Brazil’s water shortage is a big bad buying signal

Let me put this as clearly as I can: Brazil is in crisis.

Brazil's industrial heartland, the state of Sao Paulo, is in the grip of a fierce drought. The 20 million inhabitants of the country's biggest city are now facing water rationing, as are its largest firms. Around three-quarters of Brazil's electricity comes from hydroelectric sources, so power shortages are likely.

As if that wasn't bad enough Brazil's political and business elite is being torn asunder by the ongoing Petrobras scandal. Allegations of corruption within Brazil's state oil company have now spread from the country's largest corporations to its main political parties. Just months after her election victory, President Dilma Rousseff is facing calls to be impeached.

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All of this comes as Brazil's economy continues its downward slide to recession. The heady days of 7.5% GDP growth in 2010 must seem a lifetime away for Rousseff now. Last year GDP grew by just 0.1%, and most analysts reckon 2015 will see a recession.

Regular readers won't be too surprised by all of this. Ever since I started covering Latin America for MoneyWeek back in 2012, I have warned readers to stay away from Brazil. Steering clear of the region's biggest economy hasn't been easy, but it's paid off. The Bovespa (Brazilian stockmarket) is down by 20% since its 2012 highs.

Brazil's had structural problems for decades, and been overpriced for years. Now that's only half-true. The country still has serious problems, but now it's cheap as chips.

You might think Brazil looks like an awful investment opportunity, and until recently I would have agreed with you. Now, though, the negativity around Brazil has reached such fever pitch that the contrarian in me is itching to invest. Let's look at the problems that have got investors running scared.

Short-term greed screwed Brazil into the ground

Let's start with the drought, which has the potential to be the most serious of all the problems. Brazil has gone through a dry patch, with the famous rainy season failing to live up to its name for several years on the trot. But this isn't just about a lack of rain there are more deep-rooted structural causes.

Lots of scientists believe deforestation is to blame. Over the years, Brazil has hacked down incredible amounts of its forests, for logging and farming. Regardless of whether you believe in global climate change or not, it seems quite plausible that such huge changes would have an effect on a local scale.

Economic growth has also had an impact. In the 20th century, Sao Paulo became the most densely-populated and industrialised part of Latin America. That's pushed up demand for drinking water, while also reducing its supply thanks to contamination and industrial use.

But what's really frustrating for Sao Paulistas is that despite all of the above, the water shortages could have been avoided. After all, we're not talking about the Gobi Desert here - Brazil has the world's biggest supply of freshwater. But Sao Paulo's water has been terribly mismanaged. Around 30% of drinking water is lost through leaks in the system, while only 30% of wastewater is treated. That untreated water goes on to contaminate local rivers, reducing the supply of clean water. Experts have been warning about looming water shortages for years, yet no politician has wanted to make the tough decisions to deal with the problem.

At the moment the impact is quite cosmetic restaurants, for example, are serving meals on paper plates to avoid washing up but when industrial users face water shortages then the economy will suffer. If the drought continues, Brazil's hydro plants will suffer, and power supplies will stutter.

But I'd back Brazil to improve its water management. Technically, it's not impossible, it's just that until now the issue has been that no-one thought it politically worthwhile to solve the problem. Now fixing the water will become Sao Paulo's number one vote issue. If water management improves, businesses will be more secure.

Corruption has destroyed Brazil's pride and joy

Brazil has also been stung by corruption, which I covered in great detail in December.. Essentially, when Brazil found lots of offshore oil, Petrobras embarked on one of the world's biggest corporate investment programmes. With oil heading towards a record high of $148 a barrel, the company ambitiously planned to build a fleet of ships, rigs and refineries to ensure that the country made the most of the bonanza. Unfortunately, the oil has proved difficult to extract and the production schedule has gone awry.

Even worse, it's now emerged that Petrobras officials were deliberately overpaying for goods and services to earn kickbacks from contractors. These bribes were shared among greedy politicians to ensure government support. We still don't know how much exactly but the conservative estimates are talking about billions of pounds' worth of kickbacks.

Brazilians are used to corruption but this one has hit them hard. Petrobras has a place in Brazilian society that is hard to imagine any British firm having here. It was an immense source of national wealth and pride. Unsurprisingly, the majority of Brazilians think that Rousseff, who was Petrobras Chairman while all this was going on, must have known about it. With her approval ratings standing at all-time lows, some political opponents have started to call for her impeachment. Analysts reckon that she will probably survive, but the battle to find scapegoats and the huge numbers of likely culprits mean that the business and political atmosphere will be toxic.

All of the above means that the politicians and businesspeople will have less attention to give Brazil's economic woes.

There's no doubt that the corruption scandal is bad, even by Brazil's standards. But in many ways the economic damage has already been done: now it's a case of cleaning up. The political fallout will continue a little, then be resolved one way or another. Now could be the perfect time to invest, while markets are glum but before a recovery sets in.

Opportunity amid the gloom

Yes, the short-term position is dire but I'm a medium- to long-term investor and over that time frame Brazil looks alright.

I'm certainly not bullish over the Brazilian economy. Analysts expect a recession this year and I think it will take Brazil a long time to sort out its structural issues. Brazil may not grow as well as it should, I think it will still reward investors: it's just so cheap right now.

Brazil's market is now down 30% from its 2008 peak, trading on a forward price/earnings ratio of 11.3 (this means the price of one share in the index divided by the index's projected earnings per share for 2015 a measure of how expensive the index is relative to the amount of money its companies are making).

The local currency, the real, has also taken a battering. It's at a ten-year low against the pound. So if, as a sterling investor, you buy a Brazilian stock, you also stand to gain if the real strengthens.

There's lots of ways you could play this. My personal favourite would be through a tracker of Brazil's main stock index, the Bovespa. The reason that I'd go for an ETF instead of an actively managed fund is that this story could get worse before it gets better; you might be holding the position for a few years. If so, you want your annual management charges to be as low as possible. One option is the iShares MSCI Brazil UCITS ETF (LSE:IBZL).

If you insist on going down the actively managed route - and I am not recommending this - then check out BlackRock's Latin American Investment Trust (BRLA). I've met the manager Will Landers a few times and he definitely knows his stuff. The annual charges are higher, of course, but the trust is trading on a discount to net asset value of 9%. If sentiment towards Brazil changes you will get an extra boost.

Changing a long-held investment position like this isn't easy. I won't be able to use every bad story coming out of Brazil as an excuse to tell you 'I told you so', but when Brazil is this cheap, it's time to get off the sidelines.