Will Brazil's Government Ruin A Good Thing?

By Stephen D. Simpson, CFA | April 05, 2011 AAA

CEOs come and go, but sometimes the circumstances matter. That is especially true in the case of Brazilian mining giant Vale (Nasdaq:VALE), which has recently announced that its CEO, Roger Agnelli, will be stepping down.

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This is not a case of a CEO leaving for a better opportunity, "to spend more time with family," or to enjoy a well-earned retirement. Instead, Vale's CEO is basically being run off by the Brazilian government, who apparently wants a more pliable and compliant executive running one of the country's largest companies.

Not only is this a serious matter for Vale shareholders, who are losing out on the continued leadership of an executive who was at the very least competent, but it is a serious matter for all investors with an interest in Brazil. While there can be a healthy and spirited debate about the balance between public and private interests, direct interference in a publicly-run company sets a dangerous precedent and Brazil's government had better be careful or risk falling out of favor in many investors' eyes. (For related reading, see Cautionary Signs For International Investors.)

The Background of the Spat
It does not appear that there was a single issue that has led to the Brazilian government's displeasure with Agnelli, but rather a pattern of behavior. Vale has, quite frankly, been running its business with an eye towards profitability - investing in assets that seem likely to produce the highest returns, wherever that may be. In contrast, many of Brazil's politicians apparently want the company to underwrite and subsidize the development of Brazil, sourcing manufacturing from Brazil and investing in industries like steel to support their growth and development.

The last straw may have been a spat over royalties. The Brazilian government says that the company owes about $3 billion in royalties, but the company has stood firm and taken the matter to a judicial review.

The Risk of the Golden Share
Although Vale was technically privatized over a decade ago, the government still has a significant stake (through pension funds) and holds a golden share. What's more, Brazil's government exercises a fair bit of "persuasion" over other investors like Banco Bradesco (NYSE:BBD).

This is not the first time that the Brazilian government has done something like this. When Petrobras (NYSE:PBR) began making huge offshore oil discoveries, the government decided to rewrite the rules and, not surprisingly, those rewrites were not in the favor of Petrobras's private shareholders.

Brazil's influence is not just limited to Vale and Petrobras. The Brazilian government (whether at the federal or state level) also has significant influence (often in the form of "golden shares") in aircraft maker Embraer (NYSE:ERJ) and utility companies CEMIG (NYSE:CIG) and Copel (NYSE:ELP) just to name a few. Moreover, there is virtually no doubt that government officials can exercise a great deal of influence over banks like Itau Unibanco (Nasdaq:ITAU) and other major corporations through various policies and and regulations.

Not Unusual, But Not Good
To be fair, Brazil is not at all exceptional in this regard. China is well-known to exercise its influence on and through major companies like China Mobile (NYSE:CHL), Chalco (NYSE:ACH), and Baidu (Nasdaq:BIDU). Likewise, India has a truly breathtaking array of regulations and bureaucracy, and the Russian government has shown no particular compunctions about interfering directly in corporate governance to achieve its aims.

Just because something is not unusual does not make it right, and it does not mean that investors should not keep it firmly in mind as a risk factor. What's more, it is not necessarily a permanent situation - South Korea and Taiwan both had similar issues in the past on their path towards modern (mostly) free markets. (For more, see Does International Investing Really Offer Diversification?)

The Bottom Line
In a relatively short period of time investors in major Brazilian companies Vale and Petrobras have had to deal with the ramifications of direct government interference into the operations of the companies. This risk of future interference, and the possibility that the government will look at these companies as vehicles for social or welfare projects, is a factor in why these companies often carry discounts relative to peers like Rio Tinto (NYSE:RIO), BHP Billiton (NYSE:BHP), Chevron (NYSE:CVX) and so on.

While these companies have excellent growth prospects and are generally thought to be well-run, the otherwise unnecessary change in management at the top of Vale is just another reminder to investors that the rules and risks change a bit when investing overseas. By no means should investors avoid these strong growth markets, but the ideas of a risk premium and a margin of safety should be kept in mind at at all times. (For more, see Evaluating Country Risk For International Investing.)

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