Putin is trying to reassert Russian power, with eastern Europe caught in the sanctions crossfire, but the region has potential, says Matthew Partridge.
Investing in eastern Europe might seem like a brave step at the moment. Nobody knows what Putin’s next move will be and there are signs that the economies of eastern Europe are being caught in the sanctions crossfire.
On the other hand, the region has plenty of long-term potential and it remains cheap. So I believe there is a strong case for investing in eastern Europe right now.
Granted, things are still very tense in the region. Russia’s decision to double down on its support for the rebels in Ukraine has forced the government in Kiev to withdraw from Donetsk.
Many experts believe that it will now be impossible to stop large parts of eastern Ukraine from breaking away, or at the least becoming virtually autonomous.
They also fear that Putin’s success may end up emboldening him, and that his ambitions may not stop at splitting Ukraine. Indeed, there are already signs that he is eyeing Kazakhstan and Moldova as next on his list.
Perhaps the most worrying scenario is one outlined by the Russian political scientist Andrei Piontkovsky. He predicts that Putin will test Nato’s resolve further by “encouraging” the Russian-speaking minorities in Baltic countries such as Estonia and Latvia to demand independence. He will then use the resulting disturbances as a pretext to invade those countries.
What’s more, Piontkovsky is firmly convinced that Putin would be willing to threaten the use of nuclear weapons – or even launch missiles – to achieve his aim of re-establishing the Soviet Union.
While this may sound far-fetched, the Latvian government has accused Russia of using provocateurs to foment unrest.
At the same time Russia is retaliating against international sanctions by trying to turn the screws on its western-aligned neighbours in eastern Europe. For instance, Russia has banned a variety of agricultural goods, including all fruit and vegetable goods from Poland.
This has hurt apple growers, who exported over half their output to Russia. Experts also suggest that a fall in Russian tourism will hurt the region. Indeed, the sanctions were so wide ranging that they prompted the Hungarian and Slovakian governments to criticise Brussels’ original measures.
All of these problems are serious, but if you look beyond the headlines, things aren’t as bleak as some of the pessimists believe. While the settlement in Ukraine may be unfair to Kiev, it does at least seem to be holding (and may allow Ukraine’s forces to regroup).
More importantly, the United States has signalled that it will not allow Russia to use this as a pretext to attack other countries. Indeed, last week’s Nato summit agreed that the organisation would establish a rapid reaction force to protect eastern Europe.
At the same time, continued economic reforms and low labour costs mean that the underlying economic health of the region remains robust, with most of the countries in eastern Europe and the Baltic growing faster than their western neighbours.
Best of all, the various stockmarkets remain cheap, both in terms of short-term and long-term metrics. Some of these markets, such as Estonia and Latvia, are too small to be investible.
However, there is a variety of funds, ETFs and individual companies that enable the investor to buy into the three most interesting countries: Poland, Hungary and the Czech Republic.
Poland
Poland’s story symbolises how far eastern Europe has come since the end of communism. After the 1989 election threw out the old regime, the new government decided to embrace ‘shock therapy’, making a bet that rapid and radical reforms were needed to boost productivity.
Initially, this strategy seemed to backfire, with large number of firms closing down and per capita GDP falling by nearly 20%. However, by the mid-1990s the economy had recovered its lost ground, vindicating the reformers’ approach. Since then the Polish economy has continued to grow at a strong rate, closing the gap with ‘old Europe’.
Poland joined the EU during the first wave of eastwards expansion in 2004, gaining access to European markets. However, it retained its own currency, which meant it could avoid the eurozone recession that followed the financial crisis. Ironically, Poland also benefited from the relative lack of sophistication of its banking system.
While financial institutions in the rest of the world used the money markets to speculate in subprime mortgages, Polish banks stayed focused on the boring business of taking in deposits and making loans. This emphasis on ‘narrow banking’ removed the need for expensive bail-outs.
Poland’s entry into Europe has also led to the gradual removal of barriers on labour movement, encouraging a large number of people to leave in search of higher wages. This didn’t just involve the ubiquitous Polish plumber, but also white-collar workers and graduates, workers the country desperately needs to retain.
However, the good news for Poland is that an increasing number of global firms are taking advantage of lower wages and the high levels of education by relocating there. Plenty of middle-management roles have been created as well as simpler back-office jobs. Already more than 110,000 people work in the outsourcing sector, and the number is growing quickly.
The medium-term economic outlook suggests that Poland will continue to catch up with the rest of Europe. Although growth slowed last year, the economy still expanded by 1.6%.
Similarly, the central bank has indicated that it is prepared to slash interest rates (which are currently 2.5%) in the near term to stimulate demand. The Polish government is also aiming to cut its deficit to 2.5% next year. Overall, Poland is on course to grow by a very healthy 3.4% this year, with a further increase of 3.65% in 2015.
Hungary
Even before the first free elections in 1988 brought an end to communist rule, the Hungarian government had already begun to experiment with some watered-down market reforms. Because of this, the first non-communist government was able to push through a rapid transition to the private sector.
Although this strategy brought a fair amount of short-term pain, it meant that by the middle of the 1990s Hungary was growing rapidly. As a result, Hungary was able to join the EU in the first wave of eastern European accessions.
Admittedly, Hungary did suffer during the financial crisis, as exports plunged and the deficit expanded. However, thanks to financial support from the EU and a new wave of fiscal reform, the government has been able to slash the deficit. Hungary’s non-membership of the euro has also helped.
As a result, the country’s debt-to-GDP ratio is now falling and the economy has started to grow again at around 3% this year. Economists expect this recovery to continue in 2015.
Thanks to its location, excellent transport links to the continent and cheap labour, Hungary has become an increasingly important centre for car production in eastern Europe. Indeed, the sector provides more than 100,000 jobs, makes up a fifth of the country’s exports and accounts for 10% of Hungary’s GDP.
In the last year, production rose by over a quarter, as foreign firms, including Audi, Mercedes, Suzuki and Opel, continue to expand their presence there.
Hungarian industry isn’t just limited to car assembly. Thanks to its education system, Hungary has always produced a large number of scientists and engineers. However, many university science departments and technical institutes are now working much harder to make sure that this expertise directly benefits the economy.
At the same time, Hungarian entrepreneurs are starting to develop a domestic technology sector that has already produced several start-ups. Prominent successes include video streaming firm Ustream and remote networking company LogMeIn.
The Czech Republic
Both Poland and Hungary have made substantial material progress from their communist days. However, the Czech Republic is by far the closest to completing its transition from an ‘emerging’ market to a mainstream European economy. Indeed, its inflation-adjusted per capita GDP is now very close to the EU average, and is now above that of both Greece and Portugal.
In order to make sure that this convergence continues and it catches up fully, successive governments have continued to reform the structure of the economy. This has included changes to the tax system, labour laws and education.
Rich-country think tank the OECD believes that these reforms are starting to bear fruit. In a major report on the Czech Republic published in March, the OECD noted that attempts to make it easier for employers to hire workers on a flexible basis have led to an increase in the labour participation rate, with the number of part-time workers reaching record levels.
The Czech Republic also scores highly in surveys of the business environment and quality of governmental institutions. For example, the latest report by the Heritage Foundation, an American think-tank, ranks it just behind Japan and Austria in its Index of Economic Freedom. Similarly, the Institute for Management Development ranks it above Spain.
Thanks to this business-friendly environment and a skilled workforce, it has become a magnet for foreign firms and investors, especially from Germany and the Netherlands.
According to the accounting firm KPMG, the Czech Republic now receives over $10,000 in foreign direct investment per person, putting it only second behind Estonia in eastern Europe.
Czech exports have also surged, with the OECD estimating that 70% of the economy is directly integrated into the global value chain. This means that it is more integrated than nearly all economies in western Europe and Scandinavia.
Like Poland and Hungary, the Czech Republic has full control of its currency. It is also unlikely to join the euro in the near future. This monetary independence helped it to weather the financial crisis with only a brief recession in 2009.
While fiscal tightening produced another slowdown in 2012 and 2013, this tightening brought the deficit under control. The latest forecasts suggest that the country will continue to enjoy solid growth of between 2% and 3% for the next few years.
So all three countries have performed well since 2009. Looking ahead, security worries are understandable, but these countries are all protected by Nato, so they should be able to carry on growing in the years to come.
The six stocks to buy now
Polish stocks currently trade at 15 times forward earnings and a 3.3% yield – reasonable value, but not particularly cheap. But if you look at average earnings over the past decade, they look much better value, with a cyclically adjusted price/earnings ratio (Cape) of just over 12. This makes Poland much better value than most emerging markets.
While there are several ETFs that track the Polish market, MarketVectors Poland ETF (NYSE: PLND) looks to be the best bet. It is deliberately skewed towards mid-cap stocks, which means that it has a slightly lower price/earnings (p/e) ratio, and a higher dividend yield than the overall market. It has a total expense ratio of 0.61%.
There are several ETFs (exchange-traded funds) and funds that offer broader exposure to eastern Europe. However, be aware that they tend to have most of their holdings in Russia. iShares MSCI Emerging Markets Eastern Europe ETF (NYSE: ESR) is probably the best option if you want to invest in a broad fund.
While it still includes Russia, the remaining holdings are invested in Poland, Hungary and the Czech Republic (although the holdings of the latter two are small). It has a p/e of nine and a yield of 4%. It also trades at a discount to book value. The total expense ratio is 0.67%.
Asseco Poland (Warsaw: ACP, Berlin: SFB1) is Poland’s largest technology company and the sixth largest in the whole of Europe. It specialises in providing technology for banks and financial institutions, though it also has both non-financial and public-sector clients.
It recently took over the Israeli computer firm Fortune Group, a highly profitable business. At the moment sales are growing at around 7% a year. It currently trades at nine
times earnings, with a 5% dividend yield.
Bank Pekao (Warsaw: PEO, London International: BPKD) is a Polish universal bank (ie, one that combines investment and commercial banking). Currently, the management is aggressively trying to cut costs and reduce the number of non-performing loans.
Wood & Company, a broker, believes the bank’s strong capital structure should allow it to continue to pay out a chunky dividend. At the moment, Bank Pekao trades at 12 times 2015 earnings, with a yield of 6%.
Magyar Telekom Tavkozlesi Nyrt (Budapest: MTELEKOM, OTC: MYTAY) is the main provider of telecommunications services in Hungary, providing everything from mobile phones to television. It is partially owned by a consortium led by Deutsche Telekom, and itself owns stakes in Croatian and Macedonian companies.
While it is losing landline customers, the hope is that its mobile telephone and broadband segments will more than compensate for this. Currently it trades at 13 times 2016 earnings and has a solid dividend yield of 5%. It also trades at a 14% discount to the value of its net assets.
Komercni Banka (Prague: KOMB, London International: KMCA) is one of the main banks in the Czech Republic and is partially owned by Société Générale. It offers all forms of banking, from retail and commercial services, to investment banking.
While income from the investment banking (particularly foreign exchange trading) side has been weak, strong loan growth means that overall revenues are increasing at a solid rate.
The bank has a very solid capital structure, reducing any downside risk. At the moment it trades at a p/e of 13, with a very solid dividend yield of 5%.