April 22 (Bloomberg) -- Brazilian hedge fund Mercatto Estrategia FI, which is beating 97 percent of its peers this year, is selling the country’s largest homebuilders and banks because they are overvalued, according to the fund’s manager.

Regis Abreu, who helps oversee $624 million at Rio de Janeiro-based Mercatto Investimentos, is selling stocks that helped push his fund up 32 percent including Cyrela Brazil Realty SA Empreendimentos e Participacoes, the nation’s biggest homebuilder. He’s buying smaller real-estate companies, banks and beef producers such as Marfrig Frigorificos e Comercio de Alimentos SA that tumbled last year when investors fled the emerging markets.

“The liquidity crisis shook up the economy a lot, resulting in huge declines in healthy names,” Abreu, the head of equity at Mercatto, said in an interview in Rio de Janeiro. Stocks such as Cyrela “already had their time so now you have to look at the smaller companies.”

Brazil’s smaller homebuilders and food producers may also benefit from government stimulus plans aimed at boosting those industries. The National Monetary Council last week approved 10 billion reais ($4.52 billion) of loans to meatpackers and other food companies hurt by the global financial crisis. In March, the Brazilian government announced it will spend 34 billion reais on a housing program for low-income families.

Last Year’s Strategy

The strategy of buying smaller companies with “good fundamentals” didn’t work last year when investors fled emerging-market assets, Abreu said. The collapse in U.S. consumer spending and a freeze in credit markets sent the global economy into its first recession since World War II.

Mercatto Estrategia only beat 9 percent of its peers in 2008, sinking 52 percent. The fund fell more than the Bovespa index’s 41 percent drop mostly because smaller stocks were perceived as more risky and investors “indiscriminately” sold them, Abreu said.

Petroleo Brasileiro SA, Brazil’s biggest stock, and the nation’s largest banks are “expensive,” Abreu said, after the price earnings of the Bovespa jumped to a nine-month high last week of 14.7 times reported earnings. Cyrela, which fell as much as 81 percent in a year after hitting a record high in November 2007, has gained 81 percent since the 2009 low on March 2. The Bovespa has climbed 20 percent this year.

‘Risky Bets’

Smaller stocks that are less frequently traded are “risky” bets until there is clarity over the sustainability of Brazil’s stock rally, said Nicholas Field at Schroders Plc in London, which manages $155 billion. Gains among Brazil’s largest companies could falter in the next few months if earnings don’t improve enough to justify stock prices, he said.

“Taking liquidity risk at the moment is potentially a very dangerous thing to do in what is clearly a capital constrained world,” the Schroders fund manager said in a phone interview. “If you buy a large corporate and it turns out the earnings don’t come through, you sell it again quickly. But if you buy a small corporate and the earnings don’t come through you’re stuck with it.”

Abreu said smaller homebuilders, banks and food companies are cheap regardless whether the Bovespa extends its rally.

“Petrobras is going to fall so I can’t be optimistic about the index,” said Abreu. “The banks on the Bovespa aren’t cheap, but there are cheap banks. Now is the time to be selective.”

Petrobras trades at 11.22 times estimated earnings, compared with the 5.9 price-to-earnings ratio it fetched at the beginning of the year. Banco do Brasil SA, Brazil’s biggest federally owned lender, rose to 7.33 times earnings from 4.26.

Beef maker Marfrig is still cheaper than its larger rival JBS SA even after surging 48 percent this year. It fetches 5.97 times estimated earnings, while JBS has a price-earnings ratio of 11.28.

To contact the reporter on this story: Alexander Ragir in Rio de Janeiro at aragir@bloomberg.net

Last Updated: April 22, 2009 17:02 EDT