Let's play God for a moment. Let's design a country with enormous economic potential -- what characteristics shall we grace it with? How about:

  • Vast natural resources
  • A large population
  • A temperate climate
  • Arable land
  • A long coastline.

Which potential business utopia has these traits in spades? Not the U.S., not China, not Russia, not India. Winner is: Brazil.

Alas, here's where playing God ends and mortal work begins. And over the past 40 years, the mortals in Brazil have done a poor job of turning the country's blessings into sustained economic growth.

Pity the past
In September 2006, a World Bank report compared the investment climates in Brazil, India, and South Africa, and described how bad it's been: "Over the past 25 years, economic growth in Brazil has demonstrated substantial volatility around a relatively low mean."

That's right. Slow and wildly unpredictable growth. Could there be a worse investment?

The culprits -- as identified by Brazilian business managers and reported by the Bank's Investment Climate Assessments -- are clearly human inventions:

  • High tax rates
  • Macroeconomic instability
  • Political uncertainty
  • Cost of finance
  • Corrupt tax administration.

And although the government is undertaking some reforms, the Doing Business 2008 report ranked Brazil 122nd in the world for "Ease of Doing Business" -- down a spot from 2007. It's become so bad, in fact, that "tax complexity bedevils small business to such a degree that it drives most under the table," according to the Latin Business Chronicle.

Of course, the returns still rock
But somehow, against that dismal background, Brazilian stocks returned 33% in 2006 and 41% in 2007, with Brazilian flag-bearers Votorantim Celulose e Papel (NYSE: VCP) and Gerdau (NYSE: GGB) doing even better than that. And Brazilian poultry producer Sadia (NYSE: SDA) returned more than 65% last year!

What gives? Should investors be running to or from these heady gains?

The backbone of the Brazilian economy
You'll notice that both Votorantim and Gerdau are large, commodity-based businesses. The companies and their shareholders have been cashing in on the global demand for materials, but their success has not yet extended into other sectors, and the gap between rich and poor in Brazil remains wide.

Combine that inequality with government regulation that makes life difficult for small business, and you can see why current Brazilian success stories are multinationals rather than domestic or regional service businesses.

That, of course, is starting to change -- and the pace could increase if the government reduces tax rates, simplifies regulations, and maintains orderly democracy.

Looking forward
Optimism for that scenario is one reason the recent $3.7 billion IPO of BOVESPA -- the Sao Paulo stock exchange -- was met with such excitement in October, and it's why the value of stocks traded in Brazil increased from $65 billion in 2001 to more than $250 billion in 2006.

It's also why Mercadolibre is priced at 37 times sales and 180 times normalized earnings, according to Capital IQ. The online marketplace that is part-owned by eBay may be based in Buenos Aires, but it does more than half its revenues in Brazil by combining the best of the eBay and Amazon.com business models. Given the success of those two American businesses, as well as that of Internet portals such as Yahoo! (Nasdaq: YHOO) and Google (Nasdaq: GOOG), analysts get dizzy thinking about what Mercadolibre can do in a nascent market with little competition.

But patience will be crucial. According to 2007 Development Indicators, broadband extends only to 17 people per 1,000 in Brazil today. That's up from only two per 1,000 five years ago, but it shows just how far Brazil still has to go.

Remember -- natural advantages
But go back to the top of this article for a moment. Brazil has incredible potential to produce a sustained economic growth story and a vibrant middle class along with it. It's simply a matter of leveraging its natural advantages -- a process that should be far easier than what kick-started the Irish Tiger, for example.

That's why Brazil is the most attractive Latin American market, according to a Santander Investment survey of buy-side analysts and hedge fund managers.

It's also why Bill Mann and our Global Gains team were so excited to travel to Brazil (as well as Argentina and Chile) last month to meet with selected companies (including Sadia and Mercadolibre) and gather more information on opportunities there. After all, if China and India have proven anything over the past few years, it's that the transition from a state to a free market economy can be extremely lucrative for informed foreign investors.

If you're as excited about the profit opportunities in Brazil as we are, you can get all our reports from the trip as well as our top three Latin American stock picks by joining Global Gains free for 30 days. Click here for more information. There is no obligation to subscribe.  

This article was first published Nov. 23, 2007. It has been updated.

Tim Hanson does not own shares of any company mentioned. Sadia is a Motley Fool Hidden Gems recommendation. Amazon.com, Yahoo!, and eBay are Motley Fool Stock Advisor picks. The Motley Fool has a disclosure policy.