Why investors should look to eastern Europe

PUBLISHED : Sunday, 29 July, 2007, 12:00am
UPDATED : Sunday, 29 July, 2007, 12:00am

Former Soviet bloc offers diversity and high returns for HK money

On May 25, after an unsuccessful bid for the London Stock Exchange, Nasdaq announced that it was merging with OMX, the Nordic exchange comprising the bourses of Denmark, Sweden, Iceland and Finland, as well as those in the former Soviet states, Latvia, Estonia and Lithuania.

The promise of growth in emerging Europe and Central Asia was one of the key factors behind Nasdaq's interest in both the LSE and OMX, the listing places for many leading companies from behind the former iron curtain, such as Russian bank VTB and West Siberian Resources.

That is because the promise of rapid growth is attracting many investors from around the world to these markets.

The eastern and central European tigers such as Poland, the Czech Republic and Croatia - like their Asian predecessors a decade or two ago - are offering investors the chance to hop on board economies that are zipping ahead at as much as 7 per cent annually, following the de-shackling from communism.

The region has witnessed a boom in foreign direct investment, increasing to US$112 billion last year from US$77 billion in 2005.

They are being spurred on by convergence with their much richer neighbours in western Europe. Twelve countries, including Poland, have joined the EU since May 2004. The new member states could 'expect to grow significantly faster than western Europe over the next 20 years' as these economies saw their standards of living rise to western European levels, said James Owen, senior economist with the Economist Intelligence Unit.

Oussama Himani, a London-based global emerging markets strategist with UBS, notes that for investors in Hong Kong - where the market is buffeted by volatile China and the US - emerging Europe offers the added benefit of diversification, since they are not very correlated with Asia.

Riding on the booming economies, eastern European exchanges such as those of Warsaw, Poland and Ljubljana, Slovenia have seen their stocks surge.

Indeed, Slovenia's blue chip index, known as the SBI20, was the best-performing equity benchmark in the world last quarter, jumping 39 per cent in US dollar terms, according to data compiled by Bloomberg. It has more than quadrupled since the end of 2002, making the equity market of the former Yugoslav republic more expensive than even the mainland's in terms of price-earnings ratios.

As anywhere, it is hard to generalise about a region that stretches from the icy Baltic in the north and Balkans in the south, to the wheat fields of Ukraine in the east and beyond. Earlier this year, Slovenia surged ahead of the other new EU member states as the first to adopt the euro.

Meanwhile Hungary - a former reform leader - has become a laggard, with gross domestic product growth of 3.9 per cent last year due to its failure to meet budget deficit targets since 2001. Still, with growth of nearly 4 per cent, it is growing much faster than western Europe and the country's prospects are improving as the government implements austerity measures.

Juliet Sampson, chief economist of emerging EMEA (Europe, the Middle East and Africa) at HSBC, notes that one generalisation you can make is that these markets have experienced 'stronger than anticipated growth' in the past year, with a healthy German economy and a strong euro stimulating demand for the region's products, including properties.

The challenge of investing in emerging European countries like Poland 'from an investment point of view', Mr Owen said, is that these 'market are very small'. The market value of domestic firms listed on the Warsaw Stock Exchange - the largest in the former Soviet bloc outside Russia - is US$208 billion, a 10th of the US$2.5 trillion for firms listed in Hong Kong and less than the US$306.6 billion for Malaysia.

One of the reasons why Slovenia's stock exchange has risen to such frothy valuations is that domestic pension funds create excess demand for a limited number of securities. The market value of the 95 firms listed on Slovenia's stock exchange, for example, is only US$26.4 billion.

The solution pursued by many funds investing in the region has been to increase their exposure to large countries such as Russia (population 143 million) and Turkey (population 71 million), which, while not a former Soviet republic, is in many ways similarly modernising rapidly, spurred by the lure of EU membership.

For example, Deutsche Bank's US$691 million, NYSE-listed Central Europe and Russia Fund increased the share of Russia's RTX in the benchmark it tracks from 15 per cent to 30 per cent in 2003 and 45 per cent in 2004.

Another issue investors need to consider is how buying into the varied region affects their portfolio. Since energy plays a key role in countries such as Russia and Kazakhstan, an investor who already owns a natural resources fund may be better served by choosing a fund which is less exposed to these countries.

Non-EU emerging European countries are exposed to a different set of geopolitical risks than those that are members - or candidate countries, such as Croatia - increasing potential volatility.

'Russia is among the most attractive markets in the region,' Mr Himani, said, although he had a 'higher degree of conviction in Russia ex-energy'. He also said that Turkey, even after its recent surge, 'remains one of the cheapest emerging markets in the world' in terms of standard valuation measures such as price-earnings ratios and dividend yields.

This has propelled the country's ISI National 100 index more than 80 per cent higher so far this year. A recent report by Morgan Stanley noted that Turkey's economy had the potential to become a US$1 trillion economy within the next 10 years - after expanding from US$154 billion in 2001 to US$403 billion in 2006.

The one drawback, Mr Himani said, was that the Turkish lira was overvalued. It has strengthened further since last Sunday's general election.

Official results are to be released today and are widely expected to confirm the incumbent AK Party's clear mandate to form a single-party government for the next five years, boosting confidence in further reform, which has reaped rewards since the party gained power in 2002.

Nonetheless, currency is one of the factors both Mr Himani and Ms Sampson view as making emerging Europe an attractive investment option for Hong Kong-based investors. The region's economies should benefit from the strength of the euro, making their exports to the EU more competitive. At the same time, their currencies should appreciate against dollar-linked currencies such as the Hong Kong dollar, adding relative value to their stocks.

Poland's main WSI WIG Index is up 28 per cent in local currency terms, but 33 per cent when exchanged into US dollars.

The demand for local currencies should increase at a faster pace than supply, driven by factors such as Polish workers in Britain expatriating their wages to buy properties in their home country or Finnish retirees moving to Croatia, which is set to be the next country to join the EU.

High jump

Eastern Europe has witnessed a boom in foreign direct investment

This has increased (in US dollars) from $77 billion in 2005 to last year's: $112b