What's the biggest emerging market investment opportunity in the world? China, right? Well, no. India? Not quite. The answer is Brazil. At least it was at the end of February after it vaulted to the top spot on the MSCI Emerging Markets index. It accounted for 15.11% of the index versus 14.49% for second-place China, based on free-float market capitalization weightings. In late 2002, Brazil constituted just 5.3% of the index.

Brazil's rise up the charts illustrates how far it has come during the past five years. The country had long been an economic underachiever that consistently failed to harness its huge, resource-rich land mass, large population and tremendous potential. It was an economy chronically wracked by hyperinflation, weighed down by tons of debt and prone to dizzying volatility. Brazil started to get its economic house in order during the latter half of the 1990s. But as left-wing politician Luiz InĂ¡cio Lula da Silva prepared to take over the presidency in 2003, the financial markets feared that his populist agenda would return Brazil to the bad old days and cause it to default on its sizable debt. Credit rating agencies responded by downgrading Brazil's sovereign debt.

Then a funny thing happened: The government under Lula (as he's commonly called) surprised everyone with its market-friendly fiscal and monetary policies that maintained the path set by his predecessor. At the same time, Brazil's booty of iron ore, oil and agricultural products has fetched top dollar during the global commodities boom. This harmonic convergence of internal economic restraint and external cash flowing into its coffers have fattened Brazil's international reserves, generated a trade surplus, strengthened its currency and enabled it to slash its debt. The economic upturn has trickled down to consumers, where a growing middle class hungry for the good life has more income to spend and greater access to credit.
While Brazil's economy has registered solid-though hardly eye-popping-growth during the past five years, the Bovespa index of 50 stocks that trade on the Sao Paulo Stock Exchange zoomed roughly 900% in dollar terms from the start of 2003 through the end of February 2008.

And more good news might be on the way with expectations that Brazil's foreign sovereign debt will be rated investment grade sometime this year. "Getting investment grade would enable a whole new class of investors to participate in Brazil's growth," says David Riedel, president of Riedel Research Group, an emerging market equity research firm. "This is the crux of the entire Brazil story."

Brazil seems to be firing on all cylinders six years into an amazing run, which should make investors wonder if it's too late to join the conga line. Geoffrey Dennis, an analyst with Citi Investment Research, said in a late-February report that he likes Brazil long-term but not so much short-term. "We see Brazil as ignoring risks of any sort (earnings downgrades and hikes in domestic interest rates)," he wrote. "We view Brazil as overbought, expensive and overdue [for] a pause."

During the first two months of 2008 when most other emerging market countries took a header over concerns about a slowing U.S. economy, Brazil quickly rebounded from its January tumble and forged ahead with small gains. Clearly, this isn't yesteryear's Brazil.

Beyond The Big Two

To some extent the bedrock of the Brazilian market rests on two companies: Petrobras and Vale. Petrobras, formally known as Petroleo Brasileiro S.A. Petrobras, is the giant national oil company that in November discovered a huge underwater oil field off the coast called Tupi that's potentially one of the biggest finds in recent decades and could someday transform Brazil into a major oil exporter. Vale is the recently-branded name of Companhia Vale do Rio Doce, one of the world's largest mining companies and the largest supplier of iron ore that in February forced through a massive 65% price hike on steel makers in Japan, Korea and Germany.

Combined, these two megacap companies constitute roughly 25% of the Bovespa index. The share price of both companies more than doubled last year, which helped propel the Bovespa to a nearly 44% gain in 2007.

Until recently, Brazil was an export-driven growth story centered on oil and minerals, manufacturing (machinery and airplanes) and agriculture (sugar, coffee, soybeans and ethanol). But many observers believe the underpinnings for future growth will come from within. "I think it's a pretty good secular domestic growth story," says Uri Landesman, head of global growth at ING Investment Management. "To some extent, all of the BRIC (Brazil, Russia, India and China) countries are."

Some of the key developments on the domestic front include inflation abatement-it was roughly 15% in 2003; now it's in the 4% range. "When inflation was high, people ran out to buy staples before the price shot up," says Jason White, a portfolio specialist with T. Rowe Price who's part of the fund company's global emerging markets team. "Stable prices frees up money for more consumer discretionary purchases."