There's no question that Brazil remains a popular emerging/developing market for international and global investors. Unfortunately, it's all too common for long-term macro calls ("buy Brazil") to have only passing relevance to particular sectors or companies. In the case of Brazilian banks such as Banco Bradesco (NYSE:BBD), lower interest rates hold the potential for compressing net interest margins and bank profit/return on equity (ROE) growth just as we've seen lately in the United States. While investing money in Brazil may make sense today, Bradesco is not looking like the best means of going about it.

SEE: The Banking System

A Solid, Diverse Business
While Bradesco is facing some potentially punishing near-term risks, it is, on the whole, a relatively strong bank. The third-largest bank in Brazil, Bradesco holds a mid-teens share of the assets and deposits in Brazil's banking system. While loan losses are elevated in Brazil relative to the U.S., Bradesco has generally done well in managing its credit exposures and boasts a solid long-term record for ROE generation.

Bradesco has also taken a page from the "complete bank" playbook, and has coupled a large bank operation with insurance and pension operations as well. Bradesco is the largest health insurance provider in Brazil (with over 50% share), the third-largest auto insurer (after Porto Seguro and Banco do Brasil (OTC:BDORY)), and the largest pension company by assets (ahead of Itau (NYSE:ITUB), Banco do Brasil and Zurich).

SEE: Potholes In The Golden BRIC Road

Will Lower Rates Compress Growth?
Bradesco has been reporting respectable results lately. For the third quarter, the company saw 9% year-over-year growth in loans and 1% growth in adjusted net interest income (with a net interest margin nearly double that of large U.S. banks such as Bank of America (NYSE:BAC) and Citigroup (NYSE:C)). Better still, the delinquency ratio has been coming in below long-term trends (down to 4.1% in the third quarter).

Unfortunately, while Bradesco, Itau and Banco Santander Brasil (NYSE:BSBR) have all been seeing pretty good operating conditions, I think investors have reason to worry about results in the next year or two. SELIC rates, the Brazilian version of the overnight lending rate, have been coming down, and this has historically meant net interest margin compression for the commercial banks. So while Bradesco management is talking about ROEs in the high teens or even 20% next year, a repeat of past performance during SELIC declines would suggest downside risk in the mid-teens (and substantial revisions to sell-side earnings estimates).

Making matters worse, the bank doesn't seem to have a lot of options to counteract the spread pressure. Bradesco already operates a pretty efficient bank by Brazilian standards, and marketing moves such as increasing customer credit lines are typically matched pretty quickly by rivals. Lower rates will also pressure profits in the company's insurance operations, just as we've seen in the U.S. with large P&C companies such as Allstate (NYSE:ALL). What's more, a proposal to change the treatment of deferred tax assets and make it easier for Brazilian banks to reach Basel-3 capital standards would likely be of least benefit to Bradesco (and of most benefit to Banco do Brasil).

SEE: Understanding BRIC Investments

The Bottom Line
Bradesco is a bank that I would love to love, but the valuation figures just don't support that right now. A return on capital model using a long-range ROE target of 18% suggests fair value of about $17.50 today. Moreover, taking the implied earnings growth rate of 11% from that model and comparing it to the current P/E (13 times) or forward P/E (11.5 times) doesn't suggest a great bargain. Last but not least, using a long-term tangible book value/return on tangible equity regression suggests that Bradesco is, at best, fairly valued on the basis of tangible book value.

All in all, Bradesco is at best fairly valued today, and that's assuming that fears of spread compression (and lower ROE) in 2013 are overblown. The quality of this bank makes it a good one to watch, however, particularly if that spread compression leads to significant cuts in estimates and underperformance in the shares.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

Related Articles
  1. Stock Analysis

    Net Neutrality: Pros and Cons

    The fight over net neutrality has become an amazing spectacle. But at its core, it's yet another skirmish in cable television's war to remain relevant.
  2. Personal Finance

    A Day in the Life of an Equity Research Analyst

    What does an equity research analyst do on an everyday basis?
  3. Mutual Funds & ETFs

    ETF Analysis: PowerShares S&P 500 Downside Hedged

    Find out about the PowerShares S&P 500 Downside Hedged ETF, and learn detailed information about characteristics, suitability and recommendations of it.
  4. Mutual Funds & ETFs

    ETF Analysis: ProShares Large Cap Core Plus

    Learn information about the ProShares Large Cap Core Plus ETF, and explore detailed analysis of its characteristics, suitability and recommendations.
  5. Mutual Funds & ETFs

    ETF Analysis: iShares Core Growth Allocation

    Find out about the iShares Core Growth Allocation Fund, and learn detailed information about its characteristics, suitability and recommendations.
  6. Mutual Funds & ETFs

    ETF Analysis: iShares MSCI USA Minimum Volatility

    Learn about the iShares MSCI USA Minimum Volatility exchange-traded fund, which invests in low-volatility equities traded on the U.S. stock market.
  7. Stock Analysis

    Should You Follow Millionaires into This Sector?

    Millionaire investors—and those who follow them—should take another look at the current economic situation before making any more investment decisions.
  8. Professionals

    What to do During a Market Correction

    The market has what? Here's what you should consider rather than panicking.
  9. Mutual Funds & ETFs

    ETF Analysis: Vanguard Mid-Cap Value

    Take an in-depth look at the Vanguard Mid-Cap Value ETF, one of the largest and most popular mid-cap funds in the U.S. equity space.
  10. Mutual Funds & ETFs

    ETF Analysis: Schwab US Broad Market

    Take an in-depth look at the Schwab U.S. Broad Market ETF, an incredibly low-cost fund based on a wide selection of the U.S. equity market.
  1. Equity

    The value of an asset less the value of all liabilities on that ...
  2. Hard-To-Sell Asset

    An asset that is extremely difficult to dispose of either due ...
  3. Sucker Yield

    When an investor has essentially risked all of his capital for ...
  4. PT (Perseroan Terbatas)

    An acronym for Perseroan Terbatas, which is Limited Liability ...
  5. Ltd. (Limited)

    An abbreviation of "limited," Ltd. is a suffix that ...
  6. BHD (Berhad)

    The suffix Bhd. is an abbreviation of a Malay word "berhad," ...
  1. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  2. Why would a corporation issue convertible bonds?

    A convertible bond represents a hybrid security that has bond and equity features; this type of bond allows the conversion ... Read Full Answer >>
  3. How does additional paid in capital affect retained earnings?

    Both additional paid-in capital and retained earnings are entries under the shareholders' equity section of a company's balance ... Read Full Answer >>
  4. What types of capital are not considered share capital?

    The money a business uses to fund operations or growth is called capital, and there are a number of capital sources available. ... Read Full Answer >>
  5. What is the difference between issued share capital and subscribed share capital?

    The difference between subscribed share capital and issued share capital is the former relates to the amount of stock for ... Read Full Answer >>
  6. What happens to the shares of stock purchased in a tender offer?

    The shares of stock purchased in a tender offer become the property of the purchaser. From that point forward, the purchaser, ... Read Full Answer >>

You May Also Like

Trading Center

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!