Analysis: Banking on Brazil

Brazilian banks learned the importance of maintaining strong balance sheets during the country’s bouts of hyperinflation, devaluation and other financial turbulence. They could emerge as the winners in the troubled global financial sector, says Urban Larson, the manager of the F&C Latin American Equity fund.

In a world where much of the financial sector is in crisis, says Larson, the banking system in Brazil remains solid and profitable.

Nick Smith, the head of fund distribution at Allianz Global Investors, agrees. Even within Bric countries (Brazil, Russia, India and China), he favours Brazil. “By the end of January, our investment in Brazil was 27%, slightly overweight against an equally-weighted benchmark. We like China and Brazil more than India and Russia.”

Smith adds: “The banking system in Brazil – and other Bric countries – is in good shape, compared to other countries. And for an economic recovery, a country needs a well-functioning banking system.” He says Brazilian banks are well capitalised with no toxic assets or poor lending problems.

“If, at some point, the balance sheets of banks in developed countries improve, banks in emerging markets are going to outperform them. [Unlike banks in developed countries] they do not need to clean up their balance sheets.” Brazil’s banking giants Banco Itaú and Unibanco are merging from a position of strength, says Urban, whose fund is overweight both banks.

The country’s second and third-largest private sector banks respectively announced their first consolidated earnings after the Brazilian authorities approved their merger.

“The merger was announced in November and it was a big surprise to everyone.” Urban says at the time he had Banco Itaú in his portfolio and he bought Unibanco just after the merger was announced.

However, Katy Dobson, the manager of the Threadneedle Latin America fund, says that banks will only be able to increase earnings if they improve efficiency. Her Threadneedle Latin American fund is slightly overweight in Brazilian banks – with a preference for Unibanco-Banco Itaú.

“The merger between Unibanco and Banco Itaú is a good fit, both in terms of lending focus and client composition,” she says. She adds that Banco Itaú will be able to extract significant synergy benefits from the acquisition in the longer term. “In the near term, there will be significant costs associated with the merger which may weigh on the banks’ share prices,” she adds.

The combined value of the two banks will be 12.9 billion reais (£3.96 billion), says Larson.

He concludes they may be in a position to take advantage of their international competitors’ weakness to buy attractive assets cheaply, should Citigroup or other global banks need to reduce their Latin America exposure.

Some of the biggest banks are now in Bric countries, says Smith. “In fact, the Industrial and Commercial Bank of China (ICBC) is now the largest bank in the world,” he says. “We are happy to hold banks, like ICBC, Sberbank in Russia, Banco Itaú, State Bank of India.”

Mark Mobius, the manager of the Templeton Emerging Markets fund, adds that the perception of risk in the Bric markets is beginning to shift. Investors realise the countries have become net creditors with vast holdings of foreign exchange reserves, and are better able to withstand external shocks. Brazil, for example, has about $188 billion (£132 billion), he says. Foreign reserves for China are approximately $1.95 trillion, Russia $370 billion and India $250 billion.

Mobius adds that Bric countries continue to record higher economic growth than developed countries. Average growth in 2009 for emerging markets is expected to be 1.1%, compared with a 2.5% decline for developed countries.

Investors are shifting to attractive valuations in the Bric markets, following steep declines, adds Mobius. He says many markets are trading at single-digit price/earnings (P/E) ratios, with many companies trading below their net asset value.

He is finding companies across the Bric region that meet his investment criteria and offer low P/E ratios, high dividend yields, and low price-to-book values.

Mobius cites inflation as a key concern in 2008. But a correction in commodity prices eased fuel and food prices in many economies and allowed inflation to subside in late 2008. This, he says, has enabled most Bric countries to stimulate growth by lowering interest rates and implementing other fiscal measures.

Still, Mobius predicts that 2009 will be challenging, with slowing growth, volatile exchange rates and commodity prices, and the ongoing effects of the credit crunch.

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