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."

White says that Brazilian banks are doing more large-scale lending and are issuing more credit cards to bolster consumer purchasing power. He adds that lower inflation and greater personal income are supporting a burgeoning home building industry that's tapping into pent-up demand.

Along with Petrobras and Vale, one of the largest holdings in the T. Rowe Price Latin America fund is Banco Itau Holding Financeira, a $60 billion market cap bank with loan book growth north of 20% and no exposure to the subprime loan mess, and which recently traded at about 12 times forward earnings estimates.

Banks are a favorite Brazilian domestic play for William Landers, manager of the BlackRock Latin America fund. He says the group's leaders have loan book growth exceeding 20% over the past several years and generate returns on equity of roughly 30%. They're also involved in other profitable business lines such as  insurance and asset management. Landers' top banking pick is Banco Bradesco, the country's largest private-sector bank.
Landers says the real estate sector is primed for significant growth over the next decade, and he likes Cyrela Brazil Realty, Brazil's biggest developer that's involved in all facets of real estate from low-end to high-end. Elsewhere, he likes Usinas Siderurgicas de Minas Gerais, a steel maker with a majority of sales geared toward the domestic market in such products as white goods and autos. It became more self-sufficient after it recently bought its own iron ore mines in Brazil. "That's attractive," Landers says, "given rising iron ore prices."

A Relative Value

There's a sizable disconnect between the performance of the Bovespa index and the country's economic growth numbers. As the Bovespa shot to the moon during the past five years, the country's gross domestic product grew an annual average rate of 3.4% between 2002 and 2007. Last year it topped 5%. That's decent growth, but it's the smallest rate among the BRIC countries, and it even trails South American neighbors Colombia and Peru (granted, they're working from smaller bases).

The Brazilian market's rise is giving some investors pause. "Right now we're not finding a lot of things to own because of valuations and market uncertainty," says Landesman from ING. Two of his recent favorites were Banco Bradesco and Cosan, a leading global producer of sugar and ethanol.

"I like the Brazilian story," Landesman says, "but it's a matter of waiting to add things opportunistically."

Other investors are less reticent. Landers from BlackRock says Brazil's growth rate won't approach those of China or India because of infrastructure bottlenecks. "In the Brazilian GDP one area that's not getting a lot of growth is in government spending," he says. "They're keeping their accounts in line, and there's not a lot of money left over for government investments."

But Landers doesn't see that as a major problem. "The private sector is growing nicely and the domestic consumption story is really leading the way. The country can stay in the 4% to 5% growth range for the foreseeable future."

Emerging markets analyst David Riedel touts the Bovespa's trading multiple of about 12.5 times 2008 earnings, which is comparable to the Russian market and significantly cheaper than China or India.

"Some people would say, 'you have 5% GDP growth and inflation concerns, so maybe you need a better valuation than 12 times,'" Riedel says, adding that Brazil's solid macro fundamentals and its roster of companies with strong ROE growth makes for a compelling emerging market investment.

He argues that places with reasonable P/E valuations, such as Brazil, are a better place to be in during uncertain and volatile times because it decreases the odds of a contraction in trading multiple. "You might see China go from 40 times to 20 times earnings," he says, "but I doubt that Brazil will go from 12 to 6. And so far this year you've seen it hold up well."

Along with Petrobras and Banco Bradesco, his top Brazil pick is Bovespa Holding, which controls the Sao Paolo Stock Exchange. The exchange accounts for 70% of all Latin American trading volume and is the world's third-fastest growing exchange in terms of average daily trading volume. Bovespa Holding went public last year, and in February began merger talks with BM&F, Brazil's main futures exchange. If the deal goes through, it would create Latin America's largest exchange group and would strengthen Bovespa Holding's hand in the country's vital commodities sector.

Piggybacking Commodities

The commodities boom has been Brazil's friend, but the flip side could be less friendly if global growth slows and commodity demand tapers. Take, for example, the iShares MSCI Brazil Index, a Brazil-focused exchange-traded fund that skyrocketed 75% last year versus the 44% gain for the Bovespa index. The fund got a tremendous boost from its heavy reliance on Petrobras and Vale, which combined comprise half of its holdings. Both companies currently enjoy all-time high prices for their chief products, oil and iron ore, respectively, so comedowns in those commodities could leave the fund vulnerable to a decent pullback.

Brazil's outsized role in Latin America-it makes up more than 65% of the MSCI Emerging Latin America index-has been a boon to funds that track the index. Both the BlackRock and T. Rowe Price Latin America funds, for example, posted average annual gains of 54% during the past five years thanks to their large Brazil stakes.  "It's probably safe to say that Brazil is a commodity-based economy," says White, the T. Rowe Price portfolio specialist. "But increasing consumer demand will probably provide a bit of a buffer" if commodity prices drop. Nonetheless, T. Rowe Price recently trimmed the Brazil overweight position in its global emerging markets portfolio from 5% to 2%.

Making The Grade

Brazilian equities have been hot, but the fixed-income side is also generating a buzz. For starters, the country's benchmark lending rate as of late February was 11.25%, one of the highest rates in the world. "Brazil is our largest position in the local emerging markets space," says Kristen Ceva, who runs the fixed-income group at the investment management firm Payden & Rygel.

Ceva owns bonds denominated in the local currency, the real, which were sporting yields of 12.5%. She believes that Brazil's underlying fundamentals are solid, including a strong currency and concerted efforts to maintain fiscal and monetary responsibility. On a macro level, Brazil should get a huge lift if rating agencies place an investment-grade rating on the country's foreign sovereign debt. For starters, investment grade will bring in a whole new class of investors because some funds can't invest in speculative-grade securities. It would also give Brazil a wider pool of capital and could mean better interest rates as the government tries to raise funds to pay for needed infrastructure projects.

"It's not just one thing that will move Brazil to investment grade," says Lisa Schineller, a credit analyst at Standard & Poor's. She says S&P in 2002 downgraded Brazil from BB- to a B+ rating with a negative outlook due to its debt, its poor exchange rate versus the dollar, and fears that the incoming leftist Lula administration would stop debt payments and subsequently default. Schineller says S&P has had a positive outlook on Brazil since 2003, and after a series of upgrades the country's foreign currency rating is now BB+, its highest rating ever and just a notch below an investment-grade rating of BBB-. She adds that while S&P is impressed by the country's favorable economic backdrop, attaining investment-grade status isn't a sure thing because Brazil still has issues: It has to expand its transportation infrastructure, simplify its complicated tax system and continue debt reduction.

One of the key tests to Brazilian economic resiliency will be how it fares if the U.S. economic slowdown impacts the rest of the world. It helps that just 12% of Brazil's economy is U.S.-related, but a broader slowdown could deliver a hit to its important commodity exports.

A longer-term test will come after Lula leaves offi ce in 2010, and whether Brazil can maintain its fiscal and monetary discipline. "There is a sense of political transition where its political institutions are among the better-tested in the region," Schineller says. "I think it will last over time."