InvestSMART

Stars of the East

Economies developing under the European umbrella promise robust returns, but are being largely ignored by Australian investors. James Kirby explains why investors should think again.
By · 26 Jul 2006
By ·
26 Jul 2006
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PORTFOLIO POINT: Since the fall of communism, Eastern European countries have been scrambling to catch up to the West, giving investment there the potential returns of an emerging economy, with the protection of European legal and financial frameworks.

Eastern Europe is establishing itself as a choice market for global investors, and it’s not difficult to see why: it is delivering earnings per share growth rates of up to 40%, price/earnings multiples as low as 10% and all within the safety net of the European Union.

But Australian investors are nowhere to be seen. Retail investors around the world are enjoying strong returns from Eastern Europe, but Australians have missed the boat in this rising market. Why? Because for most investors, emerging markets have meant “Asian” markets for far too long.

Moreover, emerging markets '” especially in Asia '” have offered a very bumpy ride while the ASX has surged ahead throughout the past decade oblivious to almost every global crisis, with the execption of the September 11 terrorist attacks.

But the tempo of global markets is changing and the outperformance of Australian equities is no longer certain. Faced with rising interest rates, slowing prospects for the ASX and a strengthening Australian dollar, many investors are reconsidering overseas markets. Although Eureka Report recommends the bulk of your share portfolio should be in blue-chip, fully franked Australian shares, some diversification into international and emerging markets is useful in every portfolio.

As leading market observers continually point out, even if you keep all your equity investments on the ASX, a considerable portion of your investments are drifting offshore anyway, as David McClatchy, chief investment officer at ING Investment Management, explained in Monday's video interview (click here):

“The funny thing is that while there’s been a reluctance for Australian investors to put their money overseas, there hasn’t been a reluctance for the companies that they’re investing in domestically to put their money overseas and so they’re getting '¦ 30–40% of Australian companies have earnings or assets offshore.

The broad investment “theme” of Eastern Europe is compelling. Its leading markets '”the Czech Republic, Hungary, Poland and Russia '” along with the Baltic states of Estonia, Latvia and Lithuania are said to be “catching up” with the former “Western Europe”.

As Alvar Roosimaa of the Hansaa Investment Fund told Alan Kohler in a video interview in April (click here), for long-term investors the essential proposition of Eastern European markets is the prospect of growth rates that are 3–3.5% above global rates for at least the next decade

For the vast majority of Australian investors, putting money into Eastern Europe means putting money into managed funds. This is invariably the case in all emerging markets but particularly so in Eastern Europe because the market is diffuse '” spread across at least 10 countries.

After a false start in the wake of communism's collapse in the early 1990s, Eastern Europe has been a classic emerging market over the past five years. During this period the discount in terms of price/earnings (P/E) multiples offered by the region narrowed against the leading markets of developed Europe.

mTwelve-month forward PER differential vs. Developed Europe

For a brief period earlier this year, the P/E discount disappeared and Eastern European shares began trading at a premium to developed Europe; now in the wake of the May sharemarket correction the gap has reappeared. As Daniel Salter, a Moscow-based analyst with funds management group ING, suggests: "[Eastern European] markets do not look expensive. With EMEA equities trading at a discount to developed European equities, and developed European equities themselves appearing good value, this gives some downside protection."

Salter says earnings growth across Eastern European markets looks robust, with consensus forecasting of 22% earnings per share (EPS) growth this year and 22% for 2007, with that growth increasingly unerpinned by commodity stocks. Of course, within those average forecasts there are wide variations: EPS growth for Russian stocks is estimated at up 40% against just 14% for the Czech Republic. (See table)

mConsensus valuation data

So how do Australian investors access these markets? For the moment the choices are limited. Many leading fund managers are trying to build expertise in the area. In fact, a delegation including fund managers Geoff Wilson of Wilson Asset Management, David Paradice of Pardice Investment and Alex Waislitz of Richard Pratt's Thorney Investments visited Eastern Europe on a reconnaisance mission earlier this month. But for the moment, the product choices for retail investors come down to overseas listed ETFs [exchange traded funds] that can be accessed through overseas broking specialsts such as Fortrend Securities or specialist private funds.

Fortrend’s Andrew Corcoran says Australian investors often look towards US listed funds such as NYSE listed ETFs, the EMU Index Fund, EAFE Europe, Australia and Far East Index Fund, EAFE Value Index and EAFE Growth Index. Local investors also opt for London-based ETFs such as the MSCI Eastern Europe fund, which is listed on London's Primary Exchange. Corcoran says investors can access these overseas listed Eastern European related funds from $5000 upwards.

Within the managed funds sector in Australia, the best-known specialist operator is Eastern Europe is Quintessential Wealth Management (QWE). The Sydney-based fund aims to raise $50 million, with a minimum entry level of $50,000.

Today we talk to two experts in Eastern European investing: Ross Hopkins, the managing director of QWE, on the positive attractions of Eastern Europe; and Amy Auster, head of international economics at ANZ Bank, on the risks in this markets.

James Kirby: Ross Hopkins, in what way is Eastern Europe distinct from, say, Asian or South American emerging markets?

Ross Hopkins: Well, first of all you have the legal framework that is broadly accepted among all of Eastern and Western Europe, which is unlike most other emerging market regions. There's also the freer access to capital.

Why have East European funds been so slow to take off in Australia?

In Australia I think we are still pretty much interested just in Asia with a little bit of European exposure and it’s been very hard for the investor to access the key growth regions. We still find that there’s a perception that the Eastern European area is either Russia or ex-Russia without any understanding that the member states are in fact members of the euro zone, that they do operate on a euro currency and that the other members of euro are providing them with enormous amounts of capital to bring their economies '” as we’ve seen in the past in Ireland and Portugal '”up to Western European standards.

So these are investments in euro: how does the euro trade against the Australian dollar?

It's a very stable relationship and we are totally in euro and it’s unhedged and we’ve found that over the period since we’ve been running the fund that the variation has been very small. The highest movement we’ve had is 2% against the currency and more regularly on a month-by-month it’s a 0.3% or a 0.5% variation.

Are stocks cheap in these Eastern European markets?

I think this is a golden opportunity for Australian investors; not so much just because of their P/Es but more in terms of where they’ve come from and where they’re going to. The underlying companies operate within markets that are reasonably small and we’ve just seen a sell-off of the companies that are in good shape and provide the best investment opportunities So we are taking a lot of inflows at the moment, trying to get our investors organised for the next uplift.

How do you allocate funds between these different countries? [The 10 countries that were allowed to enter an ascension process to the EU in 2004 were Estonia, Lithuania, Slovenia, Latvia, Poland, the Czech Republic, Slovakia, Hungary, Cyrprus and Malta.]

We have appointed two Swedish-owned banks as our asset managers and we run the fund; they are asset managers. We did that because they have regional expertise. One of the asset managers has Russian expertise, the other has strictly Eastern European expertise, and on a weekly basis we would have an asset allocation, country allocation and a debate as to where they see the best opportunities presenting themselves. So we as the fund manager allocate to the underlying managers as to how much they can invest on our behalf, and we then have a conversation within that process over which countries will be either added to or reduced.

And how many country markets are we talking about here?

We have 15 countries at the moment

And in terms of weighting then, how does it weight? Is Russia the biggest of them?

No, not Russia. Poland is the largest. (See chart.)

mHow QWE divides its investments in Eastern Europe

Everything you say suggests Eastern Europe is a strong investment opportunity over the next year. That's obvious, I suppose, following the global correction since May 11, but I don't see the same attraction long term?

Well, look, we don’t have the same view. Yes there may well be some volatility. I actually believe that the case for volatility has been overstated but nonetheless there will always be volatility in an emerging market. We go back to our other point, which is that there aren’t many other places in the world that we can see such strong and consistent levels of GDP growth. We just can’t find it anywhere else in the world.

Needless to say, Hopkins, speaking as a specialist fund manager in Eastern Europe is bullish on the prospects for the region. A wider '” and more sceptical '” view of Eastern Europe is provided by Amy Auster, head of international economics at ANZ. Auster has worked in Bratislava (Slovakia) and Prague (Czech Republic) for the Economist Intelligence Unit. Now living in Australia, she has a unique view on Eastern European markets from the Australian perspective.

James Kirby: How would you view the idea of investing in Eastern European markets?

Amy Auster: Well, for the countries where there’s an ascension agreement to the European Union, they have very clearly set out their economic vision to join Western Europe and to abide by all of the social, political and economic parameters that go along with that. These markets are already benefiting from closer economic ties with the European Union so I think generally speaking as an emerging market '¦ it's an investment premise that makes sense. There’s other emerging market economies, particularly in Asia that I would put at a similar level, if you look for example at Singapore, at Hong Kong, at Korea, they’re similar in that sense.

Which country markets have moved furthest down the track towards EU integration?

I think with the Baltic states you get a sense that they’re more keen or there’s less political wrangling, whereas when you look at a country such as the Czech Republic clearly there’s some strong Eurosceptic flavour there.

A common theme among fund managers is that Eastern Europe is playing catch up '” that it will raft up economically to join the first division the same way that Ireland did over the last decade. What do you think?

I think it’s hard to make a comparison between Ireland and Eastern Europe. Ireland’s been benefiting from developments that are really internal to Ireland. I don’t think that EU ascension is actually the factor that’s created the success that Ireland’s been experiencing.

Unlike Ireland, Eastern European countries such as Hungary still have a very significant problem with the fiscal deficit and Hungary has just been downgraded because of concerns about the debt burden. So that’s an adjustment process that Hungary will still have to go through.

Is there a wide variation, then, in the quality of equities across the Eastern European markets?

Well, when you are talking about equities it would really be very company-focused, very sector-focussed, as opposed to just looking at the country, because there are countries where particular sectors can do very well almost regardless of what’s going on at the macro level. I mean, I would definitely differentiate the countries on their macro-economic performance but that may not have as many implications in the equity market as it would in the debt market, for example.

Russia is outside the EU but inside the Eastern European zone. Is Russian-style corruption common across these markets?

It's at its worst in Russia, whereas probably far less so in Poland and neighbouring countries.

So for an Australian investor who places a certain amount of their portfolio in Eastern Europe what would be the outstanding risks?

First of all, there is a very strong investment case. If you ask me what the risks were at the macro-economic level, I would say there are risks around ascension to Europe and specifically to monetary union.

Now how are these concerns going to affect Australians investing in this region?

With emerging economies, business cycles can be more volatile and that there may need to be scope for central banks to be more active than they would be in a fully developed economy. So you run the risk, when you have developing countries that are in a monetary union, that over time they actually grow slower than what they would because they’re sort of forced into the straitjacket of monetary policy. That can happen.

The other risk concerns some of the Euroscepticism that is developing in the larger ascension countries '” like the Czech Republic, potentially Hungary, potentially Poland '” where they may feel they’ve already done a lot for the European Union. Maybe they’ve been a little bit disappointed with the results so far. Where does that take them, because there are still quite a few years until they do fully ascend. So what happens on that score over the next say five to eight years.

Even allowing for these political risk, is the currency relationship between the Australian dollar and the euro stable?

That's another question that would be bound up in the whole question of EU ascension. If at any point that did actually start to become the question, I think you would have volatility across all asset classes in currency and in equity markets '” and in the debt markets, because there’s been such an assumption that ascension is inevitable that if they did actually ever come under question you’d see volatility across the board.

So could you rate Eastern Europe for us? Could you put it up against other emerging markets?

Well if you look at it compared to Latin America or Asia, I would say Eastern Europe is more likely to be more stable although Asia is growing more quickly than Eastern Europe. There’s obviously still a lot of concerns about how that growth is going to be managed and if it’s sustainable whereas I think Central and Eastern Europe is sort of past that point. And if the ascension process continues to unfold pretty smoothly there shouldn’t really be much to actually stand in the way of that very position perception continuing.

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