Finding the hidden dragons in eastern Europe
Forget the Brics and the Asian Tigers – the beasts sitting on the largest hoards of treasure are to be found in eastern Europe, says Jonathan Compton.
Crouching Tiger, Hidden Dragon was an enjoyably absurd American/Chinese/Hong Kong/Taiwanese co-production released at the turn of the century. The film was made for $17m, yet grossed more than $200m. It was the most successful foreign-language film in American history, garnering over 40 awards. It serves also as an investment metaphor that you need to avoid the crouching tigers and find the "hidden dragons".
Let me explain. The financial industry is suffering a slow-motion car crash. Its income is being ground down thanks to competition and greater awareness among investors of the existence of exchange-traded funds (ETFs), which are cheaper and perform better than their actively-managed counterparts. Meanwhile, its costs are soaring not so much from growing regulation, but from desperate spending on marketing and advertising to entice new investors. Hedge funds, in particular, have been hard-hit through chronic underperformance, worse even than their plain-vanilla competitors. This is sure to continue in the long run, because their high fees must detract from net returns.
It doesn't help that heavily promoted emerging markets have proven to be even more cyclical than those in wealthier countries. The marketing of high-growth economies, best encapsulated by one of the most hollow marketing gimmicks ever the promotion of the "Brics" markets of Brazil, Russia, India, China and South Africa has also resulted in disastrous losses. And there might be more to come China and Russia's implosions are far from over, to my mind at least.
Fund inflows in many areas have become outflows. Even Asia's "Tiger" economies South Korea, Taiwan, Hong Kong and Singapore, along with other occasional bolt-on neighbours have proven to be a chimera. Their economies have sputtered and their stockmarket performance has been even worse. The Tigers' pelts should be displayed in university economics departments as a reminder of hubris.
None of this should surprise us. Rising markets and asset prices follow a well-known pattern. The more they rise, the more investors and commentators are entranced, and the safer bets they appear to be. Yet there has been one group of nations which, with occasional hiccups, has been growing like Topsy while producing reasonable market returns, but attracts less attention than the weather forecast. These are the "hidden dragons" of eastern Europe.
The collapse of an empire
In 1989, Jean-George Affholder from the French National Geographic Institute conducted a survey which determined that the geographic centre of Europe is in Lithuania. This is contested it depends which barren islands you include. The strongest contender is in fact in Hungary. But in any case, the date of Affholder's survey is relevant.
By 1989, the de-facto president of the Russian Empire, Mikhail Gorbachev, had instituted reforms which inadvertently led to its collapse. Although only 26 years ago, it is hard to recall that this empire stretched halfway into modern Germany, with many free nations such as Austria and Finland cringingly subservient to their Soviet neighbour.
Amazingly, Russia's 700km retreat to the current East Polish frontier was mostly peaceful. (Or if one accepts the dubious proposition that Belarus and Ukraine are also independent, it was a 1,400km retreat.) The cause was the unsung and accidental hero Boris Yeltsin. In 1991, he replaced Gorbachev after a failed coup by the Red Army. His 48 hours of bravery facing down the rebels was followed by eight years of indecision as he sank into an alcoholic stupor surrounded by oligarch robber-barons. But this power vacuum allowed 11 independent nations to reappear in Europe alone.
As the empire fell apart there was a dangerous void: a chemical plant in Estonia or Romania would depend on supplies from across the former USSR, which abruptly ceased; apparatchik managers were wholly unused to showing initiative. It could have gone horribly wrong, with each country reverting to the widespread xenophobic despotism prevalent before World War II. But into this void stepped America and the EU. The former drove the rapid expansion of Nato; the latter poured in aid whilst dangling the massively attractive carrot of EU membership. By 1995, today's EU/Nato frontier was pretty much established.
During the rest of the 1990s, most of these countries underwent a largely successful transformation. Basics such as a working telephone system, shops that stocked food, and street lighting outside of capital cities soon became normal. The gap between "New Europe" and Russia became a chasm. The income gap, already meaningful, has steadily expanded. The human rights gap, be it a functioning legal system and property rights, a less oppressive police force and state security system, or generally free elections, became wider still. Thus, as each year passes, this new-found independence and desire to choose becomes increasingly entrenched. Yet most extraordinary of all is how rapidly each and every previous "satrap" non-state has grown.
Eastern Europe plays catch up
On many levels the growth rates for most of these countries have made the exciting Asian Tigers, Brics and frontier markets look like snails. During the last 20 years, GDP growth in the Czech Republic has easily exceeded Hong Kong. The big kid on the block is Poland with a population of 39 million. During the 1990s, its growth rate marginally lagged behind that of Thailand, a country long-considered one of the most promising in Asia, with 68 million people. Since the turn of the century, Poland's growth rate has been higher than Thailand's. Slovakia has beaten Singapore over the last decade, while over the last five years much-scorned Romania has beaten Taiwan.
The headline numbers mask more important trends. For all this growth, income per head a handy proxy for wages and costs within emerging Europe is often still below that of other developing countries. It is lower in Poland, the Czech Republic and Hungary (the big three in the area) than in all four of the Tigers. And as important is the direction of travel. Over the last ten years, average wages in China have more than doubled. In Poland they have risen by about half.
While Polish and east European wages remain slightly higher than China's, so much has the gap narrowed that the pell-mell outsourcing to China and Asia, which dominated manufacturing until 2010, has reversed as the comparative attractiveness of "legally friendly", low-cost eastern Europe has become ever clearer.
A remarkable conservatism
At the national level too, the finances of most eastern European countries are in considerably better shape, not only than mainstream EU countries but other international rivals too. Looking at government debt as a percentage of GDP, eastern Europe's conservatism is remarkable. In the Baltic countries, as well as Poland, Romania, Bulgaria, the Czech Republic and Slovakia, it is less than 50% of GDP averaging around 25%. With the exceptions of Norway and Sweden, all other EU countries have a debt-to-GDP ratio in excess of 60%.
In 2014, Mr and Ms Average in Luxembourg had a per capita GDP of €89,000 (a good proxy for wealth, wages and costs). In Germany, Britain and France it was around e35,000 and in bankrupt Greece around e18,000. The highest rates in developing Europe are the Czech Republic and Estonia, both at €17,000. Relative wages mean nothing without the requisite skills, of course. On this score, the Russian Empire was keen on technical and scientific education, if only to build a better war machine. Thus what stands out in eastern Europe is its technical expertise.
Before World War II, the Czech Republic was respected as the most advanced specialist engineering country in the world. This skill persists, which is why global companies such as Volkswagen or Fiat have relocated plants both there and to other eastern European countries. The once-derided Skoda has become one of the sleekest, relatively cheap and most-awarded mid-market car brands in the world. Romania has the largest number of IT professionals in Europe.
In 2013, 19-year-old Romanian student Ionut Budisteanu trousered a $75,000 prize from the (highly prestigious) Gordon E Moore Award at the Intel International Science Fair. His invention? "An autonomous vehicle system" or self-driving car. He worked out that Google's technology was too expensive and complex. Google and others have poured billions into futuristic vehicles without drivers. His adaptation cost $4,000.
In medicine, eastern European expertise is well regarded, but it took an emotional breakthrough for some superiorities to be recognised. Last year, the sclerotic NHS encouraged the imprisonment in Marbella of the parents of five-year-old Ashya King, who was severely ill. They had removed him from a Southampton hospital against the wishes of his doctors to seek treatment overseas for his brain cancer. They were released only after a High Court judge in London granted permission for them to seek proton beam therapy in Prague. The UK has a single, low-level machine; the Czech Republic has state-of-the-art equipment. Today Ashya shows no sign of the tumour.
The real test for eastern Europe was the 2008 crisis. During the previous six years most of their stockmarkets had risen at least fourfold, but unlike developed European countries they did not ask for aid but slashed salaries for government employees, cut spending and then rolled up their sleeves to rebuild. The folk memory of previous adversity was so strong that all of them avoided the Greek/Irish/Spanish/British banks' begging-bowl route for emergency funding.
The threat from Russia is diminishing
These nations are not problem-free. Since 2010 Viktor Orban has been prime minister of Hungary with a whopping majority. To foreign observers his message is bonkers, but it resonates well at home. Like all eastern European countries, Hungary has been flattened many times over the last three centuries, in this case by the Ottoman Empire (frequently), by Russia (several times) and by Germany (twice). After World War I it lost over two-thirds of its territory, more than half its population and a third of ethnic Hungarians. Orban appeals to historic national glory and xenophobia, while playing fast and loose with the banking system and the currency as he cosies up to Russia. Yet no group of countries develops uniformly.
The prime risk is Russia seeking to recreate the perceived glories of the failed USSR. However, despite military incursions into Ukraine and Georgia, cyberattacks on Estonia, or bribes to pro-Russian politicians across the region, the Nato/EU border grows stronger.
Russia's only real lever energy is also not as powerful as it was. Poland and Lithuania have just built new liquefied natural gas (LNG) terminals so their once-total dependency on Russian gas for electricity generation has ended; they can switch to other sources at a moment's notice. Slovakia is building two nuclear power stations, which within three years will provide energy independence.
Unless President Vladimir Putin, overseeing a rapidly imploding domestic economy and an unaffordable military, moves very soon, the key threat to eastern Europe's development will disappear. Eastern Europe represents less than 5% of world stockmarket capitalisation, with most financial advisers oblivious to the region and yet it is one of the best growth/value plays in the world. Its nations are truly "hidden dragons".
The five investments to buy now
Many of eastern Europe's local stockmarkets date from the mid-1800s. Russia's brutal interruption for half a century does not detract from a culture of essentially free-market capitalism. Until recently, equity investment has been less important than attracting foreign direct investment for economic reconstruction. This is about to change. These countries are more advanced than the Asian Tigers were when their stockmarkets were "discovered". The largest stock exchange is in Poland, with a market capitalisation in excess of $350bn, followed by the Czech Republic and Hungary.
Many other exchanges are starting to combine. For example, Estonia, Latvia and Lithuania have joined the Baltic Exchange on the Scandinavian OMX, while the $150bn Central and Eastern European Stock Exchange includes Austria, Hungary, the Czech Republic and some minor players.
As foreign equity investment has been low, these "hidden dragons" have been little affected by the much-publicised, huge foreign selling of emerging markets this year. Several local indices have actually risen, beating both the MSCI Emerging Markets index and most of developed Europe's.
Yet the real appeal is that the performance of the majority of eastern European funds, investment trusts and ETFs has been beyond dire. Not only did most slavishly follow indices (and so were overweight Russia and Ukraine, which are the wrong side of the key border), but this mistake was compounded by investing in the largest commodity companies. I can find no other regional fund group where nearly all of the five-year returns figures have been negative. Thus you are certainly buying low.
Given that most funds are dominated by Russia not a market I'd recommend my two picks would be the Aviva Investors Emerging Europe Equity Fund or the SEB SICAV 1 - SEB Eastern Europe ex Russia Fund. Both have fairly hefty management charges around the 2% a year mark but they also provide exposure to the region without the drag of Russia, Turkey and other countries, a hangover from a now-outdated fashion for funds that included the Middle East and Africa.
On individual stocks, if you are an adventurous sort and have access to a broker who will deal for you, there are several companies with a market value of $1bn-plus that are sufficiently liquid. Many are cheap on conventional criteria, and I suggest that, as these economies continue to expand, their financial systems will develop even more rapidly. The natural way to capture this is through the larger banks. Many continue to own chunky bad debts (or non-performing loans), which had been a major concern, but growth will make many of these debts recoverable, and thus a bonus to profits as they are written back.
In the Czech Republic, Komercni Banka (Prague: KOMB) is the market leader, has been a steady performer, and is a significant holding in the Aviva fund. The near-5% yield is not to be sniffed at either. In Poland the largest bank, PKO Bank Polski (Warsaw: PKO), has had problems competing against new, leaner entrants such as mBank (owned by Germany's Commerzbank). Its share price has fallen by more than 30% in the last 18 months. But this level represents a cheap entry point, and it's a good play on infrastructure development. It's a big holding in the SEB fund.
An alternative route is to invest in companies outside of the region, but with significant local exposure. Many Scandinavian groups are heavily involved in eastern Europe. The leader in the Baltics is Skandinaviska Enskilda Banken (Stockholm: SEBA). It has good controls over both costs and its loan book.
Jonathan Compton spent 30 years in senior positions in fund managementand stockbroking.