Is a bigger EU still a buy?

Posted in Europe | 04-May-04 | Author: Barbara Wall| Source: International Herald Tribune

May 1 marked a fresh start for 10 new members of the European Union, 8 of which were formerly Communist countries in Central and Eastern Europe. It is not difficult to put a positive investment spin on the European convergence story, but are the opportunities really as good as the advance publicity?

Mark Robinson, manager of an emerging European equities fund for JPMorgan Fleming in London, said that if the experiences of Spain, Portugal and Greece were anything to go by, the process of convergence should result in accelerating growth and productivity gains within the new entrants. This, in turn, should lead to higher stock valuations and improved market liquidity, he added.

The macroeconomic picture is alluring. The populations of the new entrants are highly educated, yet labor costs are a fifth of the EU average.

There are tax advantages, too. Corporate tax levels in Hungary and Poland are below 20 percent, compared with an EU average of 32 percent. Low business taxes are something that Ireland has shown to be highly effective in attracting business.

Elena Shaftan, manager of Jupiter Emerging European Opportunities fund, pointed out that Central Europe was also an ideal outsourcing base because of low transportation costs and relatively cheap currencies. The Spanish car manufacturer SEAT is moving its factory from Spain to Slovakia. Other major Western businesses are sure to follow suit, according to analysts.

Shaftan said that she expected an additional spur to growth and demand from the development of local consumer markets. The ratio of retail lending to gross domestic product in Central European countries is now a fifth of the EU average. As interest rates decline further, a boom in consumer borrowing should result, she said.

Investment opportunities in Central and Eastern Europe have been known for years, but the window of opportunity may be closing. Stocks in the most developed accession markets - Poland, Hungary and the Czech Republic - have had a strong run this year already, with gains of around 25 percent. Some investors might be tempted to sell into strength.

Matthias Siller, manager of an emerging European equities fund for Raiffeisen Capital Management in Austria, said the long-awaited sell-off in East European equities might have already begun. A pronounced sell-off in the big three accession markets would represent an ideal buying opportunity in selective stocks, he said.

Siller likes Polish exporters that have benefited from the lack of inflationary pressures in Poland, a highly skilled work force and very competitive labor costs. His picks include Kety, an aluminum packaging company, and TKN, an integrated oil company that also owns a number of service stations.

His top pick in Hungary is the country's dominant financial institution, OTP Bank, which recently gained a foothold in Bulgaria through its acquisition of DSK Bank.

Komercni Banka in the Czech Republic is a core holding in many emerging European portfolios. "Czech and Hungarian banks are a play on the low penetration of mortgages and other financial services products in Central and Eastern Europe," Siller said.

Another way of playing the EU enlargement theme is to invest in Western companies with exposure to accession countries. Erste Bank of Austria, for example, derives more than 15 percent of its profits from Central Europe.

Another investment option is an emerging markets fund. Emerging Europe is a rather ambiguous asset class, however, and investors are well advised to look closely at fund composition, since risk profiles differ.

Then there is the matter of fund size. Emerging Europe, as an asset class, is not particularly liquid: Most funds hold 50 to 100 stocks. A fund of E600 million, or $719 million, could conceivably have E30 million in one stock, which could prove difficult to shift if market sentiment turned sour.