Building a Better BRIC-Trap

In a 2003 research paper Goldman Sachs argued that the combination of countries Brazil, Russia, India and China (BRIC) has the economic potential to be larger than the G6 in US dollar terms by 2050. The countries are forecast to encompass over 40% of the world’s population and hold a combined GDP of nearly $15 trillion dollars. Goldman predicts China and India will be dominant global suppliers of manufactured goods and services and that Brazil and Russia will be dominant suppliers of raw materials. Brazil and Russia would form logical commodity suppliers to China and India; cooperation amongst the four countries would create a powerful economic block.

Although the relationships are logical, it is not a no-brainer that the potential will be realized. Take a look at these headlines.

• 3/06 Radio Free Europe – Russia/China: ‘Partners’ Struggle With an Unequal Relationship
• 4/05 Economist – Brazil and China: Falling out of love
• 10/05 Wall Street Journal – Brazil Regrets its China Affair

However, these opportunities are too great to not find common ground.

• 7/06 Chinese Gov.cn – Year of Russia in China helps deepen strategic partnership of cooperation
• 9/06 Embassy of the People’s Republic of China in the US – Top Chinese legislator hails China-Brazil economic relations. China and Brazil will meet their goal of bringing bilateral trade to 20 billion dollars in 2007.
• 11/06 China Daily- China, India trade to hit US$20b this year. Bilateral trade between China and India is expected to hit US$20 billion this year, fulfilling the target set by both governments two years ahead of schedule

Each country is acutely aware of the potential benefits, so these relationships will be handled with care.

Investors who have recognized this opportunity have profited. An equal-weighted basket of ETFs representing each country – Brazil (EWZ), Russia (TRF), India (IFN) and China (FXI) returned over 45% last year. Significantly outperforming the MSCI Emerging Markets ETF (EEM, +24%) which includes all of the emerging market countries. This has Wall Street feverishly creating new products to capture this trend. Claymore introduced the first BRIC ETF last fall (EEB) that tracks liquid U.S. exchange-listed ADRs and GDRs. However, is Claymore’s allocation of 49% Brazil, 31% in China, 14% India and 6% the ideal allocation? Last year Claymore’s allocation missed much of Russia’s gains as the Russian ETF (TRF) returned 62%.

Individual investors no longer have to wait on Wall Street’s products. Low cost brokers and basket trading have made it financially feasible and practical to create your own “pseudo-ETF.” Read my article on low cost basket trading for more details.

Currently, I am using two pseudo-ETFs to invest in the BRIC theme. The first is composed of stocks that provide raw materials and supplies necessary for the industrialization of the BRIC economies. The second is simply an equal-weighted basket of EWZ, TRF, IFN and FXI. I prefer this approach versus the Claymore, since I can control the allocations. So, if you only want broad exposure use the Wall Street products or a variation similar to mine.

That being said, I am in the process of reconstructing the second method. I believe in the long run more upside will be realized by addressing specific problems facing the BRIC countries as opposed to the broad-brush approach. So, the second ETF will be composed of stocks that address two major problems facing the BRICs – pollution management and logistics/transportation. I will address logistics and transportation in a subsequent article.

Pollution Management:

China’s rapid economic growth has had some very costly unintended consequences. Pan Yue, vice minister of China’s State Environmental Protection Administration, summed up the problem, in a November 2006 commentary republished in the Wall Street Journal, that “China is dangerously near a crisis point” with its environment. A third of China’s people drink substandard water and a third breathe badly polluted air, according to Pan. “True, China has made the kind of economic advances in three decades that required 100 years in Western countries. But China has also suffered a century’s worth of environmental damage in 30 years.”

China can no longer neglect this problem as it is costing the country an estimated 10% of GDP every year. That equates to more than US$200 billion a year. Also the impact of pollution on human health has become more obvious and is leading to social unrest of affected citizens. In a report released in June of 2006, Zhu Guangyao, deputy chief of the State Environmental Protection Agency stated that “The Chinese government will mobilize all forces available to solve the pollution problems that are causing serious harm to people’s health.” In other words, serious dollars will be thrown at this problem to the tune of $125 billion. The authorities plan to spend about $125 billion over the next five years to improve water supply and waste water treatment, according to recent reports in the official media. More than $43 billion has been earmarked for sewage treatment plants in urban areas.

China’s problem is much larger than the other BRIC countries, but they are facing similar issues. I believe that the following companies will be major benefactors from this clean-up effort.

Veolia Environment (VE) is world leader in environmental services operating in four complementary segments: water management, waste management, energy management and passenger transportation. In January, it won its 21st contract in China. It operates in 19 of the 34 Chinese provinces serving the water needs of 20.59 million people. The company is also very active in Russia. Since 1991 Veolia Water has had a majority stake in “Saint Petersburg – Pure water”, a company specializing in research into leakage from municipal water supply networks. In 2002 Veolia Water became the leading international water services company operating in Russia from Moscow and currently from St. Petersburg.

SUEZ (SZE) provides equipment and services that protect the environment worldwide. Its activities include drinking water production and distribution, waste water collection and treatment, and waste treatment and recovery. The company operates 20 joint ventures in China. These joint ventures treat or manage water distributed to 13.5 million people in major cities including Shanghai.

Companhia de Saneamento Basico do Estado de Sao Paulo (SBS) is the Americas’ largest water utility and #3 worldwide. The company provides water and sewage services in the territory of the state of Sao Paulo, Brazil to residential, commercial, industrial, and governmental customers. It distributes water to approximately 22.6 million people and also provides sewage services to approximately 18.3 million people.

Covanta Holding Corporation (CVA) is the fourth and final company in the environmental segment of the basket. The company, through its subsidiary, Covanta Energy Corporation, engages in the development, construction, ownership, and operation of infrastructure for the conversion of waste-to-energy and independent power production in the United States and internationally. Covanta has a long history in China and just recently announced a joint-venture partnership with Chongqing Iron & Steel to participate in China’s rapidly growing waste-to-energy market.

These four stocks will form the one pillar of the revamped BRIC “pseudo-ETF.” The other pillar will be comprised of stocks in the logistics and transportation sectors. Why those sectors? By some estimates, logistics accounts for 40 per cent of the cost of goods sold and four-fifths of production-cycle time in China. This compares with around 10 per cent of the cost of goods sold in the US. The antiquated logistic approaches combined with the fractured highways / railways and primitive modes of transpiration are tremendous opportunities for efficiency improvements.