By Eric Jansson
Published by Euromoney, October 2006 issue
More than two years after the enlargement of the European Union, many large equity investors remain convinced that the combined equity markets of central and eastern Europe are too small for them to invest in, despite a combined equity market capitalization of €211 billion at the end of 2005.
The trouble is that this market cap is split between 10 bourses of greatly varying size. Warsaw, for example, posted €106.8 billion in equity market capitalization and Riga just €1.8 billion. While the growing EU aegis boosts access to equity in the region and limits perceived risk, investors must still pick through a highly fragmented trading environment in order to identify good buys.
A bigger target is Russia, so many emerging Europe investors head there, treating the space between Frankfurt and Moscow as fly-over territory.
"We’ve had an extended commodities cycle. We have a high oil price. Russia’s the relatively low risk destination in some ways. Why not buy a Russian company that’s pumping oil out of the ground at $70 a barrel? Why not?" asks Paul Tucker, senior European finance analyst at Merrill Lynch.
In the new EU member states, by contrast, Tucker says: "From the perspective of a global institutional investor, there are not many companies to invest in. In Hungary you can buy three or four. In the Czech Republic you can probably only buy two." The region’s smaller exchanges, such as those in the Baltic republics and Slovakia, are "very seriously off-piste" in Tucker’s view.
Is preference for this size indicative of prudent conservatism or does it amount to a reckless lack of interest?
Leading indices on exchanges across the new EU member states have swelled since enlargement, with Warsaw’s WIG20 index up 76% and the Cyprus exchange’s general index up 177%. Other top indices in the region show post-enlargement growth rates between those of Warsaw and Cyprus, with the exception of Ljubljana’s slower SBI 20.
Some major investors freely admit that they have missed a fantastic bull run.
Peeter Saks, managing director at Suprema Securities, a Tallinn-based investment bank focusing on Estonia, Latvia and Lithuania, says big players that stay out now are missing an opportunity to benefit from what amounts to "Chinese growth on Swedish markets", citing strong fundamentals in the Baltic Republics and the benefit of the newly introduced EU regulatory environment.
"If you don’t need to invest hundreds of millions of euros immediately, the Baltic markets offer very good investment opportunities," Saks says. "Strong macroeconomic growth, the strongest in Europe for several years to come – for example Estonia recorded 12% in the second quarter of 2006 – stable politics, budget surpluses, low taxes, fixed currencies, strong Nordic financial and industrial influence make it a really low risk, high growth area."
However, risk is variable. Some countries in the region, most egregiously Hungary, suffer from twin fiscal and trade deficits, and attendant political risk. Rioting in Budapest in September coincided with a fall in the BUX, though it soon stabilized.
However, even where strong fundamentals exist, they offer little insulation against emerging market risk. Falls seen in May and June on exchanges across the region demonstrated this clearly. All 10 exchanges felt the blow when interest rate increases in the US spurred a retreat from global emerging markets.
Claude Tiramani, fund manager in charge of east European products at BNP Paribas Asset Management, says the retreat revealed a healthy opportunity for more patient investors. "The industry is too much short-term oriented," he says.
"Investors want to cash in before year-end. They want to play it safe. Marginal operators get out. People with smart money should exploit this, they should benefit from this irrational behaviour. These economies are going to benefit from transfer of structural funds from western Europe, and these markets should experience better growth than western Europe, as others like Greece and Portugal did before."
In the months since the May-June fall, the exchanges quickly recovered lost ground. After watching more than 50% of post-enlargement gains vanish, top indices on the region’s three biggest bourses – Warsaw, Budapest and Prague – had by late summer all recovered 60% or more of their losses.
Ljubljana’s SBI 20 surged past previous post-enlargement peaks. Only minuscule Malta has failed so far to rebound substantially.
The May-June fall appears to have invited change. "There was a general reappraisal of risk appetite," says Merrill’s Tucker. "Then when people decided that they wanted to come back in, they differentiated more than they had done before. All of a sudden the macro mattered."
Greater differentiation could bode well for smaller exchanges, whose defining disadvantage remains illiquidity.
"The exception on a relative basis is Poland, because of the big Polish pension funds," says Tiramani, manager of BNP PAM’s Parvest Converging Europe and Parvest Emerging Markets Europe funds.
Small exchanges might partly offset their illiquidity downside with low currency risk. All new EU member states aim to adopt the euro, and all but Poland and Czech Republic have established euro pegs. With confidence in the US dollar sagging, euro linkage gives new EU equity a key advantage over dollar-denominated Russian equity.