Ahead of the investment curve in the Balkans

Peter Elam Håkansson: A long-term love affair

By Oonagh Leighton

THE BALKANS MIGHT seem like forbidden territory for many investors but the region holds no fears for Peter Elam Håkansson. He is poised to launch an equity fund in the region, his second in as many years.

“There is still a lot of privatization left to be done in the Balkans and we see a lot of investment opportunities in the region. Just look at Bulgaria, where the privatization of the Bulgarian Telecommunication Company last year boosted the stock market by 40%. This fund will capitalize on opportunities like that,” says Håkansson, who is chairman and founder member of East Capital Asset Management in Stockholm.

The 43-year-old is no stranger to these frontier markets. With close to $1.2 billion invested in the Balkans, via several investment vehicles, East Capital is one of the biggest investors in the region. It is also one of the most successful. The firm’s East Capital Eastern European Fund posted returns of close to 90% last year and its funds consistently outperform the MSCI Eastern Europe index. Out of all the emerging market funds covered by Bloomberg, East Capital Bering Russia ranks first, with a one-year performance of 118%. Among its many accolades the company won the Lipper award in 2006 for the best emerging markets Europe fund.

These markets offer excellent opportunities. With many countries in the region emerging from the ravages of war and economic decline over the preceding 15 years they are undergoing a reversal in fortune. The prospect of European Union membership has sharpened investor interest too. This, combined with robust economic growth and a relatively stable political situation, has made the Balkans one of the few regions still offering high yields. Many investors are prepared to take on the risk associated with southeastern Europe in exchange for relatively high returns.

Håkansson says that the growing popularity of these markets is evident every time he flies to the region. “Before, we were one of the few looking at these markets. Now, you regularly see rival fund managers alongside you on flights. I think that a number of Scandinavian firms are looking at launching funds in the region.”

Håkansson: plenty of opportunity in the Balkan region

Happily for East Capital, it is ahead of the curve. The firm was quick to recognize the opportunities in the Balkans and made its first foray into the markets in 2002 via its East European Equity Fund, which invested as much as one-third of its assets in these southeastern European markets. Subsequently, East Capital launched a dedicated Balkan fund in 2004 and another fund this year. “The underlying theme for the whole region has to be EU membership. And although this is some way off, we know that within a number of years the valuation of these companies will be on a par with their peers elsewhere in Europe,” says Håkansson. “Investors want to revive the convergence play that played out so well with the last wave of accession countries. The growth prospects are substantial.”

The East Capital Bering Balkan Fund, launched at the end of July, is a Cayman Island-listed offshore fund dedicated to southeastern Europe. It aims to take advantage of the investment opportunities in second-tier stocks in the region. “We launched the East Capital Balkan Fund two years ago and, since then, we have seen a lot of smaller investment situations arise,” says Håkansson. “East Capital believes that the opportunities offered by smaller companies and less liquid stocks in the region will be more efficiently exploited by a specialized vehicle. Investors should be thinking along the lines of at least four years, and be willing to accept the risks associated with investments of that kind.” East Capital is careful to highlight the potential pitfalls of investing in the region and has categorized the fund as medium to high risk. Possible hazards include political, company, currency, liquidity, legal and administrative risk. Despite this the fund offers good medium- to long-term investment potential. “This fund is suitable for investors who are prepared to accept some short-term price fluctuations in exchange for long-term returns,” says Håkansson.

Proven formula

This investment strategy follows a proven formula by East Capital, an independent asset manager specializing in eastern European financial markets. Two years ago a small-cap Russia fund was launched that has enjoyed spectacular growth. Investing in small and medium-size companies that are not covered by the leading brokers, East Capital finds stocks that are not well known to mainstream investors. “Some of these ‘unexplored’ companies have low valuations even though they run profitable and well-managed operations, leaving room for revaluation,” says Håkansson. “Revaluation is bound to be triggered by the accelerating reform process, sector consolidation and simply by increased investor attention in the wake of massive inflows of money into the Russian equity market.”

It is hoped that the new Balkan fund, also focused on smaller markets and smaller stocks, will follow suit. The fund’s investment strategy is to be a minority shareholder in companies and Håkansson says that a minimum of 80% of the fund will be invested in listed stocks.

This type of investment strategy calls for strong local knowledge. When it comes to the investment process Håkansson says that information is one of the biggest challenges in these markets, and East Capital makes a point of employing locals. In total the firm employs more than 100 people of 26 different nationalities, the majority from central and eastern Europe.

“Most of the research produced is in the local language and, given the minimal turnover, the local brokerage research is not very developed. As a result, we do most of the research in-house, and we’ve been compiling our own database since 2004,” he says.

This research is then analysed and, once investment targets have been identified, is followed up by frequent company visits by fund managers and analysts. Håkansson and his fellow fund managers spend a large part of their lives on planes, averaging 500 company visits a year.

Because of its unique expertise in the markets, East Capital is not constrained by the use of indices. Håkansson says that there are many reasons for this: the foremost being that, in an emerging market, a stock index rarely mirrors economic reality. Therefore, growth is not necessarily captured. He says that this is the case for eastern Europe, and particularly for Russia.

“We like to buy inexpensive and undervalued companies, of which there are an abundance in eastern Europe,” he says. “Therefore, we always try to identify factors that require the shares to undergo some form of reassessment.”

Håkansson is confident that there is a healthy supply of companies due to list. “If you look at markets such as Romania, Bulgaria, Serbia and Croatia there is still a lot in national hands,” he says. “We are expecting privatization to present some very good investment opportunities.”

He says that in Croatia the Croatian Oil Company and Croatian pipeline company both look like interesting potential investments. He also points out that as yet the utilities are not represented on the local exchange.

The Serbian stock market is one of Håkansson’s top picks; though he adds, with dry understatement, that trading on the exchange “is not lively”.

He adds: “Serbia has had a difficult start to entering Europe and certainly very few European countries can claim to have been bombed by the US in recent years. Despite these problems, the country has successfully restructured its banking sector with the help of the IMF and has good growth prospects.”

He says that his experience of investing in Serbia, via other funds, has been an eye-opener. “In most companies, we were the first financial investors to go there and we really had to start by explaining what a financial investor was. Many could not understand why we wanted a 5% stake in a company, not outright control. We have taught many companies how to think and act around shareholders.”

This will be useful for firms based in countries aiming for EU membership, Håkansson says. “All the countries in this fund are on track for EU membership, albeit travelling at different speeds.” Slovenia has been a member since 2004; Bulgaria and Romania will be able to join in 2007. Turkey and Croatia have started negotiations, and the other countries are waiting in line. As the fund invests in widely diverse economies, fluctuations are reduced, although political risk is high in most of these countries and will remain so until EU membership is attained.

Despite some hints that membership might be delayed until 2008, it looks as if Bulgaria and Romania are still on course for EU membership by January 2007, and these markets are on Håkansson’s hit list. “This will put these countries in the spotlight and there will be a lot of investments for them to benefit from,” he says. “One example is the almost complete lack of motorways in Romania. The country plans to spend up to €18 billion up to 2010 on bringing its road network up to scratch.”

Membership benefits

He says that Estonia offers a classic example of the benefits of EU membership. “One cannot help but be impressed by the country’s economic growth as the first quarter of this year demonstrates; it was at an amazing 11.7%. Estonia was early in the liberalization of its economy and was the first to introduce the flat income tax system, which has since been implemented in a number of other eastern European countries.”

Croatia has won the go-ahead for formal membership talks and should join by 2009. Serbia, Bosnia and Montenegro have also begun preliminary talks that should lead to eventual membership. Macedonia also gained its coveted candidate status in December 2005. “No start date was set for negotiations, and the EU has warned that a start to talks would not only depend on Macedonia’s own reform process, but also on how the EU decides to proceed with future expansion. Some critics feel that the country will not gain member status until 2012 at the earliest,” says Håkansson. Albania and a future independent Kosovo will be next on the list.

Despite the lengthy time horizon and uncertainty surrounding EU membership, plus the fact that Macedonia and Montenegro are always going to be limited by their size, the ever intrepid Håkansson says that he and his team are actively looking at investment opportunities in these markets.

The fund hopes to profit from plays on improving domestic economies. Håkansson says that the two sectors he believes hold most value are consumer goods and financial services. “We are seeing continued strong private consumption throughout the region,” he says. “Increasing salaries combined with low flat taxes are really driving the propensity to consume. Furthermore, a large portion of the population owns its housing, due to the fact that citizens were able to buy their apartments as a part of the privatization process, so there are no mortgages to pay interest and installments on.”

However the limited liquidity in many of these markets has thrown up investment challenges. Håkansson says that finding custodians proved to be one of the difficulties, since few international custodians have sub-custodian arrangements in these markets. The Cayman-listed fund will therefore manage its own custody arrangements directly with local banks.

There are also questions about exit strategies. Håkansson is confident that given the four-year time horizon, before the fund is opened, the domestic capital markets will develop sufficiently to offer better exit options.

“We are not big traders and mainly take profits where we believe valuations are too high,” says Håkansson. “In any case these markets are broadening and developing all the time and the emergence of pension funds as players on the domestic market will further speed this up alongside increased interest from international investors.”

He estimates that from a base of zero 10 years ago, foreign investors now account for 25% to 30% of the total invested in the Balkan capital markets. He believes that both this share and the overall market will grow rapidly over the next five years. In addition both the European Bank for Reconstruction and Development and the International Finance Corporation are financing a number of projects in the region aimed at boosting confidence in these markets.

And although these markets are less liquid than western European ones, Håkansson says that they are transparent, with each stock market having its own website.

Investor interest

The closed-end fund will open for quarterly subscriptions until it reaches the size of $100 million. The minimum size for the investments in the fund is $75,000.

Håkansson says that there has been no shortage of investor interest. “Clients have looked at the success of our existing Balkan fund and been asking for us to launch a more specialized product. This fund is really aimed at the more sophisticated institutional investors, the majority of which are existing clients.”

With the success of East Capital’s first Balkan fund it is little wonder that clients want another bite of the cherry. Since its launch in October 2004, the East Capital Balkan Fund has returned 80% in US dollar terms.

The fund invests in shares in companies in Romania, Bulgaria, Croatia, Serbia, Turkey and Slovenia. It is also looking at opportunities in Bosnia and Macedonia. In contrast to the East Capital Bering Balkan Fund, a large part of the portfolio of this fund is invested in the larger companies operating in the region.

The fund has close to 160 holdings, with a bias towards the financial services and consumer goods sectors, which account for 25% and 11% of the fund total, respectively, as of the end of June. Other sectors that East Capital believes to have strong growth potential are tourism and construction.

One of the firm’s most successful stock picks was Romanian bank Banca Transilvania, whose value rose substantially when Austria’s Erste Bank acquired Banca Comerciala Romana, Romania’s largest lending bank. There was similar success with Romanian oil refiner SNP Petrom, whose value soared after Austrian oil company öMV bought a controlling stake.