Invesco Perpetual: Emerging European markets

The following is a summary of the key points raised by Liesbeth Rubinstein, fund manager in the Global Emerging Markets team, in a recent conference call on 12 March 2008. Liesbeth is responsible for managing the Invesco Perpetual Emerging European Fund, which was launched in December 2007. She also manages a number of other eastern European mandates.

Economic review

Last year the Russian economy expanded by about 8%, far superior to what developed countries achieved. The country’s currency reserves stand at over US$450 billion and government finances are in healthy surplus. Russia is now a net external creditor. However, economic success is not just confined to Russia as the Central Eastern European accession countries have become the ‘tigers’ of Europe by attracting jobs and inward investment from the richer economies of the European Union countries. The region as a whole is less dependant on international capital flow than in the past.

Strong fundamentals have created the foundations for sustainable growth, both at a macro and micro level. Coinciding with secular improvements has been the rising return on equity for companies.

Attractions of emerging European

The emerging European region offers attractive investment opportunities for investors. This is because the area offers investors unique access up and down the value chain. These can be from the basic extractive and processing industries, to innovation and centres of excellence in the field of pharmaceutical, IT and even nanotechnology. The region is rich in natural resources. For example, Russia is the world’s biggest oil and gas exporter and also has the largest reserves of gas, iron ore, nickel, coal and water. Russia and Ukraine are both abundant in fertile ‘black earth’ agricultural land. Czech and Hungary have become centres of excellence for world class pharmaceuticals research and development. In addition, Czech and Slovakia are now key manufacturing hubs for the auto industries. The motor industry in Slovakia, commonly called “the Detroit of the East”, has amazing cost advantages over the US and Germany. For example, the cost of an engineer in Slovakia is around one seventh of what it costs in Western Europe.

Emerging Europe has a population similar in size to Western Europe, but with much lower income levels per head. Our aim as investors is to take advantage of the long-term GDP ‘catch- up’ process as rising fixed investment productivity gains and export competitiveness all drive wealth creation, aspiration and income levels in these countries.

The region has a highly educated population and operates in a stable macro-economic framework. This is an extremely powerful combination for long-term broad based growth. We believe that this economic potential is yet to be fully reflected in the regions stock markets.

Foreign direct investors are already recognising this long-term potential by committing capital, opening plants and even relocating to emerging Europe. Recent examples are numerous and include; Toyota’s new St Petersburg plant and Nokia’s proposed relocation from Germany to Romania. Even Inchcape, a British company that specialises in car dealerships, has expanded operations in Russia amid declining demand in its more established markets.

Three core investment themes

1. Consumer sector

By the end of this year Russia is likely to be Europe’s largest consumer market. This provides significant opportunities for investors, whether it’s in low-cost goods such as food and beer, or high-cost items such as cell phones, washing machines and cars. Either way, the structural changes taking place in the country will provide attractive investment opportunities, both at a national and a regional level. We are already witnessing the modern retail format, for example, supermarket and hypermarkets, taking market share from the traditional old style bazaars and outdoor markets. Branded products are gaining wider public acceptance and premium brands are increasing their appeal in the region versus economy brands.

Average Russians are certainly getting richer as the booming natural resource wealth of the country stimulates personal consumption. The economy has transformed itself from the 1990’s when food queues and the lack of consumer choice was a norm.

Companies we meet that are exposed to this buoyant consumer sector are enjoying strong sales growth of 20%- 30% per year. With such vibrant expansion, the sector can become a magnet for M& A activity. Trade investors are likely to pay above stockmarket valuations to gain exposure to a sector offering long-term growth potential. Last month, for example, Unilever reached an agreement to buy the Russian ice-cream maker Inmarko. Other recent M& A deals have included the agreement by Barclays Bank to purchase Russia’s Expobank for £373 million. Furthermore, as witnessed by Allied Irish’s deal to buy a stake in Bulgarian-American Credit Bank for €216 million, cross-border activity is not just confined to Russia.

What we are witnessing through out the emerging European region is wealth creation. As well as Russia, the upbeat picture is also being seen in the Czech Republic, Hungary, Poland and Ukraine. All these countries are experiencing long-term secular growth and a clear convergence in consumer trends to Western European levels. For example, the growing affluence of consumers is reflected by strong growth rates in mortgage demands registered in both the Czech Republic and Poland.

2. Infrastructure spending

Today Russia is one of the world’s top ten economies. The government has ambitious plans to climb into the top five by 2020. However, they are very much aware that you can’t be an economic power without efficient infrastructure. This argument could be extended to the whole emerging European region.

The road system in Russia is poor. Many of its big cities are still linked by single lane roads, the vast majority of them being poor quality. By comparison, the road system in America is about ten times greater than it is in Russia, despite being physically smaller in size. Although Russia may boast one the largest railway networks in the world, freight trains crawl at an average speed of 25mph and it is still only half the length of the US.

However, the Russian government recently announced plans - at an investment conference in the Russian port of Sochi, the site of the 2014 Winter Olympics - that they intend to spend a massive US$1 trillion on infrastructure projects over the next decade. Most of this will be financed by private money as opposed to the public sector. Some of the spending will be directed towards adding capacity and updating the country’s electrical infrastructure, but it also includes other industries.

A massive spending plan will provide a potential bonanza for construction and engineering companies. The opening up of investment opportunities will extend to companies that supply materials and equipment, for example, steelmakers, manufacturers of cement and suppliers of rail wheels.

Another example of a ‘trophy’ infrastructure project under way in Russia is in Vladivostok, in the far east of the country, host to the 2012 Apex Summit. This involves the construction of the summit facilities, the building of bridges, modern high-speed roads, hotels and even reconstruction and modernisation of the water supply and sewage systems.

These large infrastructure projects are not just restricted to Russia. Football fans will need no reminding that the Euro 2012 football tournament will be held in Poland and Ukraine. Just like the build up to the 2012 London Olympics, this will mean a massive increase in expenditure on the construction of new buildings, modernisation of the transport network and the upgrading of roads, stadiums and hotels.

3. New markets and opportunities

The focus is primarily directed towards the economies of Ukraine, Romania and Slovakia, although we should also add Kazakhstan and possibly others to the list.

Taking Ukraine as an example, GDP growth has averaged around 7% per annum since 2000. Accession to the World Trade Organisation - terms have been agreed and Ukraine is likely to become a member this summer - could add another 1% to GDP growth. This year the value of M& A activity is expected to be about US$15 billion. Last year, foreign direct investment in the democracy was about US$8 billion, more than the comparative figure for Poland. Overseas investors are not only attracted by the country’s agricultural and industrial economic base, but also by the commitment from the Yushenko government to adopt the best European practices in delivering their privatisation programme. It is believed that these assets are severely undervalued and that there remains huge scope for earnings growth driven by efficiency gains.

Another driver of economic and stockmarket growth in these newer markets is the development of a retail investment boom. The start of domestic pension fund and mutual fund industries in these countries (along the lines that we have seen in Poland) is an encouraging and important positive step in that it should help to underpin market performance over the medium term.

Conclusion

The unique combination of natural and human resources, coupled with the pursuance of credible economic policies in the emerging European region, should ensure that both economic and earnings growth are likely to outperform the likes of the UK and the US going forward. Current valuations still look appealing and the asset class is trading at a discount not only to developed markets but also to other global emerging markets such as Asia. These attractive valuations are underpinned by corporate profitability. Countries such as Russia enjoy strong fiscal positions as well as high levels of foreign exchange reserves. This provides greater flexibility to adjust policy if the situation requires such a move, for example, a global reduction in risk appetite. However, the fundamentals of the emerging European region remain strong and positive with a huge potential still to be realised. Healthy market returns in recent years have coincided with economic stability in the region. We expect these positive trends to continue into the future.