Equities: Fundamentally buoyant

During the last two years, the Budapest Stock Exchange has undergone a unique and spectacular transformation. Unique because it accurately reflects the specific nature of the economic and political transition of the country. Despite the bold, decisive reforms of the early 1990s, which contributed radically to increasing the efficiency and profitability of businesses, the macroeconomic imbalances prevented the success of these developments. Whilst net profits of companies listed on the stock exchange shot up by 166% between 1993 and 1995, the stock index actually dropped by 12% (both measured in dollars), which clearly illustrates investors’ uncertainty in this period. However, the Hungarian austerity package of 1995 turned the situation around, ushering in a new era of confidence in the economy and, by the end of 1996, the remarkable progress of Hungarian companies finally came to be recognized in their share price. The last six months have seen further encouraging economic results, the effects of which are, at last, beginning to be felt by the population as a whole.

Fundamental to the progress made has been the tight rein kept on inflation, the year end target is 18%, down from 19.8% last year. Moreover there has been the improvement in the current account balance, 5.7% in 1995 and 4% in 1997 as a percentage of GDP. Another notable achievement in monetary policy has been to maintain the stability of the crawling peg currency devaluation system since the spring of 1995. This has contributed considerably in reassuring investors that inflation will remain under control. The monthly crawling peg started at 1.9% in April 1995 and it will be reduced to 1% from August 1997. Interest rates are falling, especially long-term rates, a fact which also reflects market participants’ confidence in the prevailing monetary policy. As a result, credit rating agencies have given Hungary investment grade ratings, further encouraging foreign direct investments, which so far have amounted to $14 billion, the highest figure in eastern Europe.

Current economic growth is being driven mainly by growing exports and fixed investments. The latter have increased by as much as 10% so far in 1997, principally in the infrastructure and the corporate sectors, whilst imports have mostly comprised equipment and machinery as opposed to consumer goods, paving the way for more competitive exports. GDP growth is expected to reach between 2.5% and 3% this year, the highest rate since 1987.

One area which has remained sluggish, however, is domestic consumption, which has prevented the retail sector from really taking off. However large real wage increases and slowing savings make it likely that export-driven growth will spread to other sectors of the economy, which should result in increasing consumption towards the end of the year. This in itself will obviously stimulate economic activity further, giving a boost to the banking sector in particular. It should be noted however that mainly because of the relative immaturity of the long-term savings sector, eg pension funds, insurance and investment funds, the availability of long-term resources is still limited.

High growth with low cost of capital

It is sufficient to glance at the price charts to see that the Hungarian market has experienced a dramatic re-evaluation during the past two years, with the PE ratio shooting up from 3 or 4 to 14 or 15. International investors, the major driving force on the buyers’ side, seem to have understood the very special nature of the Hungarian economy. In reality, Hungary is less an emerging market than a re-emerging market, transforming itself from a pre-war industrial economy to a post-industrial one, with the slight disadvantage of having suffered a 40 year detour under communism. The really good news for equity investors is, however, that the majority of the listed companies genuinely represents a selection of the best Hungarian companies. With between 3% and 4% annual economic growth, these companies should be able to deliver a 20% to 25% yearly improvement in profitability.

At the beginning of 1997, when nearly everybody seemed to be convinced that the era of rampant price increases was over and a slowdown in the upward trend was widely expected, investor confidence lifted the market once again: since January 1997 the equity index (BUX) has soared by 58% in dollar terms. The increase in foreign fund liquidity, surprisingly good corporate earnings and strong earnings growth forecasts have provided the foundation for the repeated boom.

In the first quarter of 1997, the 17 companies in the Concorde investment universe reported sales up by 8% in dollar terms, whilst operating profit increase per share averaged 13%. We forecast that net sales will increase by 10% in dollar terms and that the average earnings per share growth will exceed 31% in 1997. This expansion will be helped by the 30% growth in export sales. The BUX has grown from 1,528 to over 8,000 during the last 18 months. However, it could become a victim of its own success if investors use this as an excuse to profit from some recent slightly negative macroeconomic news, such as the higher than expected real wage increases or a break in the decreasing trend of inflation due to seasonal agricultural price volatility. An additional factor that may cause a correction similar to that of March or last summer is that even though the BUX shows only a moderate correlation to western market indices, the 25% correlation coefficient is still the highest in the region. Furthermore, statistical tests prove that in the short term the BSE tends to follow significant price changes on the US market. Therefore a correction in the US market could cause a transitory downturn in Budapest.

Fundamentals, however, still point to an encouraging long-term picture. An international comparison of the PE ratios and the growth prospects of the Hungarian and other emerging markets is indicative of this. We have applied the consensus forecasts of IBES International. Since IBES’s forecasts are published in local currency terms, we have adjusted the published figures to take devaluation into account. The average PE ratio of companies in Concorde’s universe is lower than the average of Czech firms, and the growth prospects are brighter as well. Hungary’s market valuation exceeds that of Poland, but seriously higher growth rates more than compensate for higher prices.

Efficiency, improvement and rationalization were the buzzwords of 1995 and 1996. Since then, the majority of listed companies have streamlined their operations by means of reducing head count, reshuffling product portfolios and introducing more efficient marketing methods, in some instances using state of the art management and information systems. Aggressive penetration into the rapidly growing eastern European markets, together with acquisitions and turnarounds, appear to be the major trends for 1997 and 1998. Hungary is not a typical emerging market. Some companies already have more than 100 years of professional history. In addition, unlike Asian or Latin American markets, there is no significant population growth in Hungary. Exposure to eastern European markets is therefore vital for Hungarian companies to make up for the lack of native growth stories. Certain sectors of the economy, though fairly well developed, are still operating at a low cost due to relatively cheap but well-educated labour. The Hungarian pharmaceutical sector is a case in point. Hungarian pharmaceutical companies are high quality, cheap, generic producers and the Hungarian market is well developed. Per capita consumption is relatively high at $80 (in Poland it has only just hit $40 and in the CIS countries it remains well under $20). Additionally, given that in the EU this figure is well over $200, these markets are expected to show spectacular growth in the next 10 years. Thanks to strong franchises established in the region during the Comecon years, Hungarian pharmaceutical companies, such as Richter Gedeon, are especially well-positioned to tap the eastern European growth story.

Construction-related companies such as the tile-maker Zalakerámia, Pannonplast which produces among other things sewage pipes, its PVC supplier BorsodChem, and the home improvement company Graboplast, are the chief beneficiaries of the healthy eastern European economic environment. Following the development of their regional marketing and distribution networks, these companies are engaging in acquisitions and turnarounds throughout the region and are swiftly becoming regional players in their market sectors. On the other hand, as the mist slowly rises and eastern Europe becomes more accessible to newcomers, rivalry from multinational companies is beginning to intensify. This highly competitive environment, however, should ensure that Hungarian companies remain cost conscious and continue to strive for improved efficiency.

Economy on track

The government remains strongly committed to continuing its growth-oriented economic policy, but at the same time is aware that it must proceed cautiously. The major task is to keep inflation on its downward trend, despite wage increases, and in the meantime prevent the currency from real appreciation that has been at the root of recent successes. Simultaneously, a tight fiscal and monetary regime must be maintained, keeping the balance of payments and the central state budget under control. With the reform of the pension system and the announcement of its aim to reduce the central state budget deficit to below 4% of GDP in 1998, the government has signalled its determination to conform to the recommendations of international institutions and its ultimate ambition to be accepted into the EU.

One question mark over further growth is the uncertainty on what the economic policy of any new government will be after the next parliamentary elections in May 1998. However, since the mechanics of the economy are now firmly established and reasonably autonomous, we believe it unlikely that any new government would seriously veer from the present course.

Emerging into Europe

With the blockbuster performance of the Hungarian market, the previously-muted interest on the part of domestic investors has begun to take off. By the end of the year the share of equity holdings in domestic investment funds is expected to more than double to between 7% and 8% of its total assets, whilst voluntary pension funds will hold 10% in equity. We expect that these domestic institutional investors together with insurance companies will own Ft40 billion in stocks, and households will hold over Ft100 billion in equities. The two together will account for close to 9% of the prospective market capitalization. Even though this rise in domestic interest is encouraging, foreign institutional investors will continue to dominate for the foreseeable future.

The daily equity turnover of the market increased dramatically in 1997 to reach $88 million. Following the first wave of re-evaluation in early 1996, the daily volatility decreased significantly to an annualized 23%, but remained higher than the 15% that has characterized the S&P 500 in the last few months. The heavy price fluctuation on the BSE shows that investors are not always sure exactly what some corporate news may mean, and often over-react. Nevertheless, thanks to what is now an impressive track record coupled with increased transparency of the market, the cross section of those investing internationally has shifted from principally risk-takers to the more conservative global funds and specialized sector funds. This trend is expected to prevail as the stock exchange expands further in the coming months. With forthcoming IPOs new sectors will be represented, for example the $1 billion placement of the telecom company Matáv, or the $100 million IPO of Rába, a representative of the machinery industry which has shown the highest production growth recently.

The Stock Exchange

After over 50 years of inactivity, the Budapest Stock Exchange (BSE) was reopened in 1990 as part of the legal and economic reform program which aimed to guide Hungary towards a market oriented economy. The origins of the BSE actually go back to 1864 when its predecessor was founded, only to be discarded by the post-war communist regime. The BSE now has three separate sections for equity, government bonds and derivative products.

The BSE is a private, self governing, non-profit organization owned by its 56 members. Earlier this year, the chief state watchdog for brokerage and banking was formed by the merger of the State Banking and Supervision Commission and the State Securities and Exchange Commission. Trades are settled through and securities are deposited with the central clearing house and depository company (KELER), which also acts as a counterparty to every futures trade concluded on the BSE. The National Bank of Hungary owns 50% of KELER whilst the remaining 50% is owned by the BSE and the Budapest Commodity Exchange.

Stocks are traded in two separate subsections of the BSE, an “A” list and a “B” list. The first requires the quarterly disclosure of financial statements and has stringent requirements regarding the free float and liquidity of the stocks. All shares within Concorde’s investable universe are traded in this more transparent subsection, providing for 93% of the total market capitalization and 98% of the trading value.

As an inevitable step in the development of an exchange, the BSE launched futures trading in its fifth year of operation. The first listed products were the three-month T-Bill, the BUX, the forint/dollar and the forint/Deutschmark contracts. Since then, an Ecu contract, the one-year T-Bill and two interbank reference rates, the one- and three-month BUBOR were added. As the first exchange in the region to come up with derivatives, market participants were doubtful about these new arrivals. This mistrust has proved to have been short-lived: trading time has been expanded from a daily 25 minutes to one-and-a-half hours, as volumes and open interest picked up significantly. Due to high volatility and the increasing number of market participants, the BUX contract has exhibited spectacular growth, and today it trades on average 4000 contracts a day. A good number of brokerage companies have set up a derivatives desk, and the market is optimistic about the anticipated introduction of standardized options and other OTC derivatives. Foreign investors have lately been permitted to trade on the BUX, and as soon as institutionalized short selling becomes available, index arbitrage will be the name of the game.