Markets & Finance

Finding Value in Eastern Europe


While U.S. stocks remain in the doldrums, the markets in Eastern Europe may perk up as countries such as Poland and Hungary prepare to enter the European Union over the next few years. Meanwhile, Russia' stock market has shot higher this year thanks to successful reforms. These themes have helped Jack Arnoff, manager of the Pictet Eastern European Fund (PTEEX), turn in healthy returns lately.

Eastern Europe is likely to avoid the bust that hit Russia after its 1998 boom, according to Arnoff, because many companies in those markets have adopted accounting and corporate-governance

models that adhere to international standards. These reforms have led Arnoff to stress Western-style investing criteria, such as the price-to-book ratio as a measure of valuation, rather

than previous concerns such as currency stability or inflation.

The fund's performance has helped it earn a 5 STARS

S&P overall rank. Arnoff and fellow manager Jura Ostrowsky steered to fund to a 26.7% gain last year, while its benchmark, the FTSE Eastern Europe Turkey Index, edged up 2.48%. So far this year, the fund has been held back because it can't match the index' Russian oil company weighting (about 30%). Through May, Pictet Eastern European gained 10.8%, while the index rose 19.2%.

Bill Gerdes of Standard & Poor's Fund Advisor recently spoke with Arnoff about his investing strategy, top holdings, and portfolio moves. Edited excerpts from their conversation follow:

Q: What is your investment universe?

A: We invest in Eastern Europe (Poland, Hungry, and the Czech Republic), the Balkans (Rumania, Bulgaria, and Croatia), and the Baltics (Estonia and Latvia). These countries are becoming part of the European Union through a fairly predictable process with strictly defined deadlines and targets.

We also invest in Russia, which has a different risk profile than Eastern Europe, and in Turkey. Turkey's risk profile falls between those of Eastern Europe and Russia because it needs to sort out certain political issues.

All these countries are emerging markets, but the prospect of joining the EU for Eastern Europe and possibly Turkey will upgrade those countries to become part of European markets.

Q: What effect will joining the EU have on Eastern Europe and Turkey?

A: It's a fairly complicated process, but becoming part of the EU will reduce the risk profiles of these countries, leading to an appreciation in assets. When risk declines, asset valuations go up. The best examples are Greece and Portugal, whose equity markets saw a strong rise before joining the EU. Eastern Europe hasn't reached that stage yet, but there should be plenty of investment opportunities over the next six to seven years.

Q: Tell us about your stock-selection process.

A: We are bottom-up investors who look for companies undergoing triggers to unlock value and spur appreciation. We divide the investment universe into three groups: stocks screened on their enterprise value; banks, which we screen based on price-to-book, return-on-equity, and cash-flow adequacy ratios; and growth stocks with unique products or unique market positions. The latter we analyze on a case-by-case basis.

Q: Why do you take a value approach to investing in Eastern Europe?

A: Because stocks there are trading at significant discounts to the major world markets, and it's very important to identify the possible triggers for price appreciation.

Q: Do you apply any top-down criteria?

A: Initially, we start with a value approach, identifying the cheapest stocks and triggers for appreciation. Over that, we apply top-down risk controls along country and sector lines. For

instance, we look at the macroeconomic profile of each country to determine whether stocks are trading at a discount due to the country's macro picture or to the company's profile. The best

example currently is Turkey, which offers lots of good, undervalued companies, but it's macro profile is rather negative.

Q: Do you have any minimum or maximum country weightings?

A: We can't invest more than 50% of the portfolio in any one country, but otherwise, we don't place any other country restrictions on ourselves.

Q: How much weight do you put on a country's macro profile?

A: A few years ago, it was possible to trade countries as opposed to stocks, but that approach has become more outdated. For example, in Central Eastern Europe, stock performance is driven much more by company-specific stories than by top-down factors. Even in Russia, which has a very specific macro profile, there are sharp differences between the performance of certain stocks or certain sectors, such as oil stocks versus utility stocks.

Q: How important are differences among countries in terms of financial regulation or corporate disclosure?

A: That's a bit of an issue of the past. At present, we have fairly transparent markets with very appropriate corporate disclosure. Most of the main companies -- the top 70% of our investment universe -- report their results in accordance with Generally Accepted Accounting Principles (GAAP) or international accounting standards. Our main issues with these countries are their macro parameters, such as interest rates, currencies, etc.

Q: Do you hedge currencies?

A: No, because we feel the markets basically discount the behaviors of their currencies. Also, our valuation methodology considers currency movements.

Q: What are your largest country allocations?

A: Russia, which has performed very well (48.7% of the fund); Turkey (11%); the Czech Republic (9.2%); Poland (almost 7%); and Hungary (6.2%). Russia offers the largest market capitalization in our universe and is undergoing tremendous restructuring. We've been concentrated in Russia for some

time, and its prospects remain very positive, although its market has gotten a little bit ahead of itself.

Q: Russia had a big run-up a few years ago only to fall sharply. Do you think that could happen again?

A: No, there's a major difference between Russia then and Russia now. The Putin Administration has established a very consistent reform record for the last two-and-a-half years. They've promised, and they've delivered. Also, there was a lot of hot money in Russia in 1998, particularly in the domestic debt markets. But now, Russia isn't leveraged at all. It's running huge current-account surpluses -- the highest in its history.

The equity market in Russia is the only one there to run ahead, but valuations are still attractive relative to other emerging markets and much cheaper than the developed markets.

Q: The Russian economy has been a big beneficiary of high oil prices. How would lower prices impact your Russian positions?

A: It would affect the Russian markets to a certain extent, but Russia is becoming much less of an oil story because of the recovery of its domestic economy. Also the government has followed very prudent fiscal policies. In this year's budget, they've planned for oil prices at $18 per barrel, but they've been running well above that.

Q: Is Russia the only country where you're overweighted?

A: Yes, we could take some profits, but Russia continues to be a very positive story. We're not very overweighted compared with our benchmark -- the FTSE East Europe Turkey Index -- because it's a little distorted since three Russian oil stocks make up 30% of the index. We're limited to a 10% position in any one stock, so we're technically a little underweight in Russia vs. the index. We've been overweight in Russia relative to the rest of the universe since the beginning of last year.

Q: The fund has had very strong performance in the past, but this year you're behind. What factors are at work here?

A: We've consistently outperformed the index for the last several years, but we've been flat compared with the index because of the index' bias toward oil companies.

Q: For what type of investor is this fund best suited?

A: The fund offers a good opportunity for investors to capitalize on the convergence of Eastern Europe with the European Union. Investors can also benefit from the turnaround in Russia and an improvement in Turkey. I can also recommend the fund for people who want to trade in and out on a 6- to 12-month basis since East European markets move up and down very sharply.

Q: You mention the convergence story for Eastern Europe, but you're underweight in those countries -- such as Poland, Hungry, and the Czech Republic -- most likely to join the EU.

A: We've focused on Russia because we've been trying to take advantage of it rising from a much lower level. The convergence story in Eastern Europe is not a three- to six-month story -- it's going to unfold over the next six to seven years.


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