The media has been quite fixated on the beleaguered Eurozone, but there’s a unique and often overlooked story coming out of some of Europe’s emerging markets that interests me more. While much of developed Europe is still struggling to get its fiscal house in order, much of emerging Europe already has. Some of the emerging markets in Europe deserve to be a greater part of the European story, and in my view, can offer compelling investment opportunities at attractive valuations.
Many investors have the view that emerging Europe equals Eastern Europe. I view emerging Europe as all former Communist European countries, plus Turkey. We also look at Austrian companies when considering this region, since many companies in Austria have sales or operations in Eastern European countries.
More specifically, in emerging Europe we tend to focus on Russia and the Central or Eastern European Three (“CE3”) countries of Poland, the Czech Republic and Hungary. We also evaluate opportunities in Romania, Turkey and the Commonwealth of Independent States (CIS) region (former Soviet bloc countries), as well as the smaller countries of Bulgaria, Croatia, Serbia, Latvia, Lithuania and Estonia, some of which are considered to be frontier markets. Of course, each of these countries faces unique challenges and risks, but also has areas of strength that can look attractive from a long-term investment perspective.
Generally lower debt than many of their Western neighbors is one of those strengths. In the key countries of Russia, Turkey, Poland and the Czech Republic, public debt does not exceed 60% of GDP.1 Private debt is also lower with loans-to-GDP at about 50% on average2, compared with more than 100% in many developed markets.
Poland, Hungary and the Czech Republic have relatively well-developed infrastructure and a well-educated, foreign-language speaking workforce. Foreign companies with high-cost labor markets looking to relocate production facilities and shared service centers are finding these countries attractive destinations. Poland was actually one of the only countries in Europe to escape recession in the wake of the 2008 – 2009 financial crisis, and I see potential for its economy to grow long-term with greater improvements in infrastructure, corporate governance and bureaucratic reforms. Of course, Poland has also faced some difficulties. Some of the banks there have engaged in mortgage lending in foreign currencies, which can cause stress on the system (and has) during times of severe currency weakness. Poland’s banking sector has been able to work through those problems and mitigate some of the risks, and while banking profits have declined a bit this year in the face of current challenges, the sector overall appears stable to us.
As bottom-up investors, we try to assess the potential risk/reward profile of each company in each country individually, in order to invest in those we believe to have the greatest long-term potential. Our team is fortunate to have the benefit of a local presence and a well-established research process that help us to uncover opportunities across a spectrum of market capitalizations in a number of countries in the region.
Impact of Eurozone Crisis Varies
Emerging Europe has not been completely immune to the crisis in the Eurozone, although the impact varies by country. The CE3 countries are still heavily dependent on exports to Western Europe, with Poland and Hungary being the least and the most dependent, respectively. Germany is the biggest trading partner for Poland, Hungary and the Czech Republic, so as long as Germany shows relatively good economic performance, those countries should benefit. In the case of CE3, while we continue to search for individual companies that we believe look undervalued, we are cautious of these economies’ relatively higher export dependency on the Eurozone.
Many Western European banks are now disposing of a number of prior acquisitions in Eastern Europe because they need capital. Many individuals and companies in emerging markets, including those in emerging Europe, are picking them back up. China is very active in this regard, and so is Russia. As a result, we are seeing a transformation in the way investments are being made in Eastern Europe.
Interestingly, banks in emerging Europe generally do not have a significant exposure to the PIIGS (Portugal, Italy, Ireland, Greece and Spain) countries. But the PIIGS countries’ banks do have some subsidiaries in Eastern Europe. Some banks in emerging Europe have significant retail loans denominated in foreign currencies (e.g. CHF, EUR). This practice was particularly popular in Hungary and Poland, which means that if local currencies depreciate as a result of problems in Western Europe, non-performing loans in emerging Europe may increase in volume.
Another concern is that many industrial companies in emerging Europe remain cautious, preferring to sit on cash instead of launching new investment projects. Thus, expectations for new projects are low as a result of problems in Europe.
In addition, the weakened fiscal positions of many Western European companies have translated into less money flowing to Eastern Europe. However, these countries are witnessing what’s happening in Western Europe, and many are accelerating reform efforts to improve their own economies. I see that as a positive, because it’s likely to lead to more privatization. The companies that are partly government-owned and listed are also likely to reform faster than they might otherwise in a less challenging environment.
For example, to improve its fiscal position, the Polish government has established a privatization program which includes reducing the state ownership in some of the largest listed companies (financial and utility sectors mostly) as well as privatizing and listing several state-owned companies. I believe this should lead to higher levels of efficiency and as a result, improve these companies’ international competitiveness. In addition, witnessing what’s happening in the Western European financial industry, local financial system regulators in emerging Europe have been trying to avoid a similar situation by imposing stricter and more conservative lending policies and capital adequacy requirements. In Poland, for example, the banking system is relatively well capitalized and healthy.
Emerging markets, including those in Europe, represent a growing proportion of the world’s stock market capitalization. Even if their overall growth this year may be a little lower than in recent years past, most of these economies are still expected to grow faster than most developed ones this year. Given generally better fiscal positions, valuable resources and resourcefulness, I believe that even as the Eurozone’s troubles dominate headlines, long-term investors should take a closer look at emerging Europe.
1. Source: CIA World Factbook, 2011. Debt-to-GDP ratio. Russia 8.7%; Turkey 42.4%; Poland 56.7%; Czech Republic 40.7%
2. Source: The World Bank, 2011. Domestic credit to private sector debt as percentage of GDP. Russia 45.9%; Turkey 50.1% Poland 54.9%; Czech Republic 55.8%