What if Brazil Really Started to Grow?

With several investments in Brazil, principally the food company Sadia (SDA) and the airline Gol (GOL) I consider the country's prospects to be significant to my portfolio's future.

So, will Lula turn Brazil back into a huge growth engine while continuing to tame inflation and help the poor ... or will he, in trying to push additional growth, bring back the freakishly high inflation of the past and sink the Bovespa ... or will he, in trying to help all the helpless of Brazil, go too far injure the homegrown companies that have helped the country become significant on the international economic stage?

I don't know ... but I hope. Lula was just sworn in for his next term, and is now considered by many to be the most successful president in Brazilian history -- and he's certainly still popular, though perhaps not as much so as when he was more of a populist firebrand in his earlier years in office (years that gave Wall Stree the heebie jeebies, for the most part).

And while Brazil is a founding member of BRIC (or CRIB, if you prefer), the big emerging countries that stand as the bulwarks of the developing world (Brazil, Russia, India and China) ... it's certainly been, in recent years at least, the least followed one in that group.

Brazil has been the kid in the back row of the BRIC class, with much slower growth than India and China who sit up in the front and raise their hands all day long ... and thankfully, with more integrity than Russia, which, to continue the strained metaphor, is the kid selling cigarettes by the loading dock (you know he's got tons of money and all the chicks, but you're pretty sure you'd get burned if you got involved with him ... just ask your friends Belarus or Ukraine).

And really, if you consider that Brazil has grown at only 2.6% during Lula's reign in office, it seems odd to consider them to be part of this fast-growing emerging group at all -- except the stock returns have been sometimes spectacular, and the future might be more spectacular still.

Brazil doesn't have the massive population of China that makes all fiscal daydreams seem possible, nor the huge wealth of educated and English-speaking labor of India ... and they don't have quite the massive buffet of natural resources to snack at of the Russians. Really, in some ways all they've got is what the US had 100 years ago -- a growing, diversified economy based on cheap(ish) labor and lots of great arable land.

They have a large population of workers that are growing in level of education and, thank to the progressive policies of the government, slowly climbing out of poverty ... or at least, from really bad poverty into just plain run of the mill poverty. And that means they have, potentially, the second largest market in the Western Hemisphere.

And most significantly, for investors, is that the country seems to be hitting a sweet spot. Lula's regime has, by most accounts, tamed inflation. Ethanol and successful offshore drilling by PetroBras mean they're less subject to oil shocks than many markets. And because much of their trade is in agriculture and other natural resources, they might not be as susceptible to a dip in US or Japanese or European demand for finished goods the way China, India, Taiwan or Korea should be.

But make no mistake, Brazil is still a risky place to invest -- and my investments are primarily domestic in nature in Brazil, since it remains to be seen whether they can become an important player in multiple industries the way China has.

But it seems that Brazil does have, at least, a population that is slowly becoming better off, a good handle on inflation, and political stability -- that's something, and if they just continue on the path to development there will be plenty of money to be made even if they don't catch fire in quite the way their more popular (or notorious) BRIC brethren have of late.

In addition to my investments in Brazilian agriculture and airlines, which depend primarily on a building domestic and regional market, I'm intrigued by Lula's promise to liberalize financial markets and make investment in Brazil easier as a way to help spur some growth. This brings to mind a few companies that might benefit.

The first ones that come to mind with that environment are the banks, of which Brazil has two biggies that are traded in the US in Banco Bradesco (BBD) and Banco Itau (ITU), both of which have been awfully successful (though BBD has a bumpier chart than ITU). I don't know a lot about those companies, but I'm not terribly interested in investing in a bank at this point.

And second is the investment banking business ... the investment houses all have interest in Brazil too, of course, including Goldman Sachs and all their Wall Street brethren ... but the one that stands out for me in Brazil is a Canadian company, Brookfield.

Brookfield Asset Management (BAM), which I looked at for a few minutes when I was pondering the next Berkshire Hathaway, has a surprisingly high (and growing) level of involvement in Brazil (and has for most of its history) -- which intrigues me. They recently IPO'd a homebuilding business on the Brazilian exchange, which if financial markets and mortgages are going to be liberalized might be one of the more prescient moves of late, and they have a growing interest in Brazilian commercial real estate. It really feels to me at times as though Brookfield is becoming the Macquarie bank of the Western Hemisphere -- and if so, that would be fine indeed for BAM investors.

I don't know if I'm ready to become more exposed to Brazil than I already am -- I think it's unlikely that I'll invest in another Brazilian company at this point, but the more I've looked at Brookfield in the past few months the more I like it ... I just wish the valuation was a bit lower, but perhaps I shouldn't get hung up on things like reported earnings when the company has such a vast portfolio of assets ... including some juicy ones in Brazil.

full disclosure: I own shares of Sadia and Gol as of this writing, and LEAP options on Goldman Sachs. I don't own any other companies or investments mentioned.

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Happy Sadia Investor (SDA)

I opened a position in Sadia SA (SDA) today, purchasing shares at $30.60.

Sadia is a Brazilian food products company, primarily producing and selling pork, chicken and processed refrigerated/frozen foods. They've had a tough year thanks to some problems with the strong Brazilian currency and weakness in some of their exports (the avian flu outbreakand resultant dip in poultry demand, and a Russian ban on Brazilian pork were negatives in the recent past) ... but management believes that the recently completed third quarter is the beginning of their export and sales growth rebound, and I'm inclined to think they have a good future ahead of them. The shares, while not at their lows, are nicely priced.

Brazil has some natural advantages in this business: inexpensive and available feed grains, inexpensive labor, a good agricultural climate, and a large number of farmers. Sadia has relied on that combination of factors for many years in building both a dominant food company in Brazil, and a significant export business to the rest of the world.

And the meat and processed foods businesses, I believe, have some significant tailwinds for the years ahead -- regardless of the success of Whole Foods and the organic foods movement in the US and Europe, I think the trend is definitively pointing toward much higher consumption of processed and convenience foods worldwide -- more people are working, fewer are farming or living near farms, and convenient refrigeration continues to spread to growing lower middle class areas in Asia, South America and elsewhere.

Add that to the fact that higher standards of living internationally almost certainly will bring higher protein consumption, as they have in the past, and I think meat and frozen convenience foods are good investment opportunities. The global trend for meat consumption has it increasing at 2% a year overall, and already we're seeing eye opening statistics -- including the fact that China now consumes half the world's pork. Meat consumption has climbed something like 500% over the last 50 or so years, and I don't expect to see that trend reverse itself in any meaningful way. That's likely to be quite bad for the environment and for global sustainability, given the inefficiency of a higher protein diet and the dirtiness of the typical factory farm, but for investment purposes that concern is largely incidental.

The company's sales are roughly evenly divided between domestic consumption and exports -- exports are a bit low at 44% of the total for the most recent quarter, thanks to the problems I noted above, but management during the conference call definitely noted that they see the balance returning to the 50/50 margin they prefer.

Domestically, Sadia is primarily a seller of frozen and refrigerated processed food -- everything from frozen chicken nuggets and pizza to ice cream and margarine, including some products like chicken carrot lasagna and cheese chicken burger hot pockets that I can only assume sound better to a Brazilian than they do to me.

The export business, in contrast, is largely in lower-margin products like chicken parts and commodity poultry and pork products. They're slowly adjusting that and trying to market their value-added processed foods in foreign markets, with particular focus on other South American countries and on the Middle East.

Sadia management sees continued opportunity for margin growth as they build and invest in their business, with a goal of seeing EBITDA margins increase to 17% by 2010 -- that would be pretty remarkably high for this business, and Sadia's operating margins are already significantly better than many competitors, including US based companies like Tyson or Smithfield (Sadia doesn't really export to the US on any meaningful level, though that might change with a free trade area for the Americas still possible, so comparisons might not be very useful). Gross margins slid dramatically earlier this year, as the fall in the stock price indicates, but have already begun a rebound and ought to return to their historical levels in the high-20s.

The company has a pretty high debt level, but with continued solid sales and growth I think that ought to be manageable, and the debt is helping to finance needed expansion. Right now, as the company believes they're on the cusp of recovering sales and margins, net debt to equity is at 53%, a touch above the board-mandated maximum of 50%.

There is also always a possibility that Sadia will make big acquisitions either domestically or internationally -- they tried and failed to take over their major competitor Perdigao earlier, and have been trying to build up their pork and beef operations, partly as a way to diversify away from potential avian flu exposure.

As with other Brazilian companies, Sadia pays out a minimum portion of earnings as a dividend to shareholders as required by law. The dividend is subject to Brazilian taxation and fluctuates significantly based on the performance of the business, but the TTM dividend rings in at well over 4%, and I expect to see a yield at least equal to that going forward.

I'm planning to hold this position for a long time, and hope to buy more at lower prices if there are further avian flu or similar short-term concerns. The opportunities for increasing sales of processed foods to the growing economies of South America, and the likelihood of increased protein consumption worldwide provide some real opportunity for a company that I think is value priced right now.

As with my investment in Gol Linhas Aereas Inteligentes (which I'm also considering adding to in the near future), this is in part a bet on the growing Brazilian economy. Rising minimum wages and inflation that is (hopefully) under control should allow for more consumption of prepared foods as well as cheap airline tickets in the biggest country in South America, but the risks with this volatile economy are certainly nothing to scoff at -- continued strength of the Real can hurt their export performance, and a return to high inflation or a wildly populist turn by the government (neither of which I expect) might be disastrous. On the flip side, one of the cabinet members is the former head of Sadia, so I'd imagine the company has a significant voice in the government.

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