ETFdb Pro’s Actionable ETF Investment Idea: BRF Is A B-U-Y

by on February 8, 2010 | ETFs Mentioned:

Each month, our team of ETF experts publishes actionable investment ideas in ETF Edge, our all-ETF newsletter. To see the rest of this month’s recommendations, including an international fixed income ETF and a China sector fund, sign up for a free trial of ETFdb Pro. In addition to the monthly newsletter, Pro subscribers get access to our line of all-ETF model portfolios, more than 60 in-depth ETF Category reports, and a monthly mailbag session with out team of ETF experts.

The first six days of 2010 filled investors with false hope, as impressive gains in equity markets fueled hope of a return to pre-recession levels for major benchmarks and personal portfolios in 2010. Unfortunately, a reality check came swiftly and harshly, as a sudden turnaround sent markets plummeting for the remainder of the month. But there’s a silver lining in January’s freefall: the pullback in many markets seems to have been a bit overdone, presenting some attractive entrance points as the calendar turns to February.

One of 2009′s best performers became one of January’s biggest dogs, as Brazilian equity markets took it on the chin to start the year. Brazil’s signature moment of 2009 came in October when Rio de Janeiro became the first South American city to be selected as host of the Olympics, but the country’s equity markets shined throughout the year. The Market Vectors Brazil Small-Cap ETF (BRF) more than doubled between its inception in May and the end of the year, while the iShares MSCI Brazil Index Fund (EWZ) added 120% in 2009.

There were a few bumps along the way, but nothing like the turbulence Brazilian markets hit in January. BRF lost 14.1%, while EWZ slumped 13.3%. Over the last year, U.S. investors have become accustomed to the phenomenon of market rallies despite the presence of good news of any significance. But Brazil’s January nosedive came despite an abundance of positive developments that seemed more likely to send the market in the opposite direction.

Brazil’s unemployment rate dropped to a record low of 6.8% in December, representing a decline of 0.6% from November and a return to December 2008 levels. By comparison, official U.S. unemployment stood at 10.0% in December, a whopping 3.6% higher than the same period a year earlier. More recently, Brazil’s IBGE statistics institute announced that output rose by an impressive 18.9% in December from the same period a year earlier.

The outlook from Brazil’s financial sector is also bright. Banco Bradesco, one of the country’s largest financial institutions, expects to expand its credit portfolio by up to 25% in 2010, including growth of 20% in its consumer portfolio and 29% in the corporate portfolio. Last week Itau Unibanco raised its growth forecast for 2010 GDP to 6% from just over 5%. Despite early signs of inflation, interest rates are expected to remain low through at least the first quarter.

The pullback doesn’t seem to be attributable to a realization that perhaps markets had run too far, too fast over the last year either. According to Business Week, Brazil’s Bovespa Index was recently trading at about 13 times this year’s earnings, well below the 15 times multiple for Mexico’s Bolsa Index and 17.5 times for Chile’s Ipsa.

So if the domestic outlook is so bright, what drove the January swoon in Brazilian stock markets? Weakness in another BRIC market was largely to blame, as worries about tightening monetary policy in China dampened the outlook for the world’s third largest economy. Highlighting China’s increased importance to the global economy, lower expectations for Chinese raw materials demand impacted markets around the world, particularly those that generate significant revenues from sale of metals and oil to the resource-hungry nation. China surpassed the U.S. as Brazil’s largest trading partner in 2009, giving a boost to the South American economy while also increasing its foreign dependence.

Brazil find itself in a much better position than China, as a weekly central bank survey reveals that local economists expect inflation to be approximately 4.8% in 2010, just slightly above the government’s target of 4.5%.

BRF's Cliff Dive Presents An Attractive Buying Opportunity

BRF vs. EWZ

Investors looking to make a play on Brazilian equities have two primary options: the large-cap EWZ and the small-cap BRF. Although EWZ’s $11-plus billion assets indicate more widespread use among investors, BRF is a better play for several reasons. EWZ is dominated by mega cap companies, which tend to be more dependent on the global industrial cycle, oil prices, and demand from China. By comparison, small cap equities depend on real growth in Brazil’s domestic economy and continued increases in both the size and wealth of the middle class (see a comparison of historical performances of small cap international ETFs in this feature). Moreover, large cap companies are more likely to count the Brazilian government among major shareholders, increasing the likelihood of these businesses being operated contrary to investors’ best interests.

More than 20% of EWZ is invested in Petrobras, one of the world’s largest oil companies which is 55.7% owned by the Brazilian government. BRF’s holdings in commodity-intensive industries are minimal, offering instead exposure to the consumer discretionary sector. This allocation should act to insulate the fund somewhat from slipping Chinese demand, making January’s drop all the more puzzling.

BRF has rebounded nicely in the first few sessions of February, but remains well below year-end levels and still has plenty of room on the upside.

More Actionable Investment Ideas

Each month, our team of ETF experts publishes actionable investment ideas in ETF Edge, our all-ETF newsletter. To see the rest of this month’s recommendations, including an international fixed income ETF and a China sector fund, sign up for a free trial of ETFdb Pro. In addition to the monthly newsletter, Pro subscribers get access to our line of all-ETF model portfolios, more than 60 in-depth ETF Category reports, and a monthly mailbag session with out team of ETF experts.

Disclosure: No positions at time of writing.