic Spanish parent Santander (NYSE: STD). Just like Banco Santander Chile (NYSE: SAN) has outperformed its parent, so is Banco Santander Brazil.

The theoretical long-short SAN/STD and BSBR/STD trades have been working as a pair, but even if you take only the individual legs of the trades, you should do OK for the moment.
Over the long-term, I have no desire to own any Western financials (other than for a bear market rally) due to their over-indebted economies and problematic profitability profiles. But, there clearly is an opportunity in emerging market banks for long-term investors due to their low-debt levels and organic sustainable economic growth.
So far this year, the Brazilian banks have not moved much, even as their earnings have grown — representing an opportunity for long-term investors.
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