Brazil is focus of regional bonanza

Brazil and other countries in the region now enjoy political and economic stability – so Merrill Lynch’s Will Landers is bullish about his newly acquired Latin American investment trust.

What a party they have had in Brazil. Share prices are up on average by 400% in dollar terms over the past three years. But can it possibly go on? Your gut says no. Much of the domestic equity market is natural resources and oil, so new investors may be very late-cycle. Hyperinflation has been quelled, but it is a brave economist who would say it is dead.

So Merrill Lynch is being very brave. This week its manager Will Landers formally takes control of the 300m Latin American investment trust, wrenching it from the hands of F&C. And he is still bullish on the region. “Brazil has a forward price/earnings ratio of 10x and earnings growth at 30%. It’s not expensive; it’s close to historical average levels,” he says.

Landers’ bullishness is not because of a booming economy – domestically, Brazil was flat in 2005 – but because the corporate fundamentals look better than ever. Structural change in the balance sheets at many Latin American companies should, it is argued, give investors greater confidence in valuing them in developed-world terms.

The trust’s annual report, out last week, says: “In Brazil, GDP growth decelerated from 4.9% to 2.3% in 2005 due to a sharper than expected monetary tightening cycle which triggered a mild recession in its domestic economy while its export sector continued to perform well. Brazilian corporates, however, continued to grow their cashflow and earnings rapidly as many benefited from the continued strength in global commodity prices.”

Note that so far I have interchanged the words Brazil and Latin America when talking about the region. That is because Brazil has emerged as the super-dominant regional giant.

If you are buying a Latin American fund, you are effectively buying a Brazil/Mexico fund. A neutral index position would have investors 52% in Brazil, 30% in Mexico and 10% in Chile. Argentina, which by rights should sit somewhere between Chile and Mexico, has simply lost the plot in investment terms, as capital controls mean there are few investable opportunities. It is now just a tiny fraction of the index.

In Landers’ fund, Brazil makes up 62% of the funds under management and Mexico 24%, with Chile at 11%. Landers believes that Mexican equities seem “fairly valued” under most measures, and its companies continue to lose market share in American import markets. He fears a lack of deep structural reform will hinder long-term competitiveness. He also thinks that all of Brazil, Mexico and Chile have broken free of the sort of political turmoil that makes investment in Venezuela and Bolivia out of the question.

But it is Brazil where he sees the best opportunities, although because of the degree to which equity prices have roared ahead, he finds better value in mid-caps than big-caps. “Valuations are compelling on both an historical and relative basis, and the political scandals involving president Lula’s PT party have had a minimal impact on what is a positive economic background,” he says. The central bank of Brazil is determined to keep inflation at bay. It says something about how far things have changed now that it quotes inflation on an annual basis. Not so long ago the inflation figures were measured on a monthly basis. In March 1990, the monthly inflation rate peaked at 82.2%. For a few years the “Collor” plan cut that to 7.3% a month but it soon re-accelerated to 48% a month by July 1994. Since then inflation has collapsed, and this year is forecast to be 4.5% after 5.6% last year. But Brazilians are paying for it with massive real interest rates, which peaked close to 20%.

Landers sees interest rates beginning to soften – “I think they are going to finish towards 12%” – which should help a rebound in the domestic economy. It is one reason why he is keen on retailing stocks and airlines. Landers’ portfolio – he runs 60-75 stocks on average – has P⭠de A蹣ar as one of its biggest holdings. The company has 556 stores and supermarkets spread across all Brazil’s states. Landers also holds Wal-Mart in Mexico.

But his biggest holding is Petrobras, at 12.3% of the fund. That is an underweight position – Petrobras is the giant of the MSCI Latin America index, making up more than 16% of the entire market cap. Another resource stock, Companhia Vale do Rio Doce (CVRD) is the next biggest holding, at 9.8%. CVRD is a giant iron ore producer, and has boomed on the back of exports to China.

Elsewhere, the fund has a number of investments in the sort of infrastructure plays that benefit when an emerging economy develops rapidly. He holds Am豩ca Lat쭡 Logistica, involved in cargo transport, storage and port development. He also likes Companhia de Concess䱠Rodovi౩as, which is the largest operator of toll roads in Latin America.

But in truth, Landers has barely got his hands on the portfolio yet. It was only formally transferred to him last week, so most of the holdings are the stock decisions made by his predecessor, Rupert Brandt of F&C.

Given that over three years the trust’s share price is up 300%, putting it at the top of its peer group, it would strike most investors that the board has been a little tough on F&C. But the reality is that Brandt had already signalled his intention to quit F&C. He also had a below-par year during 2005, when he took the fund heavily into cash, expecting a market correction that never materialised.

It is those “market correction” nerves that will make it difficult for Landers to drag in a lot of new money. But commentators said the same when Merrill Lynch’s World Mining and Gold & General funds looked like they had already enjoyed their run – and they just kept running. Perhaps Latin America will do the same.