By Horacio Marquez
Contributing Editor
Money Morning

Brazil’s economy has been given a second chance. And so have prospective investors.

Brazil will use that second chance well – shouldn’t we?

Although there are a number of ways to play this promising “BRIC” (Brazil, Russia, India and China) market, including some excellent companies, the best way to capitalize on Brazil’s terrific prospects is through the iShares MSCI Brazil Index (NYSE: EWZ).

In this special in-depth report – in which you will benefit from my special emerging markets expertise – I will demonstrate just why you will want to by this exchange-traded fund (ETF) in increasing increments between now and the end of the year. The report is longer – and more detailed – than the typical Money Morning “Buy, Sell or Hold” report. But this feature has proven so popular, and the following so enthusiastic, that in the midst of this volatile and very-trying market we thought we should go out of our way to offer our loyal following something very special. This report is the result of our wish to show you our gratitude.

My Brazil Story

It was February 1994, and I was discussing Brazil with the chief operating officer of a second-tier Wall Street investment house – one that specialized in high yield and emerging markets bonds. I remember looking directly at him and saying: “I believe Brazil will have no option other than to default or devalue its currency – possibly both.”

My words caught him by surprise and he called the head of the investment-banking firm into our meeting. At that moment, this firm happened to have more than 50% of its trading book playing the “carry trade” in Brazil.  That is, they were borrowing in Japanese Yen at very low rates and were investing the proceeds in Brazil – at the time, and consistently since then, one of the highest-yielding currencies in the world. The trade has been a winner for more than 15 years whenever the markets are relatively stable.  A sudden forced unwinding of that trade would have been extremely damaging for that bank.

I had just successfully predicted the blow-ups of both Argentina (August 1994) and Mexico (December 1994) and managed to minimize any damage from such financially horrific events, thanks to the superb team I was a member of at Merrill Lynch & Co. Inc.’s (MER) Asset Management unit. The accuracy of my predictions had been a real surprise – even to me, I’ll admit. My estimate was correct within three weeks of the actual blow-up. Now, I was very concerned about Brazil succumbing to the “contagion” effect.

In fact, I was so concerned that I had used my January vacation to travel down to my native Argentina – to visit relatives but also to check on the situation with the Ministry of Economics, the central bank and the heads of the top three Argentine banks to gauge the possible future ramifications of the Argentine fiscal crisis and the “Tequila Effect”.

I also stopped by Brazil on my way back to the United States and conducted my personal “due diligence” in that market, too. I met with the top three banks and the top local brokers, some government officials, a former head of Brazil’s central banks and a local hedge fund.  The Brazilians were all convinced that – even though the country was under extreme financial pressure from the markets – it would resist the economic and financial pressures then sweeping the region, and wouldn’t be force to devalue is currency, known as the “Real.”

At the time, derivatives contracts on the Brazilian Real had the largest open interest of all the derivatives contacts traded on the Chicago Mercantile Exchange, evidencing the incredible fight over the value of the currency that was playing out in the marketplace.  In Brazil, a similar fight was taking place, with a huge number of local players buying protection against devaluation in the forward markets.

I did not believe them.  I thought that surely the private sector would flinch, taking their currency in droves out of the country and forcing the government to devalue.

But Brazil was hanging on. Who was selling the protection?  I found out: It was the government banks, defending the currency with all their firepower, knowing that they had green light from the government, who would recapitalize them if needed.  The private sector did not panic.  Brazil held on.

Fortunately, on this part of the “Tequila Effect,” I was wrong and Brazil survived the contagion to actually thrive. I missed the first third of a zooming “gapping up” rally on the table (missing out on the profits that would have come with that near-vertical jump). But I learned a valuable lesson as I watched the first part of that rally.

I realized that Brazil had made the tough, gradual adjustments on the fiscal side and stuck to defending the stability of its financial system, evidencing a very strong resolve from the locals to stand behind their country. And I learned to recognize those patterns when they appeared again. As they have.

Suddenly, the motto on Brazil’s flag, “ordem e progresso” (order and progress) did not seem far-fetched, as it had been during the second half of the 20th century.

In fact, in Brazil, the phrase “O mais grande do mundo,” which means “the biggest in the world,” is considered locally as the national slogan and is used commonly with national pride.  Indeed, from the powerful Amazon River, to its iron ore reserves, to its incredible rain forest, Brazil has been richly endowed.  And although economic and political disorder has delayed its development for decades, Brazilian ambition has never died.  No wonder the national joke during the last couple of decades of the last century was that “Brazil is the country of the future…and it will always be.”

Even during this period, when there was no outward progress taking place, there were profound internal changes that were under way.

During the subsequent five years, many other crises reverberated around the world, and we watched as Russia and Asia – including South Korea – blew up. While it’s true that Brazil has sold off violently in response to external events or occasional internal problems, it’s important to note that Brazil has never defaulted on its debt nor resorted to a major devaluation as a policy response – unlike its nearby South American neighbor, Argentina. In Brazil, there was clearly a commitment to become a serious, orderly country. 

The only two pronounced incidents of weakness involving the Brazilian Real came as its  Mercosur partner Argentina defaulted and devalued its own currency by a three to one ratio at the end of 2001, and in a second episode toward the second half of 2002, in anticipation to the inauguration of current President Luiz Inácio Lula da Silva, known by his nickname “Lula,” since the markets believed he would lead Brazil deep into leftist policies.

In both those instances, the markets (and investors) were once again wrong to bet against Brazil. The Real came back every time, especially after President Lula launched one of the most responsible fiscal and monetary policies in the world, and also deepened structural reforms.

At the time, a friend of mine traveled to Brazil with the CEO of a major U.S. company that invests heavily in Brazil to find out what Lula would do.  Would he turn Brazil into an economic island or would he keep Brazil on track?  They came back from Brazil very pleased.  And we have all been pleased with Brazil’s order and progress since then.

Even during the “Goldilocks” stretch of the commodities boom, Brazil kept its interest rates high in real terms, avoiding any possibility of an overheated economy, bringing inflation and managing its economic house with an efficiency that some of the world’s most advanced economies could learn a thing or two from.

And Brazil achieved all of this while its major commodity and industrial exporters continued to invest heavily, expanding both their domestic sales and exports quite smartly.

Brazil’s Shrewd Game Plan for the Current Financial Crisis

Vale (ADR NYSE: RIO), formerly known as Companhia Vale Rio Doce, is the largest exporter of iron ore in the world. It has thrived and continued to expand production of this critical resource, supplying China, Japan, Europe and other major global steel-making operations.  The story behind Petroleo Brasileiro SA (ADR NYSE: PBR) is even more impressive: After decades of government initiatives focusing on oil self-sufficiency – which includes deep-sea drilling and the now-vaunted sugar-cane ethanol program – Brazil achieved that goal last year. Now, with the biggest oil discoveries in the world in decades, Brazil is well on its way to becoming an oil superpower. 

As President Lula said, “God has given Brazil one more chance.”

And us, as well.

Late last week, Brazil’s hopelessly mismanaged neighbor, Argentina, had to seize its privatized pension fund money in order to meet its fiscal obligations. We’re also watching as Hungary, Belarus and the Ukraine approach the International Monetary Fund (IMF) for help.  This directly contrasts with Brazil, which has amassed $200 billion in foreign reserves, having become a net creditor of the world.

 So, in this crisis, both the Central Bank of Brazil and the Brazilian government have acted very quickly to backstop the liquidity effects against their banks.  The Central Bank of Brazil has been continuously superbly managed, despite changing administrations: and is very experienced in crisis management. It is currently managed by Henrique Meirelles, a highly experienced and greatly respected international banker. Meirelles has operated in the tradition of Brazil’s inflation-fighting central-banking pioneer Gustavo Franco.  Franco was one of the economic advisers who put together the Plano Real, which brought Brazilian inflation down dramatically under former President Fernando Henrique Cardoso. Franco was followed at the Central Bank by Arminio Fraga, formerly associated with George Soros in the Quantum Fund, and finally by Meirelles, who was formerly with Fleet Bank.

It’s important to note that the Lula administration has many officials who have previously held senior positions with major international banks.  This is a clear indication of professionalism, transparency and commitment to serious macroeconomic and monetary policy management.  No more “brincadeira” – playing around.

President Lula went on to say that the government will buy bank stakes in order to shield its financial institutions from the global crisis.  This is happening today, as the government’s largest banks have been authorized to buy stakes in Brazilian banks.  Much like the U.S. Federal Reserve has done in here in the United States, the Brazilian Central Bank also has been authorized to enter into swap operations with other central banks in order to restore liquidity to the Real, which has been under pressure.

To add further liquidity, the Brazilian Central Bank has reduced minimum reserve requirements for the banks, extended an almost $2 billion line to the banking system to finance exporters and injected some $71 billion to ease liquidity.  The Central Bank explicitly requires the banks to lend the money and monitors closely their activities to prevent them from instead using the capital to buy – and sit on – government bonds.

The Brazilian Central Bank also has had to resort to selling only about $23 billion of its more than $200 billion in total reserves, in order to cushion the decline of the Brazilian Real. The upshot: Brazil today operates from a position of macroeconomic strength, like China, India and Russia.

And the Central Bank has stimulated housing by easing liquidity requirements and encouraging banks to lend more.  This policy will soon gather more strength.
Similarly, the government banks, rather than international investors, are the most likely to finance a huge electricity project coming for bid. And Brazil’s plans for a major infrastructure build-up should not have problems obtaining financing. 

For example, Petrobras should easily be able to finance the estimated $163 billion needed over five years to continue developing its ambitious mega-oil project out of its own cash flow, government and bank financing and profit-sharing arrangements where it chooses.   Vale and other major exporters should likewise have little difficulty in moving forward. These companies, like the government, are committed to continuing with their long-term investment plans, despite the current problems.

Nor have Brazil’s market-supporting measures stopped there. Brazil has required all companies to report their derivatives positions and even to estimate future potential losses under certain scenarios on a quarterly basis, starting immediately.  This will greatly increase transparency, dispel fears and increase confidence.  Some companies saw their currency derivatives positions get hit hard in the recent sell-off.  But these hits, which in some notable cases wiped out the quarter’s profits, are a one-time effect, so it represents a buying opportunity in those stocks.

Finally, the Brazilian banking system is sound, with strong capitalization and low delinquencies.  Credit expansion has been strong in the recent years, but not overdone.  And banks like Spain’s Banco Santander SA (ADR NYSE: STD), government banks and others are taking advantage of the crisis to buy loan portfolios from their weaker rivals, as has been the case in most liquidity crunches in emerging markets.

The critics will refer to this crisis as the first major test for Lula.  And many doubt whether he will resist the temptation to throw monetary and fiscal prudence out the window.  But Brazil, as has been seen for decades, is much more than just Lula.  Its technocratic administration and central bank have decades of experience in crisis management. Brazil’s strong local companies, which are world leaders in many industries, and committed investors, including major multinational companies, are heavily vested in the country’s success.

Going for Growth

As the Brazilian government has done in the past, I expect it to stay the course for the long term, to maintain its inflation-targeting discipline (as the Central Bank recently announced), and stimulate its economy as inflation drops markedly. That will keep Brazil in the running to be one the engines of growth in the world for the next couple of decades. 

As we’ve seen, the country’s prudent monetary and fiscal policies, coupled with its solid macroeconomic position, strong reserve position, and controlled inflation will lead to good growth. Gross domestic product  (GDP) is expected advance at a rate of between 4% and 5% next year. And since only 13% of GDP comes from exports, Brazil will have lots of room to maneuver.  The slowdown in the advanced economies will give Brazil – as well as India, Russia and other emerging economies – room to start cutting domestic rates as inflation abates, just as China is doing right now.

In China, savings are 10% of GDP more than investment, so a slowdown in foreign capital inflow to China is a blessing, since it will allow the Beijing government to deploy its own capital to work and increase China’s internally driven growth as opposed to export-driven growth.  The same phenomenon will be pervasive throughout the emerging markets that – like Brazil, India and China – have not squandered their newly found wealth.

Hence, at the current prices, Brazil is – if you’ll pardon the Wall Street slang – a “screaming buy.”  In fact, as we speak, foreign investors are flying in droves to Brazil to buy beachfront property at a discount.  Prices of financial and real assets have been hit by excessive fears of a Global Depression.  When you see that G7 nations have injected more than $3 trillion into their economies in order to backstop the credit crunch, and another economic stimulus plan in the United States is almost a given, you have to realize that this will have an enormous positive impact on the fragile global market situation we are seeing today.  As the credit markets thaw out, despite ongoing hedge-fund de-leveraging, we will see renewed waves of buying and Brazilian financial assets will be amongst the biggest winners.  Do not be left to watch from the sidelines as I once was.

Recommendation:  Buy iShares MSCI Brazil Index (NYSE: EWZ) in increasing increments over the next eight weeks.  This means that you will be increasing the amount of money deployed every week, until you’ve invested the total amount that you’ve set aside for this ETF purchase, between now and the end of the year.

News and Related Story Links:

• Money Morning Special BRIC Report (Part I):
  Special Report: Hit the BRICs for a Global-Investing Double Play.

• Money Morning Special BRIC Report (Part II):
  Special Report: Hit the BRICs for a Global-Investing Double Play.

• Investopedia:
  carry trade.

• Brazil.com:
  The Real Currency Unit.

• Wikipedia:

  Henrique Meirelles.

[Editor's Note: Horacio Marquez was working as a vice president of the Merrill Lynch Emerging Markets Fixed Income Group in 1994 when he correctly predicted that both Argentina and Mexico were headed for currency crises - cementing his reputation as an expert on both the emerging markets and on the nuances of global finance. Now Marquez brings that expertise to you with his newly created "Shadow Stock Trader" specialized trading service. To find out how to subscribe, please click here. "Buy, Sell or Hold" is a new Money Morning feature that has most recently analyzed such companies as PepsiCo Inc. (NYSE: PEP), Bank of America Corp. (NYSE: BAC), Suncor Energy Inc. (NYSE: SU), Potash Corp. (NYSE: POT), Garmin Ltd. (Nasdaq: GRMN), Berkshire Hathaway Inc. (NYSE: BRK.A, BRK.B), Cisco Systems Inc. (Nasdaq: CS), Chevron Corp. (NYSE: CVX), Valero Energy Corp. (NYSE: VLO), General Electric Co. (NYSE: GE), and steelmaker Nucor Corp. (NYSE: NUE).]

** Special Note of Disclosure: Horacio Marquez holds no interest in iShares MSCI Brazil Index.

By Horacio Marquez
Contributing Editor
Money Morning

PepsiCo Inc. (NYSE: PEP) shares plunged 12% in a single day last Tuesday – their worst one-day showing in 26 years – after the world’s largest snack maker and No. 2 soft-drink producer announced it would slash 3,300 jobs after its profits fell more than expected for the quarter and it lowered its forecast for the rest of the year.

The shares, which have traded as high as $79.79 during the past 12 months, closed Friday at $53.88. Pepsi’s 52-week low is $50.65.
Allow me to get right to the point. There’s been a lot of talk about this being the “opportunity of a generation” in the U.S. stock market. To make that comment about all U.S. stocks – across the board – is a major overstatement.

But there truly are some generational opportunities with certain specific stocks and entire sectors. And Pepsi – one of the world’s strongest consumer franchises, with a history that reaches back a century – clearly fits that bill.

To understand how we reached this point, some insight on the current mindset of the market is needed.

The U.S. stock market is in complete disarray right now.  Waves of selling are interrupted by strong short-covering rallies and pronounced lulls.  In this environment, with volatility at an all-time record, it’s difficult to talk about trading.  By the time I establish and explain one strategy, a new development in this rapidly moving environment has changed the rules, requiring traders to develop a new strategy.

But history tells us that the massive sell-off in stocks is similar in magnitude to the average sell-off since 1890.  And value indicators already have been screaming, “Buy” for months. The market is terribly oversold and offers tons of value as banks, hedge funds and other leveraged investors have been forced to sell – not because of fundamentals – but because of losses they’ve taken (and, in some cases, continue to take) in unrelated investments that force margin calls.

Here’s the problem. In a market such as this one, traditional measures – such as the afore-mentioned value indicators (such ratios as Price/Earnings, Price/Book Value, Price/Sales, and others) – often don’t work as they should. That makes bargain-hunting a much-more challenging – and potentially risky – exercise. As you’ll soon see, we’ve factored this lack of predictability into our strategy for this stock.

In a market such as this one, the problem is that emotions have taken over, and are now ruling the “thinking” that individual investors are using to guide their buying-and-selling decisions. When that happens, you can almost be sure that individual investors will invariably make their moves – and at precisely the wrong moments (selling when should be buying, and buying when they, in fact, should be selling). This is something you can count upon (for instance, nobody was selling their homes at the top, nor buying the market in the 2002 recession).

This time around, the cause of this systemic sell-off is the fragility of the over-leveraged financial system – and not the long-term viability of the U.S. economy as a whole.  When banks are not lending to one another – and are instead hoarding that potentially lendable cash, because they distrust the financial condition of their counterparty – the blood that feeds the U.S. economy (credit) ceases to flow, choking off economic growth.

And we have already seen increasingly aggressive policy responses by governments and central banks from all around the world.  These policies have enough firepower to blunt the sell-off, to reverse it, and to jump-start economic growth by the middle of next year.
Under such circumstances, good companies are being sold off along with bad ones for two reasons:

• Weak companies will founder in the crisis and “good” companies are sold to meet margin requirements of the few institutions that remain brave enough (or foolish enough) to remain leveraged in this environment, because they wish to maintain at least a portion of their positions.

• The same thing happens because of institutions that were trapped with high leverage, and are therefore now trying to hang onto their positions, praying for a quick turnaround.  Most leveraged players, however, are forced to raise liquidity to meet obligations or merely for panic.

It is precisely in these very volatile and difficult circumstances that investors seek to find the babies that have been thrown out with the bathwater. Enter the Purchase, N.Y.-based PepsiCo.

Founded in 1898, the company has navigated recessions, the Great Depression, two World Wars, and every crisis that’s touched the United States. And Pepsi came out stronger every time.  And with good reason: PepsiCo’s products are consumer non-cyclicals that suffer very little even in the worst economic times.

But the company just reported third-quarter profits that were down 9.6%, missing analysts’ estimates by 2 cents.  This compares to the 14% profit rise reported by archrival The Coca-Cola Co. (NYSE: KO), which beat earnings estimates by 6 cents in the same quarter.

Both companies are cutting costs, and Pepsi will be trimming some 3,300 jobs, or about 1.8% of its global work force, and will shutter as many as six plants.  This will cost between $550 million and $600 million in the fourth quarter, and will save the company $1.2 billion over three years.

Pepsi today has almost 50% of its sales coming from outside the U.S. market, including such economies as Japan, which has seen its currency strengthen substantially against the U.S. dollar over the past several years. What’s more, PepsiCo reported overall sales growth in both the second and third quarters – despite reduced volumes in the U.S. market. The company’s reduction in profit margin, which reversed gains made in the second quarter, has had more to do with the timing of its commodity hedges. Since the second quarter, the price of commodities (which Pepsi very prudently hedges), actually have dropped, which leads us to believe that margins will soon expand, creating a double-barrel benefit when viewed in tandem with the cost-savings being implemented.

While the company’s sales in the United States and in Europe will suffer some additional minor decline – as has been the case in every economic downturn – the benefit from expanding sales in emerging markets, widening margins and new-product introductions will restore Pepsi’s financial leadership position.

Emerging-market growth, even if slower than before, was still being estimated by the International Monetary Fund (IMF) this month at around 6% for next year.  The implementation of the policy responses by G7 countries around the world will be successful in re-liquefying the financial system, and emerging economies have plenty of room in their monetary, fiscal and foreign-trade policies to stimulate their economies.

As they do this, we will see these markets shift overwhelmingly to being driven by internal demand.  Incomes in these regions will continue to increase, and that obviously will translate almost immediately into higher purchases of such former “luxuries” as carbonated soft drinks and snacks such as Fritos Corn Chips.

And with harsh times ahead for the U.S. economy, “staying in” (which some theorists like to call “cocooning”) will trump dining out, which we believe also bodes well for Pepsi sodas and PepsiCo’s mega-brand snacks, produced by its Plano, Tex.-based Frito-Lay subsidiary, the largest snack food company in the world. As families weather the economic storm at home, watching sports events, movies and reality TV, what’s better to help pass the time but sodas and snacks?

That will translate into increased volumes and profits.

And some funds will start investing in the stock well ahead of the expiration of some anti-trust provisions, which will occur in a couple of years, which preclude the distribution of Gatorade by Pepsi bottlers.

Another strong positive of this type of company and specifically of PepsiCo is that in these times of banking illiquidity, cash is king.  And with cash and short-term investments of about $2 billion and a an annual operating cash flow of another $4 billion, Pepsi looks a lot like a money-printing operation, recognized by the strong investment grade ratings of its debt.  PepsiCo’s debt, even in these very distressed times, was trading at merely 200 basis points over U.S. Treasuries, or slightly more than 5%.  The dividend yield – as of Friday’s close – was 3.16%, a payout in line with U.S. Treasuries. But with Pepsi, investors also get all the capital-appreciation potential of a near-bullet-proof company (one that won’t succumb to such calamities as the one that befell American International Group Inc. (NYSE: AIG)), that can actually expand its margins and grow its profits while the United States stumbles through a financial-crisis-induced slowdown.

PepsiCo benefits from its long history of earnings consistency and growth, even in the worst of times.  With the just-announced cost-cutting plan, the company’s management team is working to return to that consistent performance. This long history, combined with the management’s current fix-it plan, will make Pepsi’s shares attractive to institutional buyers seeking stable growth with low risk, despite the recent earnings miss.  Confidence, however, might take some time to rebuild, as the company executes its cost-cutting strategy. 

Pepsi is trading at 13 times earnings and features a somewhat high Price/Earnings to Growth Rate (PEG) ratio of 1.43.  These high quality franchises, with their ability to deliver stable returns over the long haul, are typically terrific purchases in such unusual markets as this one.

Action to Take: Buy PepsiCo Inc. (NYSE: PEP). **

However, given the current market volatility, buy Pepsi’s shares in an increasing percentage as the market moves, by purchasing increasing amounts of the stock over the next 10 weeks, with the goal of holding this for the long-term – for a huge gain.

News and Related Story Links:

• Forbes.com:

  Pepsi Loses Fizz; Merrill Sees $1,500 Gold.

• Bloomberg News:
  U.S. Stocks Fall as Earnings Concern Overshadows Bank Plan.

• Money Morning Market Analysis:
  How U.S. Missteps Triggered a Spiral of Worldwide Margin Calls and Deepened the Financial Crisis.

• Money Morning Market Analysis:
  LIBOR Drops But Short-Term Credit Markets Remain Tight.

• Money Morning Market Analysis:
  Federal Reserve Joins Central Banks Around the World in Cutting Rates, but Is It Too Late?

• Money Morning:
  Hot Stocks: Coca-Cola’s Strong International Sales Serve Up Sparkling Third-Quarter Results

[Editor's Note: Horacio Marquez was working as a vice president of the Merrill Lynch Emerging Markets Fixed Income Group in 1994 when he correctly predicted that both Argentina and Mexico were headed for currency crises - cementing his reputation as an expert on both the emerging markets and on the nuances of global finance. Now Marquez brings that expertise to you with his newly created "Shadow Stock Trader" specialized trading service. To find out how to subscribe, please click here. "Buy, Sell or Hold" is a new Money Morning feature that has most recently analyzed such companies as Bank of America Corp. (NYSE: BAC), Suncor Energy Inc. (NYSE: SU), Potash Corp. (NYSE: POT), Garmin Ltd. (Nasdaq: GRMN), Berkshire Hathaway Inc. (NYSE: BRK.A, BRK.B), Cisco Systems Inc. (Nasdaq: CS), Chevron Corp. (NYSE: CVX), Valero Energy Corp. (NYSE: VLO), General Electric Co. (NYSE: GE), and steelmaker Nucor Corp. (NYSE: NUE).]
** Special Note of Disclosure: Horacio Marquez holds no interest in PepsiCo Inc.

By Horacio Marquez
Contributing Editor

The U.S. financial-services sector is undergoing the broadest restructuring of a single industry in the history of Corporate America, and Bank of America Corp. (NYSE: BAC) has positioned itself to emerge as one of three clear frontrunners. Indeed, along with Citigroup Inc. (NYSE: C) and JPMorgan Chase & Co. (NYSE: JPM), Bank of America could well emerge from this financial maelstrom as one of the premier players on the global stage: All three will benefit from increasing market share and increased financial intermediation margins as their weaker rivals have failed and/or been taken over in part or in total by a stronger industry player.

During the many financial crises that I have analyzed around the world, the result has always been the same: The prudently managed, under-levered institutions that did not overstretch their capital bases and that were able to maintain strong funding not only survived – they ran away with the market.

As unsavory as it sounds, the moral hazard argument of too-big-to-fail also helped them, even in the cases where risk taking had been excessive, as was true with American International Group Inc. (NYSE: AIG).

The huge benefit of being conservative – even boringly so during normal economic times – is that when the economy inevitably turns down, or when the periodic financial crisis strikes (as it has right now), these firms are among the few that actually have the capital available to cherry-pick the “crown jewel” assets of their now-foundering rivals.

Indeed, in the very worst of circumstances – such as the one the U.S. financial-services sector currently faces – strong firms actually are begged to swoop in and use their capital to buy up troubled assets, divisions or whole companies.

It helps immensely to have one of the largest deposit bases in the world, which generates dependable income on a daily basis, even during the worst of times.  This is precisely the case of Bank of America.

On July 1, BofA snapped up the operations of dying mortgage leader Countrywide Financial Corp. Bank of America ended up paying only about $2.5 billion in Bank of America stock in a deal that had actually been announced back on Jan. 11. BofA had actually already invested $2 billion for a 16% stake in Countrywide.

Then came the weekend switcheroo. In a stunning turn of events back on Sept. 15, when investors were watching and waiting for Lehman Brothers Holdings Inc.’s (OTC: LEHMQ) possible acquisition by either Bank of America or Barclays PLC (ADR NYSE: BCS), BofA instead emerged from the weekend announcing that it had struck a deal with Merrill Lynch & Co. Inc.’s (NYSE: MER) President and CEO John A. Thain.  Realizing that the credit crisis had rendered moot the concept of the standalone investment bank, Thain avoided Lehman’s ultimate fate – bankruptcy – agreeing to be bought out by Bank of America. BofA’s Kenneth D. Lewis astutely took full advantage of the opportunity.

He got to acquire Merrill Lynch in an all-stock transaction for a 70% premium over a very depressed Merrill Lynch stock price at about 1.83 times tangible book value, or about $50 billion, less than a third of its own market capitalization.  What’s more, when the transaction closes (probably in the first quarter of 2009), Bank of America will jump from $1.7 trillion in assets to about $2.7 trillion in assets, retaining a strong capitalization ratio.

The transaction is only 3% dilutive for BofA shareholders, and will have some $7 billion in cost-reduction efficiencies: The company will achieve about 20% of those reductions next year, and will have them completed so that it can benefit from them by 2012. The deal also includes about $2.5 billion in amortization and restructuring charges.

With this second transformative purchase, Bank of America will jump from merely being one of the largest banks in the world to being a commercial-and-investment banking powerhouse, one of the first true heavyweights under this new industry model that’s emerged from the current credit crisis. It will have a dominant presence – shared by very few – in such businesses as commercial banking, asset management and investment banking.  In these very uncertain times, size and strength counts for a lot.

Just in retail-brokerage and wealth-and-investment management the figures are staggering. The combined entities will have:

• 20,000 financial advisors, most of which are from Merrill Lynch.
• $2.5 trillion in assets under management.
• 50% ownership in BlackRock Inc. (NYSE: BLK), which in turns manages assets worth $1.4 trillion.
• And the Columbia Management Group LLC fund family, with $425 billion in assets under management

In banking, Bank of America will have a dominant presence on both U.S. coasts, a leadership position in 15 of the 20 fastest-growing states, and relationships with virtually all the leading companies in the United States and most leading companies in the world.

All told, this combination will yield a company that has a very balanced business mix: Global-consumer and small-business banking will still be the dominant segment, despite decreasing to 48% of the total, while global-wealth management and global corporate and investment banking will increase to 32% and 20% of total revenue, respectively.

Very importantly, the failed trading mentality of Merrill Lynch, which under the since-ousted E. Stanley “Stan” O’Neal deviated from its traditionally successful client-brokerage emphasis, a misstep that nearly brought this otherwise successful giant to its knees, will no longer be a major hindrance under the new structure. Indeed, that’s why Thain is being kept on to remain as head of BofA’s Merrill unit.

Bank of America, strongly regulated as a bank, will necessarily continue with its tried-and-true risk-management discipline.

We’ve reviewed all the good news. What about the bad?

Investing in these markets has become extremely tricky.  The volatility that we experienced last week was almost unequalled for decades.  The cause for this volatility is the extreme uncertainties surrounding the hidden risks to the viability of many financial institutions which, in turn, have caused the credit markets to freeze up. This freeze, in turn, has affected both consumer spending and economic growth. This was evidenced in the 26% drop in car sales in September, the 4% drop in August factory orders and the larger-than-expected drop of 159,000 in non-farm payrolls. While the unemployment rate remained at 6.1% the drop was exaggerated by the impact of hurricanes Ike and Gustav in the South, which typically produce initial job losses, but then actually create jobs in subsequent months, due to the necessary reconstruction.

But it is clear that the U.S. Federal Reserve’s much-feared feedback loop from Wall Street to main street finally hit as the forced restructuring of the financial industry proceeded with minimalist government intervention, designed to avoid systemic risk only.  It becomes blatantly evident that the Fed, with the danger of imminent inflation behind, given the collapse of commodity prices and economic activity, needs to use some of the ammunition it kept in its arsenal by lowering rates further to deal with the liquidity shock.  At the same time, the European countries concluded just this past weekend that there needs to be a global response to the crisis that has affected not only the United States, but also markets across the globe, from Europe to Russia to Latin America.

And as the market got out of hand and ground to a halt, as it always goes to extremes, it forced the government to pass the $700 rescue bill.  The key to how fast and how high does the system begin to normalize itself depends upon the pace and details of implementation of this package – as well as how the Fed and other central banks around the world decide to act going forward.  And this is key to dictate the immediate direction of Bank of America’s stock.  I could write another paper on these issues, which are rife with uncertainties.  I am actually a lot more constructive about the beneficial effects in the market of “surprising” policy responses by governments and central banks around the world than what I hear around in the market.

But something we all seem to agree on is that BofA will undoubtedly be one of the winners in the long term.  The company, prior to the Merrill Lynch and Countrywide acquisitions, had already demonstrated signs of increased margins due to a de-leveraging of its balance sheet, moves that had resulted in surprising earnings gains well in excess of market expectations.  The economic backdrop will continue to pose challenges, but the strong ultimately become stronger in crises.  And individuals and institutions will find safe harbor and dependability for their deposits, investment business and loans, and at higher margins than we used to pay as other survivors get more conservative and as the weak perish.

Investing icon Warren Buffet has acquired stakes in three major companies in three weeks, with his characteristic very-long-term view, so I will strongly recommend you to buy Bank of America with the same very-long-term investment horizon.  In the short term, I would take advantage of market volatility to buy in increasing amounts of cash into any market sell-offs on a weekly basis, completing your stock purchases before year end.  The ride will no doubt be very bumpy, since market talk will continue to whipsaw – reflecting elation one minute and despair the next – but don’t let that deter you from your plan.

It’s possible that all of the downside is already factored into BofA’s shares. The July 15 lows haven’t been re-visited, for instance. Even so, pursue this plan shrewdly. In other words, go for it – but prudently.

Action to Take: Buy Bank of America Corp. (NYSE: BAC). **

[Editor's Note: Horacio Marquez was working as a vice president of the Merrill Lynch Emerging Markets Fixed Income Group in 1994 when he correctly predicted that both Argentina and Mexico were headed for currency crises - cementing his reputation as an expert on both the emerging markets and on the nuances of global finance. Now Marquez brings that expertise to you with his newly created "Shadow Stock Trader" specialized trading service. To find out how to subscribe, please click here. "Buy, Sell or Hold" is a new Money Morning feature that has most recently analyzed such companies as Suncor Energy Inc. (NYSE: SU), Potash Corp. (NYSE: POT), Garmin Ltd. (Nasdaq: GRMN), Berkshire Hathaway Inc. (NYSE: BRK.A, BRK.B), Cisco Systems Inc. (Nasdaq: CS), Chevron Corp. (NYSE: CVX), Valero Energy Corp. (NYSE: VLO), General Electric Co. (NYSE: GE), and steelmaker Nucor Corp. (NYSE: NUE).]

** Special Note of Disclosure: Horacio Marquez holds no interest in Bank of America Corp.

News and Related Story Links:

• Money Morning Special Investigative Report:
   The Inside Story of the Collapse of AIG .

• Money Morning News Analysis:
  Merrill Lynch’s Thain to Remain with Bank of America.