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A Surprising Hot Spot For Equity Hunters


Cover Story: Where To Invest '96: Strategies For Stocks: Central Europe

A SURPRISING HOT SPOT FOR EQUITY HUNTERS

What are you going to do if those high-growth U.S. stocks start to look overvalued? Try giving emerging markets another look. One year after the Mexico melt down cast a pall over developing markets worldwide, Central Europe is starting to stand out as a good--and unappreciated--bet. "Investors are delinking Central Europe from the mass of emerging markets," says Susanne Gahler, an economist at J.P. Morgan & Co. in London. She predicts that $1 billion in equity investment will pour into Central Europe in 1996, up from practically zero in 1992.

It's easy to see why investors are getting enthusiastic. Gross domestic product is growing at a 3% to 6% clip, while technocrats are reining in inflation, even in Poland and Hungary. The outlook for currencies is strong, and politics appear stable. On top of that, values are low. Creditanstalt, an Austrian bank active in the region, estimates that the average price-earnings ratio in Poland and Hungary is about 7, in the Czech Republic 8.4, and in Slovakia a mere 5.2. That compares with 17 in India, 22 in Mexico, 18 in South Africa, and 20 in Taiwan.

Illiquidity helps make the region cheap: Prague is capitalized at only $17 billion, Warsaw at $4 billion, and Budapest at $2.2 billion. But throughout the region, regulations are being changed to remedy that. In Hungary, where some 90% of trading is done by foreign investors, liquidity is less of a problem because many blue chips change hands in London or Vienna. But regulators are making it easier for investment banks to trade locally for their own accounts, and they are shifting to a more efficient electronic trading system.

Still, trading remains a challenge. Gone are the days when share prices took off vertically, as they did when these markets were first getting off the ground in 1993. "People would buy anything they could spell, even companies posting losses," says Marcus Klug, an analyst for Creditanstalt.

BURNING RUBBER. Now that markets have retreated, investors have unearthed a number of gems in these countries. Poland, for one, has a large domestic market and earnings-per-share growth of over 20%. A prime mover in all of this is the growth of the country's auto industry. Korea's Daewoo Corp. plans to invest $1.1 billion in buying and expanding an auto plant. General Motors Corp. will build a factory to produce Opel Astras using local suppliers where possible. That has stock-pickers zeroing in on tiremakers. Debica, in which Goodyear Tire & Rubber Co. bought a 33% stake, saw its share price surge 140% this year. Stomil Olsztyn, which sold 52.1% to France's Michelin, promises strong foreign and domestic sales, too.

If the Polish auto business isn't your style, there's always Hungarian exporters. Strict measures designed to reverse a yawning trade gap favor pharmaceutical blue chips such as Gedeon Richter and Egis. John Roberts, director of Gog Securities in Budapest, says foreigners are sniffing around at MOL, an oil-and-gas producer privatized in November. Csaba Konkoly, a broker at Concorde Securities in Budapest, thinks MOL's share price could jump 14%, to a price-earnings ratio of three or four.

Massive rebuilding throughout the region has also put the spotlight on construction and engineering stocks. Isabel Knight, senior fund manager for Foreign & Colonial Investment Trust, likes Czech construction company Metrostav and ceramic-tile maker Chlumcanske Kermaicke, whose sales have boomed along with home remodeling. Credit- anstalt's Klug adds to the list Hungarian building-materials maker Graboplast and Poland's Gorazdze, one of the cheapest cement producers in the region, with a p-e ratio of 6.1.

BEYOND POLITICS. But investors are scouring all sectors in the search of 10%-15% annual earnings growth. SPT Telecom in Prague, partially owned by Dutch-Danish consortium TelSource, tops many lists. In Poland, order books are full at BFK, a maker of medium- and high-voltage cables, whose profits surged 170% in the first 10 months of '95. Even Polish holding company Elektrim, an early winner now languishing near its lows, looks like a bargain to James Juracka, a fund manager for Credit Suisse Investment Management's Central European Growth Fund because it's exposed both to the telecom and construction industries.

For the most part, politics has little effect on investor sentiment anymore. In Poland, the index dropped 3.8% the day after ex-communist Aleksander Kwasniewski replaced Lech Walesa as President, but it recovered swiftly. The red scare has also faded in Hungary. A year ago, Socialist Prime Minister Gyula Horn canceled the privatization of a hotel chain. Yet Horn has backed his new Finance Minister Lajos Bokros despite controversy over a painful austerity package to control ballooning budget and current-account deficits. By September, Hungary had posted its first current-account surplus in three years.

The political wild card of the region is Slovakia. Prime Minister Vladimir Meciar gave investors the heebie-jeebies with stunts such as abruptly canceling a privatization plan this fall. But experienced investors note that companies that are already privatized look good, GDP growth is over 6%, and inflation is below 8%. Credit Suisse's Juracka likes the growth prospects of Chirana Prema, a $100 million maker of high-quality medical and dental equipment that exports to Western Europe as well as to the East.

Another factor luring foreign investors is the spread of Western-style market regulation and institutions. In Poland, the best-regulated market in the region, the iron-fisted Securities & Exchange Commission controls new listings, brokerage licenses, and corporate-reporting requirements. But authorities found they were hobbling fund managers' efforts to conduct large block trades because everything had to be done through the Warsaw exchange. So Poland is launching an over-the-counter market that will boost liquidity and likely serve as a first step to facilitate trading by allowing large blocks to change hands. Investors also have an eye on 15 investment funds created last summer to manage more than 400 newly privatized Polish companies, which may be listed by June.

However, the most dramatic regulatory steps are about to take place in the Czech Republic, where an enter-at-your-own-risk OTC market exploded on its own. Some 90% of all Czech trades take place in big blocks off the Prague exchange with unreported prices. In an effort to calm wary buyers, traders now voluntarily post their prices.

SITTING DUCKS. Moreover, rapid privatization via vouchers handed out to citizens spawned 1,600 listed shares and hundreds of investment funds to manage the vouchers. Often run by banks, these funds didn't bother to restructure the companies. Instead, most sat on small holdings of many companies. In the fall, two mavericks rocked the cozy system. Taking advantage of lax Czech takeover laws and few rights for minority shareholders, Bahamas-based financier Michael Dingman snapped up stakes in 10 Czech companies. At the same time, Jan Dienstl, the 25-year-old president of brokerage Motoinvest, decided to build a financial empire by going after bank-owned investment funds, then trading at 50% discounts to the value of their portfolios. He now controls two banks and a pension fund. "I can't believe no one thought of this before," Dienstl says.

The raids are forcing a long-needed consolidation in the market as other funds horse-trade to build strategic stakes in fewer companies. "It's a beautiful lesson--a textbook case of capitalism at work and a positive sign for the market," says Zdenek Bakala, president of brokerage Patria Finance.

Textbook capitalism and positive signs. Who could ask for more? Central Europe remains on the frontier of finance, to be sure. But this frontier is growing friendlier to global investors by the day.By Karen Lowry Miller in Prague, with T.R. Smart in Budapest


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