Investors delve at margins for yield

UNTIL JUNE, IT had been a great 18 months for central and eastern European Eurobonds. The global backdrop of falling interest rates drove unprecedented amounts of money into emerging-market debt, as developed-market investors hunted abroad for yield. Many of these investors, including significant ones from Asia, were first-time buyers of CEE debt and thus most interested in straightforward Eurobonds, rather than more complicated local currency plays.

This, combined with a general optimistic assessment of the speed of CEE convergence towards EU accession and the single currency, helped to drive down CEE sovereign and blue-chip corporate bond yields. For example, for Hungary and Poland yields are now about 50 to 60 basis points over German Bunds. EU accession countries’ Eurobond yields have all but converged with EU levels. Early buyers of these countries’ bonds have enjoyed substantial capital gains.

Fundamentals ignored It may well turn out that this was a bubble, driven not by a discerning analysis of the convergence process or individual countries’ economic fundamentals but by a desire for yield and an over-optimistic view of the speed of convergence at a time when some countries’ economic fundamentals were deteriorating and political risk was increasing. Investors chose to ignore this. As one head of syndicate put it in January: “The fiscal situation of the accession countries is not a big concern for most investors. Look at Hungary – it trades very tight and is a complete basket case.”

As new money carried on flowing into CEE Eurobonds, more savvy emerging-market investors placed their bets elsewhere, in Latin America or Asia. Pimco, for example, moved out of CEE bonds at the start of the year. Mohamed El-Erian, the investment house’s head of emerging market debt, explained: “The internal policy dynamics of some of these countries suggest a considerably more challenging convergence process than appears priced in current spreads.”

Now the bubble looks ready to burst. Encouraging signs of recovery in the US economy have led to a global widening of fixed-income yields, as money flows out of bonds and back into equities. That has hit CEE Eurobonds. Marc Kersten, head of CEE debt at DWS Investment, says: “CEE hard currency [euro or dollar-denominated] bonds have suffered in line with the general sell-off in core government bond markets, which is around a 4.5% drop in return of 10-year government paper since the middle of June.”

This has been exacerbated by recent economic news from CEE countries which, Kersten says, “has been more on the negative side, such as budget deficit growth or a shift in EMU entry expectations”. Both Hungary and Poland now look unlikely to join EMU before 2009, rather than in 2007 as they had hoped.

These factors mean investors seeking attractive yields and returns in the region in the next year might have to look farther afield than the dollar and euro-denominated sovereign bonds of Poland, Hungary and the Czech Republic.

Euromoney examines three investment strategies that look beyond the CEE Eurobond market: CEE local-currency debt, and equity investment in the Baltic states and in southeastern Europe.

There are two main ways to invest in the CEE debt market – through the Eurobond market or through the local-currency debt market. For the first six months of the year, and arguably for some time before that, the Eurobond market produced better returns. But as Marc Kersten of DWS Investment says: “In the second half of the year, local-currency bonds could outperform hard-currency debt.”

Most analysts believe that the main CEE currencies – the Polish zloty, the Hungarian forint and the Czech koruna – will all appreciate in the next six months. In the first six months they underperformed, mainly because of the weak global economy, low foreign direct investment, and local political factors that hurt the currency markets. In Poland, for example, the zloty was undermined when finance minister Grzegorz Kolodko talked it down to try to boost the country’s trade competitiveness. This, along with low FDI, domestic political scandals and poor economic data, pushed the zloty down 28% against the euro since the beginning of 2002.

In Hungary, the central bank intervened in January and June to weaken the forint to keep it within its trading band. This led to a lot of forex volatility and scared off many investors from the local-currency market.

However, the local-currency play now looks more attractive. In Poland, Kolodko has resigned, to the delight of hedge funds and other local-currency investors. The signs of growth in the German economy, where the stock market has risen fast this year, will help Poland’s own recovery. FDI in particular is likely to pick up. CSFB’s economists expect it to grow from $4.3 billion in 2003 to $5.4 billion in 2004. Because of this they say: “The Polish zloty is the most undervalued currency after the Argentine peso on our real effective exchange rate measure. [It is] 10% undervalued versus its 36-month average. CSFB economists predict the zloty to strengthen by 7% from current levels, to Zl3.63 to the dollar, within the next 12 months.”

The Czech and Slovak currencies have both been hit by political risk in recent weeks, as the coalitions in each country have looked vulnerable. In the Czech Republic, the coalition, which has a majority of one, has threatened to fall apart over public sector finance reform. In Slovakia, the conservative/liberal coalition may self-destruct over a proposed abortion law.

Most analysts expect the Slovak government to hold together, but RZB’s Czech analyst, Ivo Nedjl, only gives the Czech government a 50-50 chance of surviving intact through the autumn. The coalition disputes are likely to entail volatility for both currencies over the next few months. The Czech koruna, for example, could weaken to 33 against the euro in the next few months, from its present 32.1. However, most analysts believe the medium-term outlook for both currencies is appreciation, thanks to the global economic recovery, domestic pick-up and increased FDI.

RZB expects the Czech koruna to go to 31 against the euro by June 2004.

And even the Hungarian forint looks a good bet over the next 12 months, according to some analysts. Martin Blum, head of fixed income and currency research at Bank Austria, says that while CEE currencies and the forint in particular underperformed in the first half of 2003, the “forex outlook for the second half of 2003 is brighter, with greater stability in the Hungarian forint and diminishing uncertainty with respect to the Exchange Rate Mechanism 2 expected to prove supportive for the region”. The forint will be helped by the country’s high interest rates, which, at 9.5%, offer “the highest carry in the region by far”, according to Juliette Declerq, strategist of FX emerging market research at JPMorgan Chase.

Ways into currency There are three main ways investors can buy into the currency appreciation story. First, they can invest in local-currency bond markets. Many investors that are already invested in local-currency debt, such as local-currency convergence funds or hedge funds, are simply unhedging those investments.

Kersten at DWS says: “We’re more confident about taking risks in local CEE currencies now. We have an active currency management, so we hedge local-currency investments if we think it’s necessary. We’ve been hedging investments in Poland and Hungary opportunistically. But at the moment, we’re not hedging the local-currency investments there.”

Investors that want to make a pure currency play outside of the debt markets can invest in the forwards markets, as many hedge funds are doing, or move into the short end of the local-currency debt curve, in one-year or two-year treasury bills.

Some banks are offering structured products to give exposure to CEE currencies. JPMorgan Chase, for example, has built an index product called CANDY, made up of Polish, Czech, Slovak and Hungarian currencies. Juliette Declercq, who manages the index, expects all CEE currencies to appreciate in real terms by about 3% to 4% a year in the run-up to EMU membership. She expects the index to appreciate, therefore, from its current level of around 94.6 to 110.2 in 2006.

The rationale for taking up the second investment approach of investing in equities in the Baltic republics is straightforward. Peter Hakansson, chief investment officer of East Capital, says: “The region is growing faster than anywhere else in Europe.” It had the strongest GDP growth figures in the CEE last year, and is set for the highest growth rate this year as well. Latvia’s GDP grew by 8.8% in the first quarter of 2003, while Lithuania’s grew 9.4%. The predicted average for the region is lower, at just over 5%, but is still the highest in CEE.

Investors in the Baltic region attest to the buzz emanating from Vilnius, Riga and Tallinn. One says: “You can see it all around you in Tallinn. Every time I go there’s a new high-rise block being built.” The growth is partly driven by the boom in Russia, which accounts for 15% of trade to the region, and is partly led by domestic consumption. Balts are spending faster than ever. Guntars Vitols, president of Parex Asset Management, one of the leading investors in the region, says: “People are buying like crazy. Imports rose by 20% this year. It’s driven by a lending boom, by people getting credit cards for the first time.”

Hakansson says: “The attraction of the region is that you have similar economic growth to Russia, with similarly low asset prices, but in the Baltics you have much lower political risk.” Vitols at Parex says: “We established the political priority of joining the EU some time ago. Since then, we’ve seen a gradual improvement in all areas, for example the harmonization of our legislation with the EU is more or less complete.”

The Baltic republics are likely to be the first CEE countries to join the EU’s single currency. How can investors tap into this? The traditional way would be through the debt market. However, Eurobond levels, as in the rest of CEE, are already very tight. Indeed, according to one analyst some Estonian bonds are now trading lower than some German corporate bonds.

The alternative is to invest in the equity markets, which some investors say are still undervalued. Gert Tiivas, head of Baltic development at the Helsinki Stock Exchange (HEX), says: “The Baltic economies are growing very fast, much faster than Nordic economies. They’re also becoming a lot more transparent. That has led to a significant rally in the Baltic equity markets in the past year. The Riga exchange was up 50% last year, for example, and was one of the top performers globally. It’s up around 30% this year, and Latvia and Lithuania have seen similar growth.”

Bargains in obscurity Many of the listed companies are not big enough to be covered by international research. Hansabank is the obvious exception. As one analyst says: “It’s arguably the best bank in CEE. And its recent share performance has been phenomenal – it’s been up 50% for the last four years in a row.” Lithuanian and Estonian Telecom are both also attracting international notice.

But the real bargains might be in companies too small to attract much attention, but growing at a speed that will soon change that. Most of them are in the consumer goods and construction sectors. Mercko Ehitus, for example, is one of the biggest construction companies in the region. Its net profits grew by 13% in 2002. In the first six months of 2003, its return on equity was 45%, up from 35% year on year. Since listing on the Tallinn stock exchange in 1997, its share price has risen fast – from around e1.50 in 1999 to e11.

Also trying to tap into the construction boom is Parex’s private-equity investment in real estate. Vitols of Parex says: “We’ve seen a tremendous rise in real-estate prices over the past few years, particularly in 2002. The highest area of growth is in residential housing, driven by the growth in the mortgage market. We recently developed a real-estate fund to invest into this. We anticipate 10% to 15% growth over the next few years.”

The consumer sector is also a good place for equity bargains. The Baltic economies are growing as exporters of consumer goods to Russia, Poland and Scandinavia. Much of the cheese sold in Russia, for example, is from Lithuania, where exports grew 15.4% in the first quarter of 2003. Three dairy companies, Rokiskio Suris, Pino Zvaigzdes and Zemaijtijos Pienas, are good options in this area, says Hakansson of East Capital. VP Market, a Baltic supermarket chain, is also singled out for praise by Vitols of Parex. Alcohol producers such as Latvijas Balzams, Stumbras and Alita are well placed to capitalize on the growth in consumer demand in the region and in Russia.

As with almost all CEE equity markets, liquidity is a concern for foreign investors. However, the outlook is improving, thanks mainly to the acquisition by HEX of majority stakes in the Tallinn and Riga exchanges in 2001 and 2002. Tiivas, at HEX, says: “In practical terms, the effect of HEX’s acquisitions is obvious. We’ve implemented HEX’s clearing system, and we’ve adopted the euro as the trading currency. Dealing in Estonian stocks, for example, is now almost as easy as trading in Finnish stock.”

Thanks to this ease of entry for foreign investors, Tiivas says: “More and more foreigners are buying into the Baltics. I don’t just mean Nordic investors, but also investors from London and New York such as Fidelity and Templeton Investment. In fact, the problem is not the lack of investor interest, it’s the lack of stocks.”

HEX, which is in the process of merging with Swedish exchange OM, notes that Lithuania has now decided to privatize the Vilnius exchange as well, and HEX will be an obvious candidate to buy a majority stake. Tiivas thinks the region will eventually converge with Nordic countries. Hakansson agrees: “Geographically, culturally and historically, the region has strong Nordic connections. Like the Nordic countries, the Baltics are small, open economies which are very dependent on exports, so they have to be very flexible, and have to build companies that will perform well on the international stage.”

The third investment suggestion – equity investment in southeastern Europe – is something of a departure. Until recently investment in eastern Europe has tended to focus on Russia or one of the big central European markets, such as Poland or Hungary. The Balkans, as well as Romania and Bulgaria, were not seen as attractive investment destinations. But now the two areas of fastest growth in the region are the Baltic states and southeastern Europe (SEE).

In 2002, for example, GDP grew in SEE countries by an average of 4.5% – almost twice as much as in the countries set to join the EU. Inflation is on average low, at just 5%, excluding Serbia and Romania, which both have inflation rates in the low teens.

SEE governments are pushing through privatization, particularly in Bulgaria, Croatia and Serbia, though not without legal problems. This is helping to raise FDI inflows. And after a decade of war in the region, some political stability seems to be returning, albeit with a few flashpoints such as Serbia’s fight with organized crime.

Highlighting the positive factors, Marianne Kager, chief economist at Bank Austria, claims: “After the political changes of the past few years, southeastern Europe is now well on the way to becoming the growth region within the eastern European countries. As the political situation has eased, macroeconomic stabilization measures have been taken, leading southeastern Europe on the road from the economic laggard to the top performer in terms of growth in eastern Europe.”

Cost advantage The great advantage of the region is that, while politically and economically it may not be so far behind central Europe – indeed Romania, Bulgaria and potentially Croatia all hope to accede to the EU in 2007 – assets in SEE markets are still far less costly than those in Poland or Hungary.

Croatia is a good case study for the region. Its first president, Franjo Tudjman, brought independence and a measure of stability through his autocratic and ultra-nationalist party, the Democratic Union, but its reluctance to cooperate with the International Criminal Court for the extradition of war criminals damaged Croatia’s standing with foreign investors. The succeeding coalition government, led by president Stipe Mesic, has made more effort to open up the country to the International Criminal Court, and to foreign money, whether from tourists or foreign investors.

Some braver investors, attracted by the country’s 5.2% GDP growth last year, are looking to tap into its undervalued stock market. Hakansson of East Capital says: “Southeastern Europe and particularly the Balkans has a lot of bad associations in the minds of most investors, but in fact political risk is lower than people perceive it. Croatia probably has the lowest risk level in the Balkans. To an extent, that’s reflected in the low yields on Croatian Eurobonds. But the equity markets haven’t followed the bond markets up yet.”

Ivana Robic, equity analyst at Raiffeisenbank Austria Croatia, says: “The big argument in favour of investing right now is that P/E ratios are very low compared to accession countries. Our belief is, in the coming years as Croatia comes politically closer to the EU, P/E ratios will rise.”

The P/E ratios for Croatian firms are around 40% lower than the CEE average. Even a profitable company such as Ericsson Croatia has a P/E of only two. Part of the reason is investors’ negative perception of the region, but there are domestic technical reasons as well. For one, transparency is limited. Croatian companies over a certain size have to be listed, but do not need to release much more than quarterly figures.

There is a more demanding form of listing companies can choose but, Robic says, “managers don’t see the benefits of doing this, just the threats”. Only a handful of firms list under the second form. Two of these – pharmaceutical firm Pliva and consumer products company Podravka – account for 40% of exchange turnover.

Having two exchanges in a country with such a small equity market – one in Zagreb and another in Varazdinin – adds to the other main problem with investing in Croatian equities. As one analyst says: “I would not invest in equities in Croatia, or in SEE in general. It’s too risky – the liquidity is too low.”

Others see signs of improvement. Robic of RZB says: “We have been saying Croatia has big potential for years … But the next year and a half will be the time to invest.” Hakansson at East Capital, a leading investment company whose CEE fund is weighted to the Balkans and Baltics, agrees. He says: “The stock market is certainly undervalued. Take Pliva, the pharmaceutical company. Its valuation is lower than any pharma company we’ve ever seen. We visited its research centre in Zagreb, and it’s fantastic.” Hakansson thinks the trend of consolidation in the pharma sector, which has involved regional firms such as Lek in Slovenia being acquired by multinationals such as Novartis, means “sooner or later these companies will be bought up”.

Growth in tourism Another strength of Croatia is its growing tourism industry. The country is proving an attractive destination for many beach seekers from Europe. Hakansson says: “We like the tourism sector as an investment. There are a couple of listed companies in that sector, such as the Dom investment fund, which invests in the sector.” The Dom fund is one of the more traded stocks on the Croatian market.

Liquidity may be about to improve also thanks to privatizations this year and a plan to merge the two stock exchanges. Several privatizations are also planned for the next 18 months, such as the sale of 51% of Croatia Osiguranje, the state insurance company, this year. The government also plans to list at least 25% of Hrvatski Telekom, the leading Croatian telecom company, which is 51% owned by Deutsche Telekom. And in 2004, there are plans to privatize electricity company HEP.

Transparency is also slowly improving in Croatian equity, as companies realize the benefits of listing in the more rigorous way. Ericsson Croatia shareholders, for example, are to meet this month to decide whether to move to the more advanced listing. Other companies are following, not least because under reforms introduced last year, only advanced listed companies are eligible for pension fund investments.

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