The 2006 Emerging EMEA Research Team

Strong economic growth, robust equity markets and calm politics unite a diverse region.

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The countries of emerging Europe, the Middle East and Africa, or EMEA, are a disparate lot. Sharing little culturally or economically, sector members include Russia, whose giant land mass spans 11 time zones, and Israel, traversable in a taxi ride; Turkey on the Black Sea, Poland on the Baltic, and landlocked Hungary; resource-rich South Africa and resource-poor Czech Republic. Diversity notwithstanding, these countries provided investors with the same desired result last year: heady stock market returns.

Stocks in the EMEA universe gained an average of 46.2 percent in local-currency terms in 2005, according to MSCI. Russia led the pack with a dizzying advance of 69.9 percent, followed by the Czech Republic, where shares rose by 58.2 percent. Turkish stocks gained 51.9 percent, and those in South Africa were up by 39.6 percent. Emerging EMEA was a magnet for capital seeking returns higher than those available in the U.S. or developed Europe, where shares gained 3.8 and 21.7 percent, respectively, in local-currency terms last year.

Emerging EMEA also has become more attractive on an absolute-return basis as a result of steady growth, tamer inflation and lower interest rates in most member nations. Turkish inflation, for example, fell to 7.7 percent in 2005, a 30-year low, and lending rates hovered around 13.0 percent. Polish inflation, after years of monetary tightening, is running at less than 2.0 percent. With prices tamed, the central bank last year undertook six interest rate cuts, which have driven borrowing costs to a sub-U.S. level of 4.25 percent.

“Macro fundamentals have made traditional high-risk markets like Russia and Turkey more stable,” says Darren Read of UBS, who leads the No. 2 team in the Equity Strategy sector. “During the last heyday of emerging markets, around 1993, the major markets all ran big current-account deficits and depended on funding from the rest of the world. Now you have huge surpluses in key markets like Russia.”

Jean-Christophe de Beaulieu, who helps manage $1.5 billion in EMEA investments for State Street Advisors in Boston, notes that Russia is the region’s dominant market. “It accounts for 10 percent of the global MSCI emerging-markets index now, compared with 0.5 percent for the Czech Republic and 1.0 percent for Hungary.”

With Russia in the spotlight, it’s not surprising that two firms with major research commitments to that country -- Deutsche Bank and UBS -- lead Institutional Investor’s annual ranking of equity analysts in emerging Europe, the Middle East and Africa. Deutsche, which agreed to acquire full control of United Financial Group in December, moves up to the top spot this year from No. 2. It exchanges places with UBS, which acquired full control of Russian subsidiary UBS Brunswick in December 2004. In a three-way tie for third are returning third-place winners ING Equity Markets and Merrill Lynch, and last year’s fifth-place firm, Renaissance Capital. Repeating in sixth place is Citigroup; and sharing seventh place are Moscow-based Aton Capital Group, new to the rankings, and CA IB International Markets, which slips one rank from last year. Tying for ninth place are Credit Suisse and J.P. Morgan.

Fueling Russian share performance last year were oil prices that now seem poised to remain near $60 a barrel for some time. That, plus the government’s removal of a “ring fence” restricting foreign investment in gas giant Gazprom, whopping current-account surpluses, tight central bank currency management and two years of expected political stability until the next national elections, seem to promise another sunny year for Russian equities in 2006.

“This is still a cheap market experiencing positive restructuring in many sectors, and where any public policy mistakes are relatively small,” says Alexander Branis, a director at Moscow-based Prosperity Capital Management, which manages $1.5 billion in Russian assets.

With the internal environment in most emerging EMEA nations relatively calm, external factors loom larger in shaping the region’s outlook, say observers. “In a very real way, the big question for Turkey in 2006, for example, is what happens with U.S. retail figures,” says ING’s Charles Robertson, who leads the third-place Economics team. He explains that U.S. consumers are the most potent proxy for the world economy, which is vacuuming up Turkish light-manufacturing exports. Russian analysts, Robertson adds, have become keen watchers of the Chinese banking system, fearing that a collapse there could tank world steel and oil prices.

Even without severe global disturbances, most analysts predict 2006 will be less rosy than 2005 in several emerging EMEA nations, which are running out of room to improve. “Much of the region has reached a cyclical high,” says Paolo Zaniboni, Citigroup’s chief of emerging Europe strategy and co-leader of the No. 2 team in South Africa. According to calculations by Merrill Lynch, emerging EMEA nations have a regionwide price-to-anticipated-2006-earnings ratio of 12.5, compared with a ratio of 11.2 for global emerging markets and 10.7 for Asia. Mehmet Simsek, an emerging EMEA strategist at Merrill Lynch and member of its No. 1 Turkey team, says valuations will lead to a shift in allocations. “We like Asia more than Europe because of undervalued currencies in markets such as Korea and Malaysia,” he says. “In Europe the currency appreciation story is pretty much over.”

In line for a slowdown may be Turkey and Poland, which both overcame the impact of rising fuel bills last year through control over government spending and lower interest rates. This led to the Turkish economy’s expanding by at least 5.0 percent for a fifth year running and Poland’s clocking 3.5 percent economic growth, with an expected acceleration to 5.0 percent this year. But that performance appears to be reflected in current equity prices. “If you talk about valuations, Poland already has overconvergence,” notes ING’s Andrzej Knigawka, leader of the second-ranked country team. “Multiples for banks and media companies now are above Western Europe’s. On interest rates we have some room to converge with the European Central Bank, but we are already lower than the U.S. Fed.”

Turkey’s great macro leap forward also may have already occurred, considering its modest inflation and a lean 2.0 percent-of-GDP budget deficit. Enthusiasts such as Michael Harris, who is the co-leader of the country team for Merrill, pitch a new consumer-driven-growth story, as reasonable interest rates spark an explosion of borrowing and propel expansion for manufacturers, retailers and banks. Kingsmill Bond, who co-leads Deutsche’s top-ranked Emerging EMEA Equity Strategy team, is more cautious. He believes that too much of Turkey’s new prosperity has been used to buy imports, creating the environment for a possible drop in the lira, which remained stable against the dollar last year after a 5.2 percent gain in 2004. “What you have in Turkey is an expensive currency and a current-account deficit running at 6.0 percent of GDP,” Bond says.

South Africa is a convergence and commodities story in one, points out Max Koep, who leads the top country team for Deutsche in Johannesburg and co-leads the No. 2 Telecommunications team. Soaring gold and platinum prices have dovetailed with fiscal improvements, including a doubling of tax revenue over the past five years, that allow for much-needed infrastructure investments. But Koep says that platinum, whose price has risen by two-thirds in the past two years, is vulnerable to threatened cutbacks in the auto industry, which uses about half the world’s supply, and that gold, at record levels above $500 an ounce, is “ridiculously overpriced.” To State Street’s de Beaulieu, the country’s positives and negatives offset each other to produce a neutral.

Hungary also may have peaked, say ranking country analysts. Its free-spending government has racked up 9.0-percent-of-GDP deficits in both the state budget and the current account and is a glaring exception to the sound fiscal management that prevails through the rest of emerging EMEA. Even so, Hungarian shares rose 36.9 percent in local currency last year, spurred by external factors: new Russian drug subsidies that benefited Hungarian pharmaceuticals producers Gedeon Richter and Egis and high energy prices that proved profitable for oil company MOL. At this point the “overall market probably is not far from its fair value,” says Andras Zekany, leader of the ING team that takes third place in the Hungary category. He says the threat of further policy-provoked weakness in the Hungarian forint, which has slipped 13.0 percent against the dollar in the past year, colors the market with more risk than promise.

The Czechs have maintained macroeconomic balance despite the populist tendencies of their government, as 5.0 percent growth produced enough revenue to keep the budget deficit within 2.0 percent of GDP, says Barbara Seidlová, the ING country analyst who repeats at the top of the rankings. Underlying prosperity last year fueled a surge in the compact Prague stock market, where power producer CEZ, the biggest of the country’s seven liquid shares, doubled in value as its cheap coal- and nuclear-based production enabled it to capitalize on rising electricity prices across Europe. Still, Seidlová sees limited upside remaining in a market trading on an average of 18 times expected 2006 earnings. She projects a modest 10.0 percent rise for 2006.

Israel is a unique market within a unique region -- first because the technology companies that are the country’s pride and growth engine trade mostly on the Nasdaq Stock Market, not the Tel Aviv Stock Exchange, and second because war and peace drive the market at least as much as growth and inflation. Most of 2005 was politically optimistic, as Ariel Sharon pulled Israel out of the Gaza Strip and seemed set to win an electoral mandate for more peacemaking. For the year the MSCI Israel index gained 31.6 percent in local-currency terms. That all reversed early this year as Sharon suffered a disabling stroke and the radical Hamas party won elections in the Palestinian territories. Israeli equities have slumped by some 10.0 percent since the Hamas shock as other emerging markets have continued to surge. “The market is looking for some positive data to get it moving up again,” says Joseph Wolf, an analyst on UBS’s top-ranked Israel team. Sharon’s newly formed Kadima party is expected to win a March parliamentary election, buoying spirits a bit. But for now, UBS is recommending only “selected stocks.”

Whether emerging EMEA continues to rise or levels off, the region’s resurgent popularity has created enviable problems for equity researchers. One is finding the time to meet with all the fund managers who are interested in adding emerging EMEA holdings. “The biggest difference in our jobs these days is that we are more in demand,” quips Deutsche strategist Bond.

This ranking was compiled by II staff under the direction of Director of Research Operations Group Sathya Rajavelu, Assistant Managing Editor for Research Evan Cooper and Senior Editor Jane B. Kenney, with Senior Associate Editor Tucker Ewing. Contributing Editor Ben Mattlin and Contributors Pam Baker, Michael Forman, Alan Gersten, Tom Johnson, Scott Martin, Craig Mellow, Rosalyn Retkwa and Paul Sweeney wrote the sector reports.