Investment - Articles - Liesbeth Rubinstein provides her outlook for Emerging Europe

 
•   Region makes a positive bounce back from global financial crisis
 
•   Attractive investment opportunities in Russia and Turkey

 
•   Regional approach provides valuable diversification at the regional and sector level
 
•   Domestic consumer and mid-cap stocks are the exciting parts of emerging-market growth

 Economic overview

 The region has bounced back well from the global financial crisis. Economic recovery is certainly gaining traction and, as elsewhere in emerging markets, domestic demand is a strong driver of growth for this region. In fact, we continue to see some very encouraging economic data releases, for example retail sales in Poland for February rose by 13% year-on-year, which compares favourably to similar releases in the UK. Also, the proximity of the region's manufacturing base to the Eurozone makes the Czech Republic, Hungary and Poland an important beneficiary of any German super-cycle.

 While the Eurozone and the UK are still working off their debt hangover, public finances in emerging Europe are on a much sounder footing. Both public- and private-sector debt in the region are low. Households have considerably less leverage than their western European neighbours, and accessing the domestic consumer in this region we believe still represents a multi-year catch-up opportunity.

 While living standards have certainly risen across the region over the past five to 10 years, labour costs in eastern Europe are still considerably below the European Union's average (see chart below). This explains the trend of multinationals such as Dell and Fiat relocating to this region. These companies are opening plants and committing capital, attracted by cheaper labour costs versus their home markets as well as business-friendly tax regimes and flexible labour laws. In our view, this dynamic will support the catch-up in living standards for many years to come.

 Russia

 The country has a vast natural-resource endowment. Last year Russia struck a number of strategic tie-ups with China, providing access to natural-resource reserves in exchange for cheap financing. This year, the theme is gaining momentum, as western multinationals are now starting to get in on the act. We have seen many western multinationals taking stakes in Russian energy companies, for example there have been landmark deals between BP and Rosneft and also Total and Novatek. We believe this is a clear signal that Russia has become and is becoming even more open for business. We expect to see a greater number of strategic alliances in the future, which we believe will lay the foundation for further cooperation.

 On another level, FIFA's decision to allow Russia to host the World Cup is another significant vote of confidence in the country. Additionally, reform and privatisation are further steps on this route towards economic glasnost. The government remains committed to reform as it will encourage direct investment.

 Turkey

 We believe that Turkey offers a cheap and broad-based investment opportunity. The country has favourable demographics and a strong and healthy banking system. It is also the industrial base for the Eurozone, with companies like Fiat and Ford having their most efficient and profitable production and assembly plants located in Turkey.

 Policymaking in this country has been a success. After a history throughout the 1990s of boom-bust economics, the last five to 10 years have seen a big success in Turkey's disinflation programme. We are even looking at the potential for Turkey to be upgraded to investment grade this year. At a macro level, there are certainly parallels to Brazil, whereby the lower interest-rate backdrop in the country has really been transformational for allowing companies and households to plan their investments with greater confidence.

 Region and sector diversification

 We believe in the values of a regional approach when investing in emerging Europe. This provides valuable diversification at the regional and sector level, providing exposure both up and down the value chain, from basic extractive and processing industries in countries like Russia and Kazakhstan through to research and development and centres of excellence in fields like pharmaceutical, information technology and aerospace in central and eastern Europe (see pie chart below).

 The domestic consumer and mid-cap stocks are really the exciting parts of emerging-market growth: the domestic economy and the emerging middle class. In our view, mid-cap stocks in the region give us the best exposure to these themes. It is something that is very difficult for developed-market or multinational companies to access as precisely.

 If the global economy was to experience a significant slowdown in growth this would have an impact on the economies of emerging Europe as they are not immune from such developments. However, the domestic-demand dynamic in the region provides a powerful driver and should offer some protection against any downturn in global demand. During previous bouts of increased risk aversion, market weakness proved to be temporary and provided us with attractive buying opportunities. We believe that emerging Europe remains structurally sound and that policymakers have generally done well in policy decisions. So if global growth does disappoint on the downside, we believe that the policymakers are in a much healthier position to respond.

 Attractive valuations

 We believe that the fundamental strengths of emerging Europe are not reflected in its valuations. This is the cheapest region in emerging markets, and emerging markets are still at a discount to developed markets. According to consensus estimates, Russia is the cheapest market within the emerging Europe region (as at March 2011). We believe that the country's strengths and unique advantages in terms of energy dominance are not being truly reflected by the financial markets.

 Conclusion

 Despite last year's relatively strong performance, the region is still under-represented in global portfolios and, in terms of equity inflows, has lagged other emerging market regions. In our opinion, discount valuations do not reflect the inherent strengths of the region. We believe this will change as more investors realise the real potential of this asset class.

 Q&A session

 Do you believe that the Russian government is serious about encouraging international companies to invest in the country?

 We are seeing an important improvement in the investment climate between Russia and the developed world. For example, in recent months we have seen three major transactions where multinationals have taken stakes in Russian firms: BP in Rosneft, Total in Novatek, and even PepsiCo buying Wimm-Bill-Dann, a juice manufacturer. Added to this, the government's privatisation programme also highlights Russia's clear commitment to attracting international investment. It is, of course, worth pointing out at this stage that the attraction of the region to multinational companies in search of growth is not just limited to Russia. In recent weeks, we have seen Diageo announce a deal in Turkey, as well as its plans to enter central and eastern Europe, so the attraction of the region to multinational direct investors does not just stop at Russia - it is a theme that dominates the entire region.

 Following on from the recent political volatility in oil-producing countries in the Middle East, could you provide an update as to how this may affect emerging Europe, and the opportunities and risks that this may provoke?

 As a major exporter of oil and gas, Russia is certainly benefiting from higher energy prices. With oil prices remaining above US$100 per barrel, the country's current account is being supported, government budget revenues are being boosted and foreign exchange reserves are rising. From a company perspective, higher oil prices are improving the profitability and cash flows of the energy firms. Earnings revisions for the energy sector are likely to be revised higher given this strong positive momentum. At the personal level, the oil and gas windfall has a trickledown effect to the man in the street and his spending power, so that is certainly a powerful tailwind for consumer stocks.

 Can you provide us with some insight into the country breakdown of the IP Emerging European Equity Fund?

 Just over three-quarters of the fund is invested in Russia, which is slightly higher than its benchmark weighting. We have significant exposure in Poland and have holdings in Turkey, Czech Republic and Ukraine as well. As highlighted earlier, we believe this is an exciting time for Russia at the moment. It is extremely cheap and under-owned. There is a story of change, with a move towards being more investor-friendly and potentially joining the World Trade Organisation.

 Is inflation a problem in Turkey and do you see the country joining the EU in the near future?

 Turkey has done extremely well in terms of its disinflation progress over the past five years or so, which has enabled the central bank to cut interest rates. Living standards continue to improve and with its huge domestic base, we believe the country offers attractive investment opportunities.

 Talks about joining the EU have been long and protracted. Dialogue continues and it is difficult to put a specific date as to possible membership. Having the EU talks in the background has strengthened the resolve of the country to adopt and implement economic and political reforms. The progress that Turkey has made in recent times is being reflected by the increase in the likelihood of a sovereign credit rating upgrade during the second half of 2011.

 Russia will be hosting the Winter Olympics in 2014, followed by the World Cup four years later. What impact will these have on the economy?

 These decisions are a vote of confidence in the country and its future. In terms of the impact on the economy, we are confident that it will be positive. The government, with the direct assistance of the private sector, is likely to increase investment in infrastructure projects. This will also provide a great opportunity to modernise urban areas through the building of new facilities as well as changing the appearance of the landscape; replacing old-style bazaars into more modern retail formats. Such a transformation should also bring human benefits such as enhanced safety standards.

 Your exposure to Kazakhstan did increase for a while but now appears to have been reduced. Any particular reason why?

 We have done relatively well with our stock selection and investments in this country over the past couple of years. We have reduced our holdings and taken profit in our Kazakhstan stocks. It has been an important country, just as Russia has, in terms of being a country that is open for business, with strategic alliances and tie-ups between Russia, Kazakhstan and China. Similar to Russia there are some important trade and infrastructure links between China and Kazakhstan with both countries being extremely well placed geographically and historically to benefit from Asian growth. There has been a great deal of joint development of raw-material projects over the last year, again with the Chinese sovereign wealth fund taking stakes in Kazakh oil and mining companies. We view it as a natural-resource play at a discount.

 Other than Russia and Turkey, where do you see other attractive investment opportunities in emerging Europe, and why?

 Poland offers a very broad and deep investment landscape. It has a large mid-cap sector, which allows access to the strong consumer opportunity of the emerging middle class, and some strong, well run regional franchises. Poland also offers valuable diversification. Stocks we invest in include some that are consumer-focused, such as multiplex operators across not just Poland but other countries such as Romania and Bulgaria etc, as well as fast-food-outlet operators. For example, the operator of KFC and Pizza Hut listed in Poland is the most profitable of the entire Yum! Brands group globally, its American-listed parent.

 How does the ongoing uncertainty in peripheral Europe affect the emerging European market, if at all?

 Sentiment towards emerging Europe can sometimes sour when there is negative news flow on debt management and solvency issues out of peripheral Europe. However, we would underline the strengths of the policymaking in emerging Europe and the relatively stronger public finances of the region versus its peers in the West. For example, Russian government debt in 2010 was just 6% of GDP, which is about one-twentieth of western European governments. Elsewhere in the region, the public debt of countries such as the Czech Republic, Hungary and Poland is still less than a quarter of that in Italy. So any market weakness induced by Eurozone debt fears normally provides us with an opportunity to buy companies at even more attractive valuations.

 Is corporate governance in Russia a big issue for you as an investor?

 Corporate governance in Russia has really been on an improving track over the last five to 10 years. Transparency is certainly improving. There has been a growing trend to involve foreigners on the boards to run assets, and the government has certainly become more aware of the need to attract foreign investors and foreign direct investment. Stock-picking is key. We choose companies with funding from outside shareholders. The payment of dividends is also a good measure of alignment of interests between shareholders and companies. Our active approach, supported by diligent research and frequent trips to the region to meet company management, also helps.