Brazilian blue chip stocks are starting to look expensive after a long market rally, but their ready liquidity will continue to trump value picks among smaller companies.

"Any fund manager who has been burned by illiquidity over the last two years knows that even though he can find better value in small or mid-cap names in Brazil, he has to go with the stocks he can sell fast if we have a double-dip recession in the U.S.," said Richard Kang, chief investment officer of Emerging Global Advisors in New York.

Brazil's most liquid stocks are hardly value plays. Upside is shrinking for names like Petrobras (PBR) and mining company Vale (VALE), said Ed Kuczma, equity analyst at Van Eck Global Advisors, managers of the Brasil Small Cap (BRF) exchange-traded fund, and holders of Petrobras and Vale in its emerging markets fund (EMRIX).

"We used to like steel guys Usiminas (USIM5.BR), but they have had an amazing run and it's tough to judge their earnings because they are not working at full capacity," he said. "They're going to have inflated multiples.

"The airline names like Gol (GOL) and Tam (TAM) are in a very competitive market and too expensive. If you want emerging market airlines, stay away from these names," said Kuczma.

Yet, for fund managers who aren't afraid of a little high stakes beta action among Brazilian companies with market capitalizations of around BRL2 billion, there are a few value stocks with volume to be had. Demand for them is growing among both domestic and international money managers, said Werner Roger, equity analyst at Victoire Brasil Investments, a $240 million offshore asset management firm in Sao Paulo.

About 69% of the companies listed on the Brazilian Stock Exchange are considered small to mid-cap stocks, which represents just 7% of total market capitalization. Within that universe, no more than 33% of small to mid-cap names have sell-side coverage.

Investors who aren't gun shy might like names such as homebuilder Even Construtora (EVEN3.BR), said Kuczma. The stock is up 140% year-to-date, while the benchmark Ibovespa index is up 61%.

On a price-to-forward earnings basis, Even is trading at six times 2010 earnings while the more liquid Gafisa (GFA) is trading at 11 times forward P/E, Kuczma calculated.

"We sold Even during the crisis because investors were nervous about volume," he said.

That hasn't kept Van Eck away from Brazil's small and mid-sized companies. Kuczma's favorites include airport retailer Dufry (DUFB11.BR), with volume of about BRL4 million daily, and trading at multiples of 10.8 times forward earnings.

"As international travel increases, Dufry should outperform," Kuczma said. Its shares are up 70% year-to- date.

Victoire's top small-cap stocks are chrome alloy and stainless steel maker Ferbasa (FESA4.BR), which trades just BRL3.5 million daily and has a market cap of BRL1 billion. Ferbasa has no debt and BRL300 million in cash, said Roger. Arcelor Mittal (MT) is its biggest client. Victoire has a price target on the stock of BRL21.50 for 2010, compared to Thursday's close of around BRL12.70.

Another favorite is bus body manufacturer Marcopolo (POMO4.BR), one of the biggest bus makers in Latin America, with a 40% market share in Brazil. "They make the body for Volkswagen buses and they have solid joint ventures with Mercedes Benz and Tata," Roger said.

"They've been at this for 60 years and have a good management team. This is a good stock, and I say that with strong conviction," he said.

Roger has a price target on Marcopolo of BRL12.25. It was trading at BRL5.67 on Friday. The stock's up 80.7% year to date.

Brazil's economy is expected to grow by around 4% in 2010, according to current market estimates. Although analysts see shrinking upside to a stock market whose benchmark index has doubled since last year, they're still betting on Brazil long-term.

"Valuations are looking stretched," said Kuczma. "But given the attention on 2010 growth, I would say a lot of these [current] prices [for blue chips] are justified."

-By Kenneth Rapoza, Dow Jones Newswires, 5511-2847-4541, kenneth.rapoza@dowjones.com