How to Profit From Politics in Brazil

Brazil’s elections could have a profound effect on the country’s investment prospects for years to come. Martin Hutchinson offers the inside scoop.
Sunday’s first round of Brazil’s elections left President Dilma Rousseff in a commanding position, with 42% of the vote compared with the 34% of centrist Aecio Neves. Rousseff and Neves will advance to a runoff on October 26, and the chances of Rousseff’s re-election depend on the voters for the third-place candidate Marina Silva, who was knocked out of the run-off. Another four years of Rousseff will exacerbate rather than solve Brazil’s problems, while Neves may put the country back on the right track.
Rousseff is in the true sense a “red diaper baby.” Her father was a wealthy businessman born in Bulgaria, where he had been a member of the Bulgarian Communist party, illegal at that time before World War II. Brought up to denounce the capitalism by which her father made his money, she has never really renounced her early faith.
As Workers’ Party President since 2010, Rousseff has meddled in the management of state companies such as Petrobras, expanded public spending both directly and through the guarantee operations of the state development bank BNDES and controlled domestic market prices of gasoline and other products. Moody’s has just put the country on negative credit watch; one more credit downgrade will remove Brazil from investment grade for institutional investors, making its access to international markets much more difficult.
During the first years of Workers’ Party rule, Brazil did fine. Luiz Inacio “Lula” da Silva (President 2002-10) was fiscally fairly careful, and the economy benefited from a run-up in commodity prices during his period in office that seemed to justify the “BRIC” hype. He also instituted one genuinely beneficial welfare program, the “Bolsa Familia,” which makes payments to parents for keeping their kids in school. This has softened Brazil’s extreme poverty and given poorer Brazilians a better chance at success.
However, Brazil has an additional problem in that the 1988 Constitution entrenched much overspending, linking public sector salaries to a multiple of the minimum wage and making it very difficult to fire public sector workers. As a result, Brazil’s public sector is among the largest in the developing world, absorbing some 43% of GDP.
Initially, Rousseff seemed likely to be re-elected, partly because her opposition offered little real choice. Eduardo Campos, nominated by the Socialist party, seemed to offer little opportunity from his party’s ideology of rolling back the overblown Brazilian state. The third candidate, Aecio Neves of the Social Democrats, running well ahead of Campos in opinion polls, was favored by business but had been a notably big-spending governor of Minas Gerais state.
However, on August 13 Campos was tragically killed in a plane crash and his vice presidential candidate Marina Silva was elected to succeed him as Socialist party candidate (Silva’s own party had been disqualified from the election on a technicality.)
Silva, a former environmental protester with a mildly pro-market approach to Brazil’s problems, initially seemed likely to beat Rousseff in a run-off, but in the event the statism of Brazil’s electorate rejected her leanings towards a free market, and she fell back in the polls, finishing third in the first round and being eliminated from the run-off.
Brazil’s electors now face a stark choice. If Rousseff is re-elected, her policies of meddling, price controls and state spending, together with the immense costs of the 2016 Olympics, are likely to lead Brazil’s budget into a crisis. Neves offers a better choice, but his own party’s record is by no means spotless. He is however unlikely to make Brazil’s fiscal problem worse, and the essential buoyancy of the country’s economy should over a four-year Neves term allow some recovery to take place.
There are several ways to play the October 26 runoff and profit from politics in Brazil:
Petrobras (NYSE: PBR). Brazil’s national oil company, would probably be the greatest single winner from a Neves victory. First, domestic gasoline and diesel prices could be restored to market levels. Currently, Petrobras is making large losses in its refining sector, because it is forced to sell in domestic markets at a loss. Second, it’s likely a new government will stop forcing Petrobras to invest in loss-making biofuel projects. Third, a Neves government may relax local content restrictions, allowing Petrobras to buy better, cheaper equipment for its oil-drilling program.
Finally, a new government would presumably allow Petrobras to remove the Rousseff crony that is currently Petrobras’ CEO. Petrobras shares jumped 12% on the first round result, but still trades on 14 times depressed earnings and at only 70% of book, so it’s heavily undervalued if Neves wins.
If you want a stake in Brazil as a whole, you can buy the MSCI Brazil Capped (NYSE:EWZ) index ETF, which is currently trading at 19 times earnings with a 2.6% dividend yield. Indeed, if you wanted to speculate in the result of the Brazilian election (which I don’t recommend as a strategy for more than “mad money”) you could buy November 2014 put options, which expire on November 22, well after the election’s second round. Options with a $41 strike price are currently selling around $1. A Rousseff victory might make you a nice profit on these, which would compensate you for the lack of opportunities to make sound longer-term money on a Brazil investment. (To learn more about options, see our Options Advantage service.)
Finally, an apolitical play. Ambev S.A. (NYSE: ABV), the beer company, will do very well out of the 2016 Olympics, an even larger spectacle than the 2014 World Cup, both in Brazil and in the other Latin American markets where it operates. It’s a little pricey on 24 times earnings, but will allow you to profit whether Brazilians are toasting new-found prosperity or drowning their sorrows.

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