Banking on Empty

08/12/2011 9:49 am EST


Jim Jubak

Founder and Editor,

Want to know why Brazil’s stock market was the first global market to fall into a bear?

You can see the reasons for the fears that have been crushing Brazil’s stocks in the August 3 earnings report from Itau Unibanco (ITUB), for my money Brazil’s best-run bank. (Itau Unibanco is a member of my Jubak Picks 50 long-term portfolio.)

The company announced that for its second quarter, net income climbed 14% from the first quarter in 2010. Adjusted earnings per share, which exclude one-time items, were 73 centavos a share. Analysts had been expecting adjusted earnings per share of 82 centavos, so the bank missed estimates by almost 11%.

The problem with the quarter wasn’t loan demand. Lending was up 22% in the quarter, and the bank told investors to expect 15% to 20% growth in its loan portfolio in 2011. That’s not a whole lot slower than the 21% growth in 2010.

But there are doubts that this level of loan growth is sustainable. Brazil’s central bank has raised its benchmark interest rate to 12.5%.

With credit demand growing at a 20% annual rate, the fear is that Brazilians are tapped out. Right now, they’re using a record 26% of disposable income to make loan payments, according to the Banco Central do Brasil.

With the economy slowing as the central bank fights inflation, that may be such a big burden that Brazilian consumers will have to cut back on purchases—and default on some current debt.

Itau Unibanco’s results fed right into that fear. Provisions for credit losses climbed to 5.11 billion reais (the plural of “real”), a 29% increase from the second quarter of 2010. In the first quarter of 2011, provisions for credit losses came to 4.38 billion reais.

The default rate—debt where payments are 90 days overdue or more—was up 4.5% at the end of the quarter in June, compared to the end of the first quarter.

That was actually a slight improvement from the 4.6% rate in the second quarter of 2010, but an increase from the 4.2% rate in the first quarter of 2011. That drop to 4.2% had led some analysts to believe that the worst of the problem might be over for Itau Unibanco.

What do you do now with shares of Itau Unibanco in particular, and with Brazilian stocks in general?

The stock is down 30.8% from its April high. I don’t think that means the danger is out of the stock, but it does mean that the shares of this extremely well-managed bank are trading at just 11 times trailing 12-month earnings.

I prefer to deal with the danger that Brazil—and not China—is headed toward a hard landing by holding on to the best Brazilian stocks that I own—like Itau Unibanco—and cutting back or eliminating positions in less-well-run banks or companies. A rising tide lifts all boats…but when the tide stops rising, I think that suggests that the difference in quality among boats matters more.

The global crisis of confidence that has produced the current rout in the world’s markets may actually help Itau Unibanco and Brazil with its near-term credit crunch, by slowing the central bank’s schedule for further interest rates. (This would, of course, just put off the fight against inflation to another day when the problem may be even more entrenched.)

I wouldn’t rush to add to my position in any Brazilian stock at this moment, or until global markets show some signs of stability. But Itau Unibanco is one of the first Brazilian stocks that I would be buying when the risk in the market has receded a bit.

The reward is certainly present in these shares. It’s just that I don’t like the balance of risk and reward at the moment.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund, may or may not now own positions in any stock mentioned in this post. The fund did own shares of Itau Unibanco as of the end of June. For a full list of the stocks in the fund as of the end of June see the fund’s portfolio here.

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