Turkey stands out on emerging Europe's edge
27th November 2012 14:50
by Patrick Smith from interactive investor
With the seemingly intractable problems of the eurozone on its doorstep, it's easy to see why Eastern Europe is a risky investment prospect.
Many of the region's banks come under eurozone-domiciled ownership and the eurozone is also an important export market. It means when the West sneezes, the East catches a cold.
However, the region's stockmarkets haven't fared too badly - as at 1 November the exchange traded fund is up 7% and 1% over six months and one year respectively. Undoubtedly the brightest star has been Turkey - the ETF shows gains of 22% and 28% over six months and year respectively.
The macro picture across the region isn't that exciting, but compared to the eurozone most countries have lower deficits, lower debt burdens and higher growth. However, it's possible to find businesses that are trading at significant undervaluations.
David Reid, lead manager of presses this point: "Most important is not merely to look at where the economic situation is, but rather what's priced into the market. Eastern European stocks are trading very low compared to their own history and indeed other emerging markets.
"Stocks are trading at a price to earnings ratio of around seven times, which has only been seen once before now."
The resilience of currencies in the region is a plus point. Unlike those in the eurozone, countries have been able to respond to the crisis and become more competitive as a result. Instead of having to implement severe austerity measures, states are better placed to grow as export economies and grow their way out of their troubles.
However, the region relies heavily on international investment. This means stocks tend to do well when investors from outside are willing to take on more risk, but during times of volatility there is not a strong local base to sustain share prices when foreign investors run for the hills.
But Eastern Europe is not so reliant for its growth on investment from the ailing West as it once was, since it has been attracting investment from China. "It's starting from a low base but it's coming up quickly. Ukraine is seeing a lot of activity, and a Great Wall motor factory was recently opened in Bulgaria rather than in Asia for example," said Reid.
Earlier this year China announced a $10 billion (£6.3 billion) special credit line for joint investment projects in Eastern European infrastructure and technology, followed by the signing of 27 deals worth $15 billion with companies including Oleg Deripaska's Rusal, the world's largest aluminium producer.
Most investment schemes focused on the region are heavily weighted towards Russia. The country has been unfashionable for a long time but investors are starting to wake up to the possibilities that the great bear offers. Low tax, a cheap currency, high skills base and the close proximity to appealing markets make it an attractive prospect. The country has seen growth slow slightly in the last few months, but economists still expect a 3.5% to 3.9% increase in GDP over the next year.
Aberdeen Asset Management's Eastern European Equity Fund takes a slightly different tack on Russia to most. While holdings in the country do make up the largest block at nearly 50%, the fund is underweight compared to others. With so many of the country's companies focused on resources, they are exposed to any changes in the global economic winds.
The fund chooses to invest heavily in consumer-focused businesses instead, which can take advantage of the growing wealth and emergence of a middle class in the region, with less exposure to the volatility of the global markets.
Aberdeen has a holding in Russian food retailer Magnit, which is leading the drive away from the informal retail economy to the formal and as such has opened thousands of convenience stores across the country. The company saw its revenue grow by 25% last year.
Inevitably the fund also has holdings in oil and gas companies but avoids the big boys (significantly it has no stake in Gazprom), and instead focuses on the smaller, low-cost producers, with greater prospects for production growth.
Eastern Europe has not in the past been the first place to look for income stocks; high-growth companies have historically been the focus for investors. This is changing however. JP Morgan Asset Management says that it is believes Russia in particular is an attractive market for investors hunting income with average dividend yields now at 3.6%.
The higher dividends have been prompted by political interference as the government seeks to improve the valuation of state-owned enterprises before selling them. Russia hopes to raise £7.5 billion next year from such privatisations, its finance ministry revealed in July.
Oil conglomerates in which the government has large stakes have duly obliged. In September Rosneft doubled its dividend and will now pay out a quarter of its profit, up from the previously announced 11.5%.
Turkey shines
Turkey has had a dazzling year so far, with 10.2% growth in the first half, and economists predicting a soft landing in the longer term. Aberdeen is overweight when it comes to Turkey with around 25% of its holdings in the country. Fund manager Joanne Irvine points to the country's strongly-regulated and well-capitalised banks and its low level of public debt, which is below 40% of GDP.
Retail- and consumer-focused businesses are prospering, and it's easy to see why. Per capita income in dollar terms has trebled and domestic purchasing power has grown by 60%. Brewer Anadolu Efes is tapping into this market effectively - particularly with the country's young population - as well as expanding abroad, including in the UK.
With construction booming in the country as well, Irvine backs engineering and real estate company Enka - which is also prospering from the recovery just across the border in Iraq, where it won a contract with earlier this year.
One thing to look out for is the recent weakening of the Turkish lira, which fell more than 20% against a basket of currencies this year, bad news for foreign investors.
Poland's economy is expected to grow by slightly less impressive 2.4% this year, but if that comes true it will add to what has been a quite startling economic performance in a time of crisis. The economy achieved a 15.8% total expansion from 2008 to 2011, while the EU as a whole saw its GDP shrink by 0.5%.
The performance is largely down to strong domestic demand, driven in part by consumers who respond to crises by spending rather than saving and a flexible exchange rate that helps buffer exporters. Poland has been assisted by its large internal market. Exports of goods and services account for about 40% of GDP, less than half the rate in smaller and more open economies such as the Czech Republic and Hungary.
However, BlackRock's Reid warns about investment in certain nations such as those in the Balkans, where there is a heavy reliance on exports and the markets are less liquid.
Emerging banks performing well
The banks offer a source of worry for some investors. The domestic financial sector in the region is not highly developed and as such foreign banks, predominantly from the eurozone, dominate. This is less than ideal for credit-hungry companies as the banks look to repatriate funds to their struggling domestic markets.
However, this also offers an opportunity for domestic banks to grow in their place. Many Eastern European banks have shown strong performance in recent years based on a more traditional banking model with a focus on consumer banking. They tend to be less heavily leveraged than their eurozone counterparts and have a lower asset to equity ratio.
Aberdeen's Irvine is keen on Russia's Sberbank, which she describes as "an amazing deposit-taking machine", adding that it has "made huge strides in operational and transparency reform".
Pekao Bank in Poland seems to be making a strong showing too. It is the second largest bank in the country and reported net earnings of 710.6 million zlotys (£137 million) in the first quarter, 9% higher than in the first quarter of 2011.
But Irvine is still restrained in her overall outlook for the region: "It's a volatile period, but the fundamentals are strong. The economies haven't gone far enough to deal with the problems in Europe so volatility will transfer. They can't decouple from Europe."
Eastern Europe's connections to the eurozone will undoubtedly take their toll and growth has been slowing in many countries. However, considering the undervaluation of many companies there is the prospect of strong returns for those careful enough to choose the right investments in the right countries, or to entrust the task to specialist fund managers who can do the job for them.
Market analysis, where appropriate, provided by J.P Morgan Asset Management.