Fund Managers Turning To Brazil's Small-, Mid-Cap Stocks

With Brazil's economy showing signs of a turnaround, investors are getting bullish on small- and mid-capitalization companies as a way to diversify from more familiar names.

"When you go and talk to European institutional investors, they tell you they want less exposure to commodity companies and more exposure to companies serving domestic consumers," said Mohamed Mourabet, manager of Victoire Capital, a $250 million asset-management firm in Sao Paulo, Brazil's financial capital.

Although still facing a recession because of the global crisis, Brazil's domestic economy has been surprisingly resilient, with consumer credit volume expanding modestly and income levels stable.

Brazil is famous for its bellwether commodity stocks, from oil major Petrobras (PBR) to mining companies such as Vale (VALE). But now smaller companies that benefit from solid domestic consumer demand are also likely to prosper.

However, exposure to the small names is hard to come by. None of them have American Depositary Receipts, despite being some of the biggest retail brands in the country like Lojas Renner (LREN3.BR).

Brazilian asset managers have been able to fill the void, by creating portfolios for qualified, foreign institutional investors looking to invest in locally-focused stocks.

Investors are starting to pile in, but the bigger trend is still a year or more away, said Mourabet.

Yet, according to equity analysts at Citibank, emerging-market small caps have outperformed large caps so far this month.

In a report Wednesday, Citigroup analysts said international investors are going into less liquid names, a sign that "the rally is real and that regional economies are close to their trough." Brazil is an "overweight" for small- and mid-cap investors.

So far this year, the iShares Brazil BM&FBovespa Small Cap index is up 67% in dollar terms, beating the Ibovespa stock index in Sao Paulo by five percentage points.

The iShares Brazil MSCI Index exchange traded fund (EWZ) is up 55% since Jan. 1.

Two weeks ago, the Van Eck Global fund opened the first-ever Brazil Small-Cap ETF (BRF). It's up 4.24% this week, slightly trailing the iShares Brazil ETF, which is up 4.92% since Monday.

"Brazil's small- and mid-cap names still trade at a big discount to their peers because of risk perception, so these are high beta bets," said Ed Kuczma, a Van Eck analyst.

"But when you really consider where the risk has come from over the last 10 months, it's been in the U.S. and Europe. No Brazilian banks or companies have failed," he added.

During past economic crises, Brazil was affected by its high foreign debt levels. Today, Brazil is a net lender with around $205 billion in foreign reserves. While other emerging markets have funded growth by debt, Brazil has maintained a steady growth rate of around 4% during the 2004-2007 period, according to government numbers.

Van Eck's newest edition to the emerging-market exchange-traded fund world is overweight on "consumer discretionary" and "industrials" when compared to the MSCI Brazil index.

Its top picks include home builder Cyrela Brazil Realty (CYRE3.BR) and utility Eletropaulo (ELPL6.BR), which has seen increases in residential and commercial electricity demand.

Brazil's small-cap stocks are also trading at multiples well below their peers. Rental car agency Localiza (RENT3.BR) is trading at six and a half times its earnings before interest taxes depreciation and amortization. Avis (CAR) in the U.S. is trading at 19-times Ebitda and is in a contracting market.

"Institutional investors and sovereign wealth funds that are looking long-term want access to alternative, under-researched names," said Mourabet. Around 70% of Victoire's assets are from European and Middle East pension funds, and "all of them are holding small- and mid-cap companies," Mourabet added.

-By Kenneth Rapoza, Dow Jones Newswires, 5511-2847-4541, [e-mail]