Hosting the World Cup has put Brazil on the world stage. Brazil is the largest economy in South America and has vast natural resources, including offshore oil reserves. However, along with other emerging markets, the Brazilian stock market has underperformed recently. Share prices have dropped so much that now could be a good time to invest in some high-quality companies in Brazil.
A tale of two stock markets
The following graph shows the performance of the iShares MSCI Brazil Capped (EWZ 0.13%) ETF relative to the SPDR S&P 500 (SPY +0.18%) ETF over the last five years:
The iShares MSCI Brazil Capped ETF is designed to capture 85% of the Brazilian stock market. Brazil faces some near-term economic headwinds. In particular, the country is coping with weak prices for commodities and slower growth. However, Brazil's long-term prospects are still bright.
A promising future
Brazil has a young population and a growing middle class. While income inequality is rising in the U.S., it is falling in Brazil. Brazil is the 10th-biggest oil-producer in the world, according to the U.S. Energy Information Administration. Its national debt as a percentage of GDP is approximately 57% compared to about 102% in the United States.
2 investment ideas
Brazil is home to leading regional-jet manufacturer Embraer S.A. (ERJ +0.73%). Due to the high barriers to entry in the commercial aviation manufacturing industry, Embraer has a competitive advantage. Technical and regulatory barriers make it difficult for prospective new entrants to obtain air safety certifications from governments around the world, which are necessary to break into the market.
Rather than competing head-to-head with global aircraft titans that produce jumbo jets, Embraer is focused on building smaller, regional jets with no more than 130 seats. Embraer is a market leader in the regional jet niche. Its jets have superior head space, legroom, and luggage space. Aside from commercial airlines, Embraer sells jets to business executives and military customers.
The company's strategy of upgrading its existing lineup of planes, rather than building a new family of jets, is expected to generate positive results. This approach does not require customers to put faith in an entirely new airframe, which could face delivery delays after orders are placed due to stringent testing requirements for new airframes.
Airlines in the U.S. are looking to replace smaller 50-seat jets with larger planes that offer better fuel efficiency. Embraer could sell 150 of these larger regional jets through 2015, according to chief executive Frederico Curado.
Vale S.A. (VALE 0.58%) is another investment option to consider, especially for value-minded investors. Vale is one of the largest mining companies in the world, producing raw materials used in the production of steel and other industrial products.
Due to weak commodity prices, Vale faces some near-term challenges. Its revenue has declined 14% over the past four quarters. However, the company has engaged in a cost-cutting campaign, and as a result, its five-year net profit margin has climbed to 23% -- much higher than the industry average of 14% -- and its ratings outlook was recently upgraded by Moody's from neutral to positive. The company's cost-cutting campaign extends through 2015 and includes three phases:
- Low-hanging fruit, including simplification of organizational structures.
- Efficiency and productivity, with a greater focus on exploration.
- Structural changes, such as plant optimization efforts.
Lowering costs can help a mining company maintain profitability during the ups and downs of the commodity price cycle. But cost cutting cannot continue forever.
However, Vale has already seen benefits from its cost-cutting initiatives. "For the first time in more than 40 quarters, expenses was the main driver of improvement," said chief executive Murilo Ferreira during a conference call discussing first-quarter performance. Ferreira added, "This is not a one-off event." Vale has a corporate culture of austerity that helps it stay strong when commodities prices swoon.
Currently, Vale has a price-to-book-value ratio of 1.5 -- just half the industry average of three. The price-to-book ratio is a useful valuation metric in capital-intensive industries such as mining, because companies in the mining industry have enough net assets, or "book value," to make a meaningful contributions to profits.
Vale's low price-to-book ratio is a sign that the company is undervalued. This could be a good time to acquire a stake in the company at a low price. Vale's current price of about $13 could be 10%-20% below its intrinsic value.
Don't just watch the games, but consider investing
Both Embraer and Vale look attractive at the moment. Embraer is likely to continue outperforming due to a strong global brand in the regional jet niche. Vale's recent efforts to reduce its costs leverage the company's strategic advantage, and the company appears to be trading at a discount to intrinsic value.
While some may argue that Brazil has lost its competitive edge, the country has a number of long-term advantages due to the size and youth of its population, plentiful natural resources, and growing middle-class consumerism. Rather than following the crowd away from emerging markets, now could be a good time to be contrarian and buy stocks in Brazil.
