It doesn’t always pay to sell on the news. Last May 1 the celebrations in eight Central European countries marking their official entry into the European Union could easily have been mistaken for the end point of a strong rally that had pushed Hungarian stocks up 23.8 percent, Czech stocks up 23 percent and Polish stocks up 9 percent in the first four months of the year. For most of these countries’ bourses, though, it turned out to be a joyous beginning.
Rather than falling as the euphoria subsided, the stock markets of the biggest accession states -- the Czech Republic, Hungary and Poland -- put on a brilliant display, outshining dynamic favorites like China and India. In euro terms the Hungarian stock market shot up 72.4 percent in 2004, the Czech market rose 69.4 percent, and Poland climbed 44.7 percent.
That’s not to say these markets won’t see a correction sometime soon, but the long-term potential of Central Europe’s fast-growing economies looks very attractive to global investors.
Consumer demand in these countries is growing much faster than in Western Europe, notes Alexander Karpov, head of global emerging markets at Union Investment, Germany’s third-largest money manager. “There is above-average economic growth, above-average business growth and no correlation to Western markets.”
Adds Matthias Siller, fund manager for the E600 million ($778.4 million) emerging Europe fund at Austria’s Raiffeisen Capital Management, “I’ve been a little overwhelmed by the strong inflows of global money into Central Europe.”
Equity values have surged despite a rising tide of popular discontent over economic reforms in the region. Voters have overturned governments in six of the eight Central European countries, and resistance to further reforms has forced most of these countries to push back their target date for adopting the euro until 2009 or later. Investors, however, appear confident that the delay won’t imperil growth.
Emerging-markets funds began targeting Central Europe several years ago, but EU accession accelerated the investment flow. In turn, greater liquidity has made it easier for pension funds and other large institutional investors to participate. Today the region makes up 3 percent of the MSCI emerging-markets index.
Still, investors must juggle their positions wisely. Recently, John Chisholm, cochief investment officer at Boston-based Acadian Asset Management, which has a $600 million emerging-markets portfolio, reduced his stake in Czech stocks and boosted his position in Polish equities. “One of the keys to making money in emerging markets is avoiding meltdowns,” says Chisholm. He felt that the Czech market, at an average price-earnings ratio of 18.8, looked riskier than Poland’s, where the average P/E is 13, or Russia’s, with an average P/E of 10.
Chisholm, whose portfolio has returned 14 percent annually on average for the past five years, cites an additional risk: higher oil prices for countries that are net importers. Acadian sold some of its stake in Ceske Energeticke Zavody, the Czech Republic’s largest utility, for 194 koruny ($7.46) a share in August and the rest at Kcs254 in October; the firm had purchased the shares in November and December 2003 for Kcs137 and Kcs134, respectively.
Reflecting a global portfolio that is 17 percent overweight energy stocks, Chisholm’s Polish holdings are dominated by Polski Koncern Naftowy Orlen, a refiner with a chain of gas stations and a heating oil distribution subsidiary. Refining margins recently hit $5 per barrel, up from $2.20 a year ago.
Like many Central European energy companies, PKN Orlen sells at a discount to its global rivals. It recently traded at 7.7 times earnings; Greece’s Hellenic Petroleum trades at above 10; Austria’s OMV at 9.5; and Spain’s Repsol YPF at 9.2. Acadian bought the shares at 27 z?loty ($7.10) in January and February 2004. The stock traded at Z?l37.30 in late January.
Acadian also purchased KGHM Polska Mied´z, a copper and silver mining company with an interest in Poland’s third-largest mobile phone service, a valuable holding because Polish cell phone use is growing faster than expected. The stock sells at a modest P/E of 4.5, or three times cash flow. Chisholm’s bet hasn’t paid off yet, though. Acadian bought shares in March at Z?l32.70 and more in July at Z?l31. The stock traded at Z?l32 in late January.
Jasper Crone, fund manager at F&C Asset Management, which has about $150 million of its $3.5 billion emerging-markets portfolio invested in Central European assets, has been moving funds out of Hungary.
Crone is concerned because the Hungarian government raised wages for state workers and introduced mortgage subsidies in 2002 and 2003, moves that fueled a consumer boom and caused a brief run on the forint. The country’s current-account deficit has ballooned to 9 percent of GDP, from 6.3 percent in 2001. The deficit could cause fresh currency turmoil and force the government to increase taxes, Crone believes.
By contrast, Raiffeisen’s Siller is bullish on a number of Hungarian companies. He owns shares in oil refiner MOL Magyar Olaj-es Gazipari, which has a 50-50 joint venture with Russian oil giant Yukos in the West Malobalyskoye oil field in western Siberia. Like PKN Orlen, MOL gets its crude from Russia’s Druzhba (Friendship) pipeline. The price differential between cheaper heavy Russian oil and Brent crude moved from about $3 a barrel to as high as $8 in 2004. Although the differential may shrink, it is expected to remain at at least $3.60 a barrel over the next year. Siller contends that MOL’s access to the cheaper Russian crude and its ability to refine it gives the company an edge over many rivals because it sells the refined product at current world prices.
Although shares of MOL more than doubled in 2004, Siller views the recent price “not as a bubble but as an adjustment to reality.” Earnings also doubled, so the company’s P/E remained stable at 7.5.
Additionally, there is a wild card in the MOL play. The company recently sold off a significant part of its gas utility business to Germany’s E.On Ruhrgas for a price that valued the entire business at E2 billion, well above the E1.2 billion Siller estimates it is worth. E.On paid E425 million in cash and assumed E350 million in debt for 75 percent of MOL’s gas trading and storage businesses and 50 percent of its gas importing operation. Extra cash on the balance sheet may lower the return on assets, Siller explains. The deal contains a two-year put option for MOL to sell E.On the 25 percent of the gas trading and storage businesses E.On doesn’t already own. It also gives MOL a five-year option to sell E.On 75 percent of its gas transmission operation. Siller’s fund added to its MOL position when strong third-quarter results -- profits soared 139 percent on a 23 percent revenue increase -- were announced in October.
Siller’s other Hungarian favorite, OTP Bank, is exporting the successful mortgage and consumer loan model it developed at home to Bulgaria and the former Yugoslavia. OTP bought Investicna a Rozvojova Banka, a small bank in Slovakia, in 2001 and Bulgaria’s leading retail bank, DSK Bank, in 2003. In November it purchased Nova Banka in Croatia.
OTP has been a core holding for more than five years, and Siller’s fund recently added to its position, paying Ft5,200 ($28.25) per share, or 8.7 times estimated 2005 earnings of Ft600. OTP constitutes 6.5 percent of the fund’s assets, MOL 4.8 percent.
Siller’s fund, which gained 37.2 percent in 2004, also bought Poland’s PKO Bank when the government floated shares on November 11. The offering was ten times oversubscribed at Z?l20.50. As the stock ran up to Z?l27 through the end of December, Siller began to sell.
Union Investment’s Karpov also invested in the PKO IPO. “It is the first chance you have to invest in the retail banking sector,” says Karpov, who compares the operation to OTP and Komercní. He views retail banks as key holdings in Central Europe, given that consumer spending is growing about 10 percent a year. Nonetheless, he used the run-up of OTP’s shares to cash in about half his profits, reducing the fund’s position from 10 percent to 8.5 percent.
About two years ago Karpov began investing in Romania, which now accounts for 4 percent of his portfolio. He bought Banca Transilvania in November 2003; since then the stock is up 171 percent.
Not long before Ukraine’s election crisis erupted, Karpov began to buy into that country’s market. The fund invested in Zaporizhstal, a steel firm, and Concern Stirol, a chemicals outfit, three or four months before the vote. Each rose more than 30 percent before the market closed because of the disputed election. Since it reopened on November 29, the two stocks have jumped a further 30 to 40 percent, and Karpov remains optimistic. “We see only one direction for Ukraine to go,” he says, “and that is with Central Europe.”
Karpov’s fund gained 40 percent in 2004, 18.5 percentage points ahead of the MSCI Eastern Europe index, which includes Russia as well as Central Europe.
