EMERGING EUROPE: Milking the markets

In recent years it has been possible to make very impressive returns by investing in Emerging Europe. However, these opportunities are becoming harder to find. Nick Fitzpatrick considers how to benefit from these markets today

07_12_cow.jpgEast European equity markets have been a source of great returns in recent years – at least if you were in early enough. But now those opportunities are getting tougher to find. A recent report by Credit Suisse said that emerging European equities today trade at a 5% discount to Western European equities (based on forward P/E ratios). Five years ago the discount was a staggering 40-60%.

, to seek impressive returns in East European markets today, fund managers will have to work hard, quick, and be clever. Product designers will come under pressure to rethink the pricing of Emerging European funds too. At least this is what Carl Meurling, chief executive of Emeralt Investments, believes.

“A lot of long-only Eastern Europe equity funds are charging absolute return fees. In 2005 you could get an 83% return from Russia, but you could take 20% out of that just for following the market. Investors are paying for a lot of beta so it’s time for them to wake up and think about what they’re getting.”

 an example of the kind of gains seen in Eastern Europe, the Russian Trading System Index was up 83% in 2005 and 71% in 2006. But to sustain impressive results, experienced Emerging Europe managers are looking away from traditional strategies and indices, and turning instead towards short-selling strategies, small caps, private equity and frontier markets such as Serbia.

“[Emerging Europe] markets are still interesting and can provide good returns. But they won’t be the same amazing returns that we have seen over the past five years,” says Meurling, whose firm recently launched its flagship long/short Emeralt Emerging Europe Fund.

“The markets are still inefficient so it is better to be able to take long and short positions,” he says. According to Meurling, who is a former director of East Capital, shorting has been possible in emerging Europe markets for about a year, with a universe of up to 80 stocks.

Reaching out to the West
Emeralt recently presented an investor roadshow in London, but the firm has not been alone in reaching out to Western European investors recently.

LimeStone Investment Management, based in Tallinn, Estonia, and formed recently by the former Emerging European equities team at Sweden’s Hansabank, was also in London in November marketing to institutional investors. So too was the Romanian investment management firm New Europe Capital, which markets largely to high-net-worth investors and uses LCF Edmond de Rothschild Securities as its broker.

LimeStone was due to launch its first fund this month (December), a Luxembourg-based specialised investment fund aimed at institutions. Called the East European Opportunities Fund, it will invest outside of the main regional indices and tap into new so-called frontier markets like Serbia and Romania. It will also seek pre-IPO and small cap opportunities. A Ucits-compliant retail fund is planned for next year, as are a socially responsible fund and a real estate fund.

Paavo Põld, head of business development at LimeStone, says: “The fund at Hansa had great performance and we became more ambitious in terms of where we wanted to invest. The East European Opportunities Fund tries to encompass such ideas that we came across at Hansa.”

He adds: “Poland, the Czech Republic and Hungary are not so exciting anymore.”

Alvar Roosimaa, chief investment officer at LimeStone, says: “Three to four years ago Hungary, Poland and the Czech Republic looked like frontiers, but the main index stocks there are now in almost every emerging market fund in the world.

“The style of investing in emerging Europe has changed. Discount rates have come down significantly. You now have to be a decent stock picker, but a lot of investors are not seeing this. You have to cherry pick.”

LimeStone uses the Dow Jones EU Wider Index, which presents around 570 relevant stocks. Two billion euros of assets under management can lead to capacity constraints in this still-small market place and for this reason specialist boutiques will be more successful, Paavo says.

Having built up a track record at Hansabank, LimeStone has already found seed capital from Scandinavian institutions, who were already early investors in Emerging Europe.

“If a Scandinavian fund has e20bn in equities, and if they like you, they will give you e10m as part of a satellite investment,” says Paavo. “There is no extensive RFP with the Scandinavians. We are looking at e100m for a soft close and we will launch with e30-50m and get to e100m by mid-next year.”

Distribution comes through JP Morgan and T. Rowe Price. Operationally, European fund administration in Luxembourg provides administration, and custody is with KBC, a Belgian-listed banking business with extensive interests in emerging Europe.

aavo says: “KBC recently bought a small broker in Serbia and has operations in all the new countries, from Poland down to Serbia. It’s a good match for us.” KBC is also a seed investor in the Emeralt long/short fund.

New Europe’s Reconstruction Capital II Fund (RC2), run by Romania-based Ion Florescu, was created in 2005 to invest in private and listed equities and fixed income securities. The primary focus for RC2 is Romania and Bulgaria, but the team also invests opportunistically in neighbouring countries such as Ukraine, Serbia and Albania. Florescu was also in London recently on a second round of capital raising.

Think small
Florescu was one of the investors lucky enough to be in Eastern Europe when capitalism began. The strategy of his first fund, Reconstruction Capital I, which launched in 1997, was to seek shareholdings in formerly state-owned, mid-cap companies, concentrating on Romania.

Wishing to list the fund on the Alternative Investment Market in London, RC2 was launched “with a clean slate” after problems with requirements to value the first fund.

Florescu says: “The fund has not been correlated with emerging markets in general… In the emerging market crisis in 1998 we only lost a few percentage points.”

Emerging Europe economies turned around in 2000, he says, but discrepancies in GDP per capita between the Eurozone and the parts of Emerging Europe where RC2 is focused are still seen. “These countries have the potential to catch up and already are doing so. We think that over a ten-year horizon living standards will converge.”

Florescu is bullish on oil, steel, petroleum, wood processing and the automotive industry. “Romania will soon make as many cars as the Czech Republic, which is the largest manufacturer in Eastern Europe.” He also says that the pipeline of industries is growing enormously.

Emerging Europe is a market where fund managers can benefit with a local presence due to the lack of coverage by international research houses. Florescu says: “If you do not have a local presence, you miss the information advantage. Larger broker firms have no motivation to provide research in these companies.

“For example, we did a deal in Albalact [Romania’s leading dairy company] in 2006 before EFG and Raiffeisen initiated coverage. When coverage started, the share price increased and other managers started to appear on the share registry. However, we had sold by this time.”

Be small, be local and look to the frontiers: these are the rules for Emerging Europe managers, going by these three fund houses. Market share may now be dominated by non-regional houses, but as fund management in Emerging Europe matures, this may change.

© fe Decembr 2007 / January 2008

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