Emerging-markets valuations have made an extraordinary V-shaped move in the last six months, yet Brazil still looks almost as cheap as it did back in August.
Believe it or not, a big Brazil fund such as EWZ (NYSE:EWZ) has rebounded only about 6% since late August, when the Bovespa had been pounded to a forward P/E of 8.3.
As a result, the improvement in tone has barely brought EWZ back to a P/E of 9 — still far enough below the broad MSCI Emerging Markets valuation of 10 to tempt traders back to this healing-but-still-bruised market.
The question is, can those forward-looking earnings forecasts be trusted?
A slowing global economy will naturally drive analysts to downgrade their Brazilian earnings models to reflect reduced appetite in Asia for iron ore and pulp — China alone accounts for 15% of Brazil’s exports.
The answer is to focus on stocks that are less exposed to China. So skip Vale (NYSE:VALE), the second-biggest company on the Bovespa and the largest miner of iron ore in the world. Besides, Vale’s mines have been washed out by heavy rain, forcing it to leave 2 million tons of ore contracts unfilled.
We know China is still buying plenty of oil, though, which makes Petrobras (NYSE:PBR) a natural place to start looking. PBR is huge, but it’s definitely on an upward trend — up 20% year to date and just cracking the 200-day resistance line in the last few days.
If we hold this line, there’s plenty of room for upside. Before collapsing in the August sell-off, PBR was moving in a comfortable range of $30 to $45 over the last few years.
To get back on that footing again, PBR will need to rally an additional 17%. Meanwhile, the stock is on the cheap side, with a P/E of 8.85, and even with its massive petroleum reserves, it’s still priced at maybe 1.05 times book value.
PBR also stands to benefit from the ongoing shift in institutional portfolios, which were very underweight this stock for a long time. It takes a lot of buying to shift the needle here — we’re talking about the fourth-biggest stock in the world — but the needle is definitely moving back in the right direction.
On the domestic side, banks are also relatively immune to the shifting export cycle and are best-positioned to benefit from the local central bank’s recent efforts to relax some of the highest inflation-adjusted interest rates in the emerging world.
Still, Brazil seems to have won at least a temporary victory against inflation. The job market is tight, and despite the occasional problem for a fringe lender, credit quality is improving.
With conditions like these to work with, Banco Bradesco (NYSE:BBD) is probably our favorite name in the sector. BBD has it all: improving loan margins, net interest margins and a PEG ratio of just 0.50.
While the P/E is a little rich at north of 10, it still fails to reflect the true value of BBD’s loan portfolio. Price to book is all the way down at 0.33.
Compare BBD with Itau Unibanco (NYSE:ITUB) and the choice is clear on just about every measure. ITUB is more richly valued, with a P/E of 11+, trades at 2.45 times book value and a PEG of 1 and even has much worse credit quality than its rival.
So why buy ITUB when you can get BBD? We have yet to hear a good answer.
On last note: Watch the Brazilian real for your next hints on where the Bovespa is headed. The real was one of the worst-performing currencies last year, printing a 10.5% decline against the dollar. But in the last three weeks, it has shaped up as one of the fastest-appreciating currencies in the world.
Institutional traders need to buy reais before they buy Brazilian stocks. If that’s what’s going on here, the long-looked-for rally could be on the way.