Investing in Eastern Europe is a case of sentiment, convergence and risk

Before the Euro or membership of the EU, Eastern Europe was beckoning investors. This article originally appeared in the Asian asset management magazine, Benchmark March 1999.

It wasn’t long ago that investors were failing over themselves to be invested in Eastern Europe. Predictably the fund companies launched the bulk of their products somewhere near the top of the market leaving most investors with burnt fingers. But as Feature Writer Gerry O’Kane finds, whether you are taking a paper loss on your original investment or interested in this region for the first time, Eastern Europe offers some interesting bargains for investors willing to take a long-term view.

Emerging markets have become the weakest link in the global investment business. They have consistently showed volatility as they have become victims of what has become known as ‘contagion’.

Asia’s financial pox had festered for months and only minor pustules had appeared in other emerging markets. Had they escaped infection? By the third quarter of 1998, the disease had erupted across Russia, causing economic collapse and the government to default on its international debt. Brazil followed, with a run on its currency. Then investor scepticism hit all the markets of Latin America and Eastern Europe.

But recent months have seen some recovery in the markets of Eastern Europe. Analysts have identified its close proximity to Euroland as one reason for investor optimism. Since last October, as recovery looked more obvious, Morgan Stanley’s Capital International Eastern European index rose by 47% versus a 22% rise in the emerging market general index.

But the story is not as clear-cut as it might first seem. While companies such as Templeton are currently overweight in Eastern Europe as part of their emerging markets’ strategy, outperformance is not all-pervasive.

“It’s interesting if you take a closer look at performance levels,” says lan McFarlane, emerging markets strategist with Paribas. “Since the beginning of the year the Polish index is up 8.31 per cent in US dollar terms, Hungary up 1.42 per cent but Russia is down 8.5 per cent and the Czech Republic down 5.7 per cent,” he rattles off.

But even those better performing markets of Poland and Hungary have stimulated less interest and confidence than might first seem apparent. According to McFarlane, while Paribas is overweight in those two markets, they still fall low on the emerging markets investment scale. He points to statistics from the IFC’s (International Finance Corporation) Investment Universe Index for emerging markets. In the IFC index, Eastern Europe is lumped in with Africa, the Middle East and less developed Mediterranean economies such as Greece and Turkey.

“In terms of investment percentages, the IFC index shows Greece, Israel, Turkey and even Jordan rating higher than Poland.” he says.

An issue of sentiment

So why is there a feeling in the international investment community that Eastern Europe is the emerging market to be in? How have some of these funds clocked better performances than might first be indicated by a breakdown of the nations?

First there is sentiment. Some investors view the nations of central and Eastern Europe as upcoming battlegrounds for new European businesses. Others see it as having the opportunity to ride on the coat-tails of a more prosperous Europe under the Euro. Others simply say market changes such as privatisation can but boost the economies.

In terms of fund performance one of the best has been Morgan Grenfell’s Emerging Europe fund. But according to Chris Turner, the fund’s manager, one reason for its healthy performance were the returns from Mediterranean countries, such as Greece (the world’s best performing stock market last year), in which the fund also invests. This comment is worth noting because it is currently an example of one of the latest European growth theories: convergence.

The there’s convergence

And convergence is one reason that Peter Kysel, the fund manager of Govett’s European Strategic Unit Trust, Hungary Investment Company and the New European Investment Company, is so gung-ho on some Eastern European markets.

“Many of the Eastern European countries are managing their affairs responsibly and in fact largely comply with what was handed down in the Maastricht Treaty – public sector borrowing requirement and debt, that sort of thing,” views Kysel.

He also points out that many of the nations have already applied for membership of the European Union. To eventually become successful, their economies have to fall in with the rest of Europe.

It is a view heavily supported at Fleming Asset Management. Michael Hughes is the product manager on Fleming’s emerging markets desk which manages funds for Jardine Fleming. He argues that this convergence dynamism was one reason why Greece’s performance over the past 18 months was so strong.

EU membership lessens risk premia

“As they prepare for membership they’re required to get their economies into shape and gradually they’re seen as a safer European market – the risk premia falling, he explains.

To climb aboard the convergence bandwagon, these countries are cutting interest rates and also seeing inflation fall. Their eyes are on membership of the European Union (EU). Hand-in-hand with that are analysts picking up newly-privatised firms inexpensively priced and in expanding markets.

“If the Portuguese and Greek examples are anything to go by, convergence stimulates the equity markets and while there is no evidence of this yet in Eastern Europe there are initial convergence indicators,” explains Kysel. Apart from the advantages of foreign investment from the EU and subsidised loans, there would be about Euro 80bn for developing infrastructure.

Low PE ratios

On top of that are equity valuations. Both Kysel and Hughes point to price earnings ratios which stand at somewhere between eight and 10 times in Eastern Europe. In Germany and France they are currently about 25 times, according to Kysel. As convergence continues these PEs will move together bringing, so the theory goes, huge profits for those who bought low.

If you accept the convergence argument (it is worth bearing in mind that not all do) it also becomes apparent that not all Eastern Europe countries will have the same growth factors. Indeed there seems to have emerged a two-tier Eastern Europe investment policy. Everyone seems to love Hungary and Poland. Everyone has serious concerns over the Czech Republic, its banks and privatisation regulations. But it is on the convergence road too, so thumbs up for the long-term.

But countries such as Bulgaria and Romania are less attractive, even though statistics for Bulgaria show that growth in 1998 was about 5.5 per cent and inflation dropped to 22% in 1998 from over 1,000% in 1997.

All the positive news has been based upon the convergence theory. It is a view to which Turner at Morgan Grenfell does not subscribe.

“The convergence view looks at EU membership by 2003 to start with. I talked with the guy heading Poland’s move to join the EU and even he does not expect membership until 2008 at the earliest,” reveals Turner.

His view is that too much store is put on the convergence theory and he prefers solid company fundamentals and a longer term view than the simple story.

Sentiment remains key

This brings us back to sentiment. Convergence encourages foreign investment on the back of bigger markets and better and more-reliable equities. All those that BENCHMARK talked to argue that any investment in Eastern Europe has to be taken with long term intentions. Turner expects “bumps along the way” and Hughes warns of “hiccups”.

But both Kysel and McFarlane point out that the contagion effect has been stripped out of sentiment now and Russia has less of an impact. (Flemings, once a big fan of Russia now has less than a 3.5 per cent weighting in the country and all of that is in oil stock).

But all warn that the unexpected is most likely to happen in Eastern Europe and a long-term perspective is vital. So stripping out convergence and the pot-luck of sentiment, what other important factors affect the Eastern Europe markets?

Kysel points to the development of private pension funds. Both Hungary and Poland are heavily involved in this new policy divergence.

“These reforms push for part of the money to go into privately managed funds and naturally a bias will be for buying domestic funds and equity. Apart from a liquidity boost, its impact will be to reduce foreign influence on the markets. I expect that in Poland you could see foreign institutional activity fall from 80 per cent of market turnover to 50 per cent. This will help reduce market volatility,” he argues.

The fund managers keep their closest watch on construction, banking and telecommunications stock and hope that political stability will last long enough to allow better-regulated markets and full privatisation.

Should you invest in Eastern Europe? Certainly, there is a solid argument that it is a good target should you want money in emerging markets. But not all of Eastern Europe shows the same promise. It is not for the faint-hearted, nor for the short-sighted and impatient.

But should you even toss the convergence argument out the window, then, McFarlane’s argument is worth considering: that as the EU grows it will benefit geographically close markets. Similar to how Asia benefited from Japan’s growth in the 80s. It is also worth remembering the maxim of buy low, sell high. Eastern Europe fails squarely into this category.