To Buy Brazil, Buy the Market’s Operator

Buying Brazil is often seen as a bet on stuff that sits under the ground or grows out of it. There is a good reason for that: 39% of the country’s stock exchange by market capitalization consists of natural-resources, materials or agriculture stocks.

Another option, though, is to buy the market itself, or at least the company that operates it: BM&F Bovespa SA. BM&F operates Brazil’s stock and futures exchanges and has a market cap of 21 billion reals ($11.4 billion). There are both near-term and structural reasons for investors to own it.

Trading activity has been strong so far this year. Average daily traded volume of stocks on Bovespa hit 6.9 billion reals in April, up 7% from March and 43% from a year earlier. It also represents a near-complete recovery of all the ground lost since October, when Brazil introduced a new tax on foreign purchases of domestic securities.

Looking ahead, Citigroup reckons Brazil should account for most of a $40 billion to $50 billion Latin American stock-issuance pipeline this year, fueling volume further.

Trading on the futures market has also surged, fueled primarily by a desire to position for the latest tightening cycle in Brazilian interest rates. The central bank raised the benchmark Selid rate aggressively last month to 9.5%. Investors expect it to hit 11.75% by year-end, according to HSBC’s latest survey. The implication is continuing healthy demand for interest-rate and currency futures.

Structurally, BM&F has the potential to become a financial hub not just for Brazil but for Latin America as a whole. Bovespa’s total stock-market cap of $1.34 trillion at the end of 2009 was 1.6 times that of Mexico’s, Peru’s, Colombia’s, Chile’s and Argentina’s exchanges combined, according to the World Federation of Stock Exchanges. In value terms, almost half of Brazil’s stock-market turned over last year, compared with just 24 % in Mexico, the next most active market.

Renato Lulia-Jacob, a managing director at investment bank Itaú BBA, says clients from around the region are showing interest in listing in Brazil. Apart from liquidity, he cites the appeal of Bovespa’s Novo Mercado market, where tougher listing requirements foster better governance on the part of companies listing there. In addition, it is easier for Latin American companies to grab the attention of investors and analysts on Brazil’s smaller market than on traditional foreign destinations, like New York or London.

Given BM&F’s growth potential, its price/earnings multiple of about 15 times looks cheap relative to peers: Asian exchange operators trade well north of 20 times. On 2011 forecasts, BM&F’s multiple falls to about 12 times, close to those of developed-market diversified exchanges like Australia’s ASX Ltd. or Germany’s Deutsche Börse. Investors seeking Brazil’s riches should start digging in downtown São Paulo.