In this article published in The IRS Report in April 2010, Chris Gilchrist explains why we should buy India and Brazil...

Profits are the reason to buy India and Brazil

Over-excitable investors have become entranced by the argument for investing in emerging markets. Some of them are ropy. One of the easiest factors to understand is the demographics: the pitch for emerging markets is that over the next 20 years there will be more old retired people in Western countries and fewer workers supporting them, while in the emerging countries there will be far more people entering the workforce and comparatively few leaving it. That is certainly a recipe for more dynamic and faster-growing economies. But  this does not apply either to China – thanks to its one-child policy its demographic trends are almost as bad as those of Western Europe – nor to Russia, whose population is shrinking. Positive demographics do apply both to India and Brazil, but a better reason for investing there is that both should benefit from high business profitability.

There are other reasons to be wary of the former communist empires. When I met Anthony Bolton recently on his promotional tour for Fidelity China Special Situations, I told him that China's infrastructure boom reminded me of another one that at the time was also the largest in history: the development of the US railroads. Notoriously, investors didn't make a dime: thousands of miles of rail were built, often duplicating existing lines, by venal promoters who cheated investors every step of the way.

Yet by the late 1800s the US had better securities laws and investor protections than China or Russia have today. That is why I consider investment via companies established in jurisdictions with real investor protections, listing requirements, accounting standards and so forth preferable to buying domestic Russian or Chinese companies. Even if such companies are clean today, there is no way that foreign investors can prevent the state or a group of mafiosi from taking control of them. Indeed, Bolton actually gave an example of a Chinese company that he had considered investing in but rejected only after using a private investigation firm to check out its CEO.

India and Brazil are, in contrast, functional democracies with constitutions, mostly independent judiciaries and functioning legal systems. Of course there is corruption, but there are also plenty of Frenchmen who are wondering how and why their government spent a billion euros buying enough swine flu vaccine to inoculate the entire population twice over. The point is that with a constitution and an independent judiciary, abuses will be the exception rather than the rule.

JPMorgan is a believer in the BRIC story and already has Russian, Indian and Chinese funds. I heard its managers put the case for Brazil with the launch of their JPMorgan Brazil Investment Trust, and found it convincing. The principal factor with Brazil is the rapid evolution from a commodity base to industrialisation and consumerism. Already, exports account for only 10% of GDP and with the flattening and rebuilding of a large chunk of Rio de Janeiro now certain to happen in advance of the 2016 Olympic Games – and a football World Cup preceding this in 2014 – the nation is set for a massive boost both economically and psychologically. Some $50bn will be spent before the World Cup and at least a further $15bn on Rio before the Olympics.

On top of this, the vast offshore “pre-salt” oil discoveries, giving Brazil the world's fifth largest reserves, means a huge exploration and production boom is sure to happen over the next decade. This should provide tax revenues to finance the ongoing infrastructure spending the country needs for a population of 200m in an area the size of Western Europe.

JPMorgan emphasises the quality of local entrepreneurs, many of whom are rapidly building successful businesses in fields from consumer retailing to oil and gas exploration.

This is a country so confident of its ability to manage its own destiny that it has slapped a 2% tax on foreign inward portfolio investment. That is a negative for foreign investors, but as JPM points out, it adds to the merits of a closed-end fund, which will pay the tax only once (it will not be paid when selling and purchasing Brazilian investments once the currency has been purchased). On the other hand, an open-ended fund that had to repatriate funds to meet redemptions would have to pay the tax again on fresh investments.

India lacks most of Brazil's advantages: it has little free energy (hydro power generates over half Brazil's electricity), very little oil and is short of land for food production. But India and Brazil do share an important common factor: better economic management. In India, the past
decade under a reformist promarket government has seen GDP growth accelerate, economic reforms remove obstacles to business, and large infrastructure programmes begin to open up the vast rural hinterland in which the majority of India's 1.2bn people live.

India's comparative advantage is younger people – more of them, many well-educated. As in China, tiny increments in the per capita spending power of rural populations translate into gigantic business opportunities.

Valuing emerging markets is tricky. Brazil lacks a decent index – Petrobras still accounts for 40% of the BOVESPA, and India's BSE Sensex is not much better. So while talking about the P/E or book value of the Footsie or the S&P500 makes some sense, this methodology is suspect with India or Brazil. Still, for what it is worth JPM's global strategists reckon that on the basis of a combination of dividend yield, price-to-book, P/E ratio and price-to-cashflow, India and Brazil are  both “fair value” – neither cheap nor dear in terms of the historical range of valuations.

But what about profits? This is the key to investing success. It seems likely that in both India and Brazil profitability will rise. In Brazil, because it is still emerging from a decade of underinvestment and in India because business stands to gain greater benefits from deregulation and economies of scale. Corporate earnings in Brazil are slated to rise by a quarter this year.

The recent sell-off in China may result in further weakness in other developing markets. But the underlying trends in India and Brazil seem so strong that you may wish to consider the approach I have adopted, which is to start by buying a quarter of your intended final stake. If you don't get the opportunity to buy more on weakness, there are worse things than buying into a rising market.

You can see all of Chris Gilchrist's articles at www.TheIRSReport.com

Chris is the editor of The IRS Report every month

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