Markets & Finance

Tracking Europe's Hot Spots


By focusing on small and midcap growth stocks, the Driehaus European Opportunity Fund (DREOX) has been outperforming its European stock-fund peers by a wide margin. Bulgarian-born manager Ivo Kovachev searches for companies that are showing classic growth traits, such as accelerating sales and earnings growth. Kovachev, who runs the fund from Prague, Czech Republic, particularly favors some smaller British retail outfits and Russian telecommunciations stocks. He also holds some large stocks like Vodaphone.

Driehaus European Opportunity fund delivered an average annualized return of 13.7% for the three years ended Oct. 31, vs. an average loss of 11.3% for stock funds that invest specifically in Europe. Year-to-date through Nov. 15, the fund edged down just 0.3%, while its benchmark, the MSCI Europe Index, lost 18.9%. In 2001, the fund dropped 21.5%, close to the 21.2% drop in the index. The $26 million portfolio typically holds 70 to 80 stocks.

Kovachev has managed the fund, which carries Standard & Poor's highest

overall ranking of 5-STARS, since April, 2001. Palash Ghosh of Standard & Poor's Fund Advisor recently spoke with Kovachev about investing in the region and the fund's strategy. Edited excerpts from their conversation follow:

Q: How do you select stocks?

A: We are bottom-up growth investors, seeking stocks with classic growth characteristics such as accelerating sales and earnings, and upward earnings revisions. It has been difficult to find such stocks in this current climate, but we have had some success in finding high-growth companies in certain niche industries.

Q: Can you invest without regard to capitalization size?

A: We are an all-cap fund, but based on our investment criteria, it's easier to find growth among the smaller and midcap sectors, so we tend to be focused there. However, we do contain such notable large-cap stocks like Vodafone Group (VOD) and Koninklijke (Royal) KPN (PHG).

Our focus on small and midcap stocks has helped our performance in 2002. During the first half of the year, small and midcap stocks outperformed their larger-cap counterparts. This was partly because large caps were fully or overvalued, forcing investors to look elsewhere for growth, namely in the smaller-cap arena.

Q: What are your top country allocations?

A: As of Sept. 30: Great Britain, 28.2%; France, 9%; Russia, 6.8%; Spain, 6.1%; Netherlands, 5.7%; Italy, 5.3%; Germany, 4.5%; Switzerland, 3.9%; Israel, 3.4%; Finland, 3.3%; Austria, 3.2%; Belgium, 2.9%; and Sweden, 2.8%.

Although Britain is our largest allocation by far, our exposure there actually represents a slight underweight relative to our benchmark, the MSCI Europe Index. However, we think the economy is quite strong, especially compared to France and Germany, each of which are underweighted in our fund. In Britain, the currency is robust, and retail sales numbers are impressive. We have performed very well with some small and midcap British retailing names.

Q: Relative to your benchmark, in what countries are you significantly overweighted?

A: Given that Russia and Eastern Europe are not components in the index at all, we are most overweighted in these regions.

Q: Russia has a small stock market, but it has performed well.

A: The recent success of the Russian stock market has been based largely on its oil economy. The price of oil has been high since they emerged from their economic and currency crisis of 1998. Thus, with a relatively cheap ruble and high oil prices, a lot of hard cash has entered the country, creating a very attractive macroeconomic backdrop. Russian energy companies have benefited greatly from high commodity prices, radical restructuring, and increased production.

In addition, Russian President Vladimir Putin has successfully persuaded Russian corporations to adopt Western-style business-management practices, such as restructuring, corporate governance, and accounting policies -- everything that's designed to improve earnings and to attract the interest of foreign investors.

Even more important, as the Russian economy has appeared to stabilize, Russian consumers have started to show some confidence in their country. We also like Russia's burgeoning telecom sector, which can be viewed as a "consumer play." In fact, telecoms represent our largest industry exposure in Russia.

Q: Tell me about the emerging European countries like Poland, the Czech Republic, and Hungary.

A: The fundamental premise of investing in these countries is that they will soon be allowed entry into the European Union. In fact, these countries are already benefiting tremendously from the convergence of their economies with those of the EU. Officially joining the EU will continue to be a positive development for them.

Hungary, Poland, and the Czech Republic, which will likely join the EU in 2004, are enjoying a low interest-rate environment, low inflation, high equity valuations, and increased foreign investment. We have already seen how convergence with the EU has helped the markets of Spain, Portugal, and Greece.

Q: Do you consider Turkey and Israel as part of your investment universe?

A: Yes, we do. In 1999, Israel was a great place to invest, particularly their high-tech stock sector. But since then, they have faltered badly, partially due to their deepening political situation as well as the blow-up of technology.

I generally like the Turkish economy. However, one of their major problems is that there's much sentiment in Europe against the Turks joining the EU.

Q: Why do you have such an underweight position in Germany, Western Europe's most important economy?

A: From a bottom-up perspective, we have not found many high-growing German companies. From a top-down view, the macroeconomic picture in Germany is poor and not improving. I think Germany looks like a prime candidate to go through a Japanese-type recession.

Q: What are your top individual holdings?

A: As of Sept. 30: Erste Bank der Oesterreichischen Sparkassen [an Austrian bank], 2.8%; Grupo Ferrovial [a Spanish construction company], 2.6%; Koninklijke (Royal) KPN [the Dutch telecom giant], 2.3%; Wavecom (WVCM) [a French digital wireless company], 2.3%; Taro Pharmaceutical Industries (TARO) [an Israeli pharmaceutical company], 2.2%; Willis Group Holdings (WSH) [a British insurance broker], 2.2%; EGG [a British insurance and financial-services company], 2.0%; VimpelCom (VIP) [a Russian telecom provider], 2.0%; Merloni Elettrodomestici [an Italian household-goods producer], 2.0%; and Saipem [an Italian manufacturer of oil-field equipment], 1.9%.

Q: Could you discuss one of your favorite holdings?

A: Merloni has been one of our biggest winners this year. It's growing sales by 30% each quarter. Its profits are growing even faster, but the stock is still only trading at about 10 p-e. It sells goods primarily to Western Europe, but it has recently opened up markets in Russia, which will help it even more.

Q: In what industrial sector are you most overweight?

A: Relative to the index, we have a double-weighting in the telecommunications industry. Although that sector has been battered around the world for the past few years, we have actually discovered some telecoms which have posted better-than-expected earnings and are exhibiting solid growth. One example would be Mobistar, a small Belgian-based mobile operator which is delivering 20% annual growth.

Telecoms in Europe are dealing with the problems in their industry by cost-cutting, restructuring, and enacting such measures as moving from prepaid customers to contract subscribers.

One must be careful with the European telecom industry, however. Keep in mind that in the markets of Western Europe, the penetration rate is very high -- 70%, or even greater in many places -- so you will not find much sales, revenue, and subscriber growth there.

Q: What about Russia's telecom industry?

A: The Russian telecom industry is poised for tremendous growth. The penetration in that country is only about 10% as a whole -- even in Moscow it's only about 40%, and in St. Petersburg, 25%. My top Russian mobile-operator stock is VimpelCom (VIP). Revenue and profits are flourishing, and there's so much more room for them to grow, especially in the Russian provinces. We also like Mobile Telesystems, where we keep a smaller position.

Q: What is your portfolio turnover rate?

A: In 2001, it was over 500%. This year we have reduced it to about 300%. Our high turnover rate reflects the extreme volatility of European stock markets. Hedge funds have been particularly active here in Europe. They have aggressively moved into high-performing sectors and engaged in short-selling. This has exacerbated the situation.

Q: How has the weakening U.S. dollar affected European stocks?

A: The faltering U.S. dollar and the stronger euro has particularly hurt the big European multinational companies, which depend much on exports to the U.S. However, the weak dollar has clearly helped European companies that focus on local markets and derive most of their revenues in euros.

Another aspect of the weakening U.S. dollar is that it has attracted American investors into European markets -- they're making quick profits as a result of the dollar falling against the euro.

Q: What's your outlook on Europe for 2003?

A: We're more bullish on Eastern Europe, but somewhat cautious on Western Europe. Many are hoping that the European Central Bank will take the necessary step of cutting interest rates later this year, following the lead of the U.S. Federal Reserve. However, we feel that once the American economy and stock market rebounds, Europe will likely follow suit.


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