This is the fourth in a series of articles regarding the outlook for emerging market investments in 2006 and beyond.
As most readers may have noticed, I am rather bullish about emerging markets in general -- and in the BRIC countries in particular -- because of favorable demographic trends and rapid gross domestic product growth that should lead to the continued expansion of a consumer-oriented middle class in many developing nations.
One such nation is Brazil, the Latin American component of the BRIC brotherhood (which also includes Russia, India, and China) and a country I thought it especially appropriate to take a look at due to the re-election of president Luiz Inacio Lula da Silva -- affectionately called "Lula" -- last weekend.
I bring up Lula's re-election simply to point out that Brazil is experiencing political stability and relatively consistent economic policies that had been sadly lacking in the past. After all, it was only in 1986 that Brazil emerged from 21 years of military rule, and there have been quite a few rough patches -- economically and politically -- since then (remember the devaluation of the real in 1999 or the seemingly endless waves of corruption scandals that have tainted governments?).
The fruits of this stability and consistency are reflected in the economy, which is expected to expand around 3.2% this year and a further 3.5% next year, according to a survey by the Brazilian Central Bank. While these numbers represent a downgrade from previous estimates due to the effect of a strong real on exports (not to mention worker absences during the World Cup), they are likely to prove conservative in the face of aggressive rate cuts by the Central Bank.
The Central Bank has cut rates by a whopping 600 basis points over the past 14 months, yet that has brought overnight rates down only to 13.75% -- still a mind-boggling high number, but the lowest number in more than two decades. Similarly, inflation has been slowing markedly: Economists now expect inflation in the neighborhood of 3.63% this year, down from 7.6% in 2004, and well below the Central Bank's target rate of 4.5%. Obviously, this leaves room for further monetary easing.
I know, I know . these numbers seem frightening to U.S. investors fretting about the possibility of domestic interest rates hitting 5.5%. But Brazil's consumers, for one, certainly see it differently. According to a recent report by Brazil's National Federation of Industry (CNI), consumer demand is expected to grow by 4.5% in 2006 and by more than 5% in 2007.
In my last two country-specific articles -- about China and Mexico -- I mentioned that investors in emerging markets needed to look for companies that were strong (if not dominant) players at home, had good growth prospects, and carried attractive valuations: essentially national blue-chip companies by any other name. Simply put, investors need to focus on companies that have the political connections and economic clout to operate safely in an environment where the rule of law can be somewhat, well, arbitrary.
Now, while there are many interesting Brazilian plays that fit this criteria, ranging from aircraft manufacturer Embraer
That's why I believe investors should take a look at Brazilian companies that generate the majority of their business from the domestic market. Two such companies are BancoItau
Banco Itau, formally known as Banco Itau Holdings Financeira, is the second-largest private bank in Brazil, with roughly $100 billion in assets at the end of the third quarter (after the BankBoston acquisitions). It trails only archrival BancoBradesco
The company primarily operates through three divisions: Banco Itau BBA (corporate banking), Itaubanco (traditional retail banking), and Itaucred (targeting the low-income consumer). The combined businesses boasted a domestic client base of more than 12 million active customers at the end of 2005, serviced by close to 2,400 branches and more than 22,000 ATMs. According to Banco Itau, 85% of its branches are located in the relatively affluent southeastern region, an area that accounted for 55% of Brazil's GDP in 2005.
Banco Itau's traditional strength has been its leadership position in corporate banking and wealth management, a position it further strengthened with its acquisitions of Bank of America's
Not a bad deal in my book, especially because Banco Itau expects the acquisitions to add to earnings starting in the second half of 2007 and also gains a partner with some serious financial muscle.
At a recent price of $33.25, shares of Banco Itau trade at roughly 12 times consensus fiscal 2007 estimates of $2.84, a 25% discount to the company's projected long-term growth rate. Given the company's organic growth prospects and the potential upside from its BankBoston acquisitions, I believe that Banco Itau is an attractive play for risk-tolerant, long-term investors interested in cashing in on Brazil's domestic growth.
Companhia de Saneamento Basico do Estado de Sao Paulo, better known as SABESP, is a state-owned utility that provides water and sewage services in the state of Sao Paulo through 193 water treatment facilities, more than 420 sewage treatment stations, and more than 2,000 water reservoirs with an aggregate capacity in excess of 2.5 billion liters of water.
As of June 30, the company delivered water to more than 25 million people (57% of revenue) and offered sewage services to about 17 million people (43% of sales) in 367 of the 645 municipalities in the state of Sao Paulo. SABESP offers these services to residential, commercial, industrial, and government customers, with residential (84% of total revenue) making up the lion's share of the business.
While SABESP lacks the growth potential of Banco Itau, its options for growth aren't as limited as they first appear. Remember that SABESP operates in less than 57% of the municipalities in San Paulo, and further that a law enacted in March now allows the company to operate outside the state of San Paulo and even in the international arena.
Now, before your eyelids start feeling heavy (I know my eyes are starting to glass over), let's get to the heart of the matter. In simple terms, because SABESP is a utility, it is less exposed to the global economic cycle . an attractive fact because growth is decelerating in the U.S., Europe, and even some parts of Asia. Furthermore, SABESP should benefit from the continued strength of the domestic economy, lower interest expenses due to reduced debt (the company has pared a fair bit of its dollar-denominated debt), and the Central Bank's continued rate cuts. The strength of the real is also a positive.
Those factors have allowed SABESP to generate first-half gross operating revenue of $1.4 billion, up 11.5% over last year's period, EBITDA of roughly $604 million (up 15%), and net income of $236 million. I mention these numbers simply because SABESP is required to pay out a minimum of 25% of earnings in the form of dividends. Though the stock yields roughly 4.8% according to Morningstar, SABESP is expected to bump the dividend higher later this year.
Recently at $30.38 per share, SABESP trades at nine times forward estimates of $3.41. Given the decent dividend yield and the likelihood of a higher payout in the near to middle term, I think income-hungry investors might want to take a look at the largest water and sewage utility in the Americas.
For more international Foolishness:
- Banco Itau: Give Credit Where Credit Is Due
- An Old World Bank With New World Opportunities
- Emerging Market Musings: China
If you're interested in taking advantage of the benefits of international investing, consider a 30-day free trial of Global Gains. Even if you just want to take a peek at the Global Gains team's inaugural picks, it's worth your while.
Embraer is a Stock Advisor pick, and Bank of America is an Income Investor selection.
Fool contributor Will Frankenhoff is enjoying his time writing for The Fool more than reading the Financial Times, rooting for the New York Giants, or pondering the vagaries of life (pretty unsuccessfully so far). He welcomes your feedback. He does not own shares in any of the companies mentioned above. The Fool has a disclosure policy.