BRICs Report: Is the Samba Over for Brazil?

This is part of a four-article series discussing the outlook for and ways to invest in the BRICs countries.

Brazil is world renowned for its beaches, its potent caipirinhas and, of course, the Rio de Janeiro Carnival. Onto more serious topics, it also is a world leader in alternative energy production and happens to be sitting on one of the world’s largest supplies of traditional energy. Brazil’s deep-water Atlantic fields will make the country a force to be reckoned with in the oil market for the foreseeable future.

But with Brazilian stocks drifting downward for the past two years — and showing significant weakness since March of this year — it is fair to ask: Is the party over?

The short answer is “no,” though investors might want to consider sitting out a song or two.

The Country of the Future

Brazilians have said for decades, tongue in cheek, that Brazil is the country of the futureand that it always will be. It seems that every time Brazil started to make real development progress, the familiar hurdles of hyperinflation, class warfare and government instability would get in the way. Brazil, for all of its potential, had never quite been able to reach that tipping point of middle-income, democratic stability — but there is real reason to believe that this finally might be changing.

Brazil’s domestic economy is healthy, and the country’s living standards continue to rise at a clip not seen in a generation. According to Morningstar, Brazilians classified as “middle class” grew from 38% of the population in 2001 to 55% last year. For a country of Brazil’s size, that amounts to more than 32 million people.

To give a little perspective, if the 32 million Brazilians that became middle class over the past decade were an American state, they would be more populous than Texas and only slightly smaller than California.

Why the Middle Class Matters

Revolutions are rarely born in the tree-lined streets of suburbia. Once you take on the trappings of middle-class life — a job to keep, a home to maintain, neighbors to keep up with — you have a stake in the system. Those with a stake in the system have an interest in stability, and stability breeds prosperity.

Furthermore, a consumer-based economy is far less volatile than one dominated by commodities and exports. Brazil still depends far too heavily on both — and I will address that shortly — but its middle-class consumer market is making its presence felt.

Before I go any further, I should note that “middle class” means something very different in Brazil than it does in the United States. Someone earning $10,000 per year and living in a 500-square-foot home (which they might or might not have proper title to) would be considered middle class in Brazil. It might not be life in a 1950s-themed Norman Rockwell painting, but it is enough to provide for basic needs and to allow a reasonable budget for discretionary purchases such as contemporary clothes, mobile phones and the occasional meal in a restaurant.

Collectively, Brazil’s retail market is worth about $230 billion, and I only see this growing in the years ahead.

China: The Elephant in the Room

If Brazil’s outlook is so rosy, why have its stocks underperformed both the S&P 500 and the iShares MSCI Emerging Markets ETF (NYSE:EEM)?

To be sure, some of the weakness is because of the strength of the Brazilian currency, the real, and fears that it might be due for a correction. Already, Brazil’s industrial firms have suffered from the same “hollowing out” that ravaged American manufacturers in the 1980s and 1990s during the years of the strong dollar. Brazil’s government has vowed that it will not lose a “currency war” with other emerging markets, and investors take those claims seriously.

But the biggest worry has little to do with Brazil and everything to do with China. China might or might not be heading for a “hard landing” (it is my view that China’s slowdown will be relatively mild), but Chinese commodity consumption should moderate in the months and years ahead as its pace of urbanization slows. And given that Europe looks to be mired in recession and crisis for a while, the West is not likely to support higher prices, either. This presents a major risk to Brazil and other commodity-exporting nations like Australia and South Africa.

So, even while Brazilian stocks are cheap — the stocks making up EEM collectively trade for just 10 times earnings — the fear is that the earnings might come under pressure as commodity demand inevitably falls.

Though I tend to take a contrarian position when “everyone” agrees on the direction of commodity prices, this time I am tempted to agree. I cannot see commodities enjoying a sustained uptrend when final demand is weak and prices already are artificially inflated by new ETFs, mutual funds and other “investment” products that track commodities. (Yes, “investment” should be in quotation marks. An ETF or mutual fund that rolls over commodities futures contracts is not an investment. It is a speculation, and given that many popular commodities are trading in contango, a rather poor one.)

Still, I would not want to bet against the Brazilian consumer. The growth of the middle class is real, and I believe the change is durable this time.

Investors probably will want to shy away from the popular iShares MSCI Brazil ETF (NYSE:EWZ) because of its high concentration in materials and energy. But investors with a longtime horizon might find value in some of Brazil’s world-class consumer-oriented stocks. I have written favorably about mega-brewer AmBev (NYSE:ABV), and I would reiterate that view today. AmBev is a fantastic way to benefit from rising incomes among Brazil’s newly minted middle-class consumers, and it pays a great dividend of 3.7%.

Another good option would be Arcos Dorados (NYSE:ARCO), which was one of the stocks selected in InvestorPlace’s Ten Best Stocks for 2012 contest. Arcos Dorados is the largest McDonald’s (NYSE:MCD) franchise operator in Latin America, and about a third of the company’s revenues come from Brazil. Arcos has had a rough start to the year, but the stock should be a fantastic long-term vehicle to play rising living standards in the region.

Other BRICs reports:

Charles Lewis Sizemore, CFA, is the editor of the Sizemore Investment Letter, and the chief investment officer of investments firm Sizemore Capital Management. As of this writing, he did not hold a position in any of the aforementioned securities. Sign up for a FREE copy of his new special report: “Top 3 ETFs for Dividend-Hungry Investors.”

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