Why I’m glad I steered clear of Brazil’s corporate giants

Regular New World readers will know that I've never been a big fan of investing in Brazil. Ever since I wrote my first piece on Latin America for MoneyWeek, back in August 2012, I have felt that the region's biggest economy hasn't been the right place for small private investors like us.

Instead, I've been looking for investments in some of the smaller, more dynamic Latin American markets especially those that make up the Pacific Alliance. And, so far at least, I feel that stance has been broadly justified.

Since I wrote that first article, Brazil's main index is down by about 20%. Of course, that's not to say that there aren't good investments there. Brazil's a big place, and I'm sure that lots of people far smarter than me have made a tidy profit there over the last few years. But, on balance, I felt there were more exciting places for us to invest.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

And if I was generally sceptical about Brazil I was scathing about its two economic champions iron ore producer Vale and oil company Petrobras.

Since I told readers to steer clear of these two, they've both lost around two-thirds of their market value. Sometimes the stocks you don't invest in are more important that the ones you do, so I think it's worth taking a look at just what went wrong with Brazil's corporate giants.

I love Brazil, but

Back in 2008, I was sent to the country's oil and gas capital, Rio de Janeiro, to write a report on the country's massive offshore oil discoveries. Young, free and single in Rio de Janeiro it was one of the best three months of my life. Brazil is a beautiful place, filled with friendly people, it's long been a cultural powerhouse and over the last ten years it's started to become an economic force too.

Yet, like any country, Brazil has its problems. Crime, inequality and corruption all hold Brazil back. Indeed the last problem has proved a real bugbear for Petrobas more on that later.

But the common denominator in the downfall of Vale and Petrobras has been state interference.

The Brazilian government has a majority stake in both companies. This corrupts the decision-making process so that it no longer serves what's best for shareholders, but instead suits the government. That might work for a while if the interests of both are aligned. But over time they are bound to diverge.

Of course, back in 2012, this ownership structure didn't seem to be a problem. Both firms were riding the commodities boom and seemed to be doing well. Yet even back then, there were warning signs.

In 2011, Vale's successful CEO was replaced, apparently because he was resisting government hints that the iron ore miner should expand into the less profitable, but more labour-intensive, steelmaking industry.

Meanwhile, Petrobras was also making a slew of decisions such as selling its oil at a loss to the domestic market that showed it was serving Brazil, not its shareholders.

That's why, back in December 2012 I warned readers off the companies. "The common theme here is that both were founded as state champions and though they've partially listed they still receive a lot of political direction'. And while I think they're great engines of growth for the Brazilian economy, I don't think you should be investing in Latin America through stocks like these."

When disaster struck

At the moment, Dilma Rousseff's one saving economic grace and it's not one that should be taken lightly is that Brazilian unemployment is near record lows. The last thing she needs is for some of the country's biggest employers to start laying-off workers.

The other option is to pull back on some of the crazy capital investment. Yet, as I noted above, these firms also drive national growth.

LCA, a So Paulo-based market analysis agency, estimates that a 10% cut in Petrobras' capital expenditure would knock 0.5% off Brazil's GDP. Given that growth is only scheduled to come in at 0.5% this year, that's something that Rousseff can ill afford. And that's why these firms have done even worse than their private competitors. For example, in the world of giant miners, Vale has underperformed rivals such as BHP Billiton and Rio Tinto by 40% over the past three years.

And as for Petrobras, it's done even worse.

Interfering in a large company to boost the national interest may not be great for minority shareholders, but it's understandable. As I said back in 2012, Petrobras has done a lot of amazing things for Brazil.

Back in the 1950s it doggedly searched for oil, when the received private-sector wisdom was that there was none to be found. It also drives research and development in the country.I visited its CENPES oil investigation facility back in 2008 and was impressed to discover a lair of white-coated scientists and futuristic inventions. Latin America lags the West and Asia in R&D spending, so Petrobras' efforts are an important contribution.

But the problem is that state interference in Petrobras hasn't just been a bid to boost Brazil. Now a huge corruption investigation is revealing that politicians also exploited their influence in the company to make a slew of corrupt deals.It's alleged that overpaying for contracts and assets created scope for billions of pounds worth of bribes to be handed out to key figures in the public and private sector. So far 12 senators, 49 federal deputies and at least one governor have been accused of being involved in the £2.5bn scandal though fresh details keep emerging.

When to buy Petrobas

The big question for us now is: when should we invest in Petrobras? I must admit the firm's massive problems and struggling share price make it attractive for a contrarian investor especially when you consider the massive assets it still has at its disposal.

Analysts at JP Morgan believe it's too early to jump back on board yet. They advise waiting until at least 31 January 2015, when Petrobras is finally due to release its delayed third-quarter report. It's sound advice, and I'm going to be keeping an eye on both it and Vale and will let you know when I'm ready to change my opinion on Brazil's corporate giants.