Why Half a BRIC Is Better

05/03/2010 12:01 pm EST


Chris Gilchrist

Editor, The IRS Report

Brazil and India trump Russia and China on politics and demographic, advantages that should translate into better investment returns, writes Chris Gilchrist in The IRS Report.

JPMorgan is a believer in the BRIC story and already has Russian, Indian, and Chinese funds. I heard its managers put the case for Brazil with the launch of their JPMorgan Brazil Investment Trust (London: JPB), and found it convincing.

Positive demographics apply both to India and Brazil, but a better reason for investing there is that both should benefit from high business profitability. India and Brazil are, in contrast [to China and Russia], functional democracies with constitutions, mostly independent judiciaries, and functioning legal systems. Of course there is corruption, but the point is that with a constitution and an independent judiciary, abuses will be the exception rather than the rule.

The principal factor with Brazil is the rapid evolution from a commodity base to industrialization and consumerism. Already, exports account for only 10% of [gross domestic product] and with the flattening and rebuilding of a large chunk of Rio de Janeiro now certain to happen in advance of the 2016 Olympic Games—and a [soccer] World Cup preceding this in 2014—the nation is set for a massive boost both economically and psychologically. Some $50 billion will be spent before the World Cup and at least a further $15 billion on Rio before the Olympics.

On top of this, the vast offshore “pre-salt” oil discoveries, giving Brazil the world's fifth largest reserves, means a huge exploration and production boom is sure to happen over the next decade. This should provide tax revenues to finance the ongoing infrastructure spending the country needs for a population of 200 million in an area the size of Western Europe.

JPMorgan emphasizes the quality of local entrepreneurs, many of whom are rapidly building successful businesses in fields from consumer retailing to oil and gas exploration. This is a country so confident of its ability to manage its own destiny that it has slapped a 2% tax on foreign inward portfolio investment.

India lacks most of Brazil's advantages: it has little free energy (hydro power generates over half Brazil's electricity), very little oil, and is short of land for food production. But India and Brazil do share an important common factor: better economic management. In India, the past decade under a reformist pro-market government has seen [gross domestic product] growth accelerate, economic reforms remove obstacles to business, and large infrastructure programs begin to open up the vast rural hinterland in which the majority of India's 1.2 billion people live.

India's comparative advantage is younger people—more of them, many well-educated. As in China, tiny increments in the per capita spending power of rural populations translate into gigantic business opportunities.

Valuing emerging markets is tricky. Brazil lacks a decent index—Petrobras (NYSE: PBR) still accounts for 40% of the BOVESPA, and India's BSE Sensex is not much better. So, while talking about the price/earnings ratio or book value of the FTSE or the Standard & Poor’s 500 makes some sense, this methodology is suspect with India or Brazil.

Still, for what it is worth, JPM's global strategists reckon that on the basis of a combination of dividend yield, price-to-book, P/E ratio, and price-to-cash flow, India and Brazil are both “fair value”—neither cheap nor dear in terms of the historical range of valuations.

But what about profits? It seems likely that in both India and Brazil profitability will rise—in Brazil, because it is still emerging from a decade of underinvestment and in India because business stands to gain greater benefits from deregulation and economies of scale. Corporate earnings in Brazil are slated to rise by a quarter this year.

The recent sell-off in China may result in further weakness in other developing markets. But the underlying trends in India and Brazil seem so strong that you may wish to start by buying a quarter of your intended final stake. If you don't get the opportunity to buy more on weakness, there are worse things than buying into a rising market.

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