Eastern European Expansion

Long-short European equity strategies for 2007 and beyond

Florian Homm, Absolute Capital Management
Originally published in the February 2007 issue

The expansion of the European Union, which now includes numerous former Soviet satellite nations, must be viewed as a clear positive for European equity markets. Numerous western European companies are already witnessing a positive earnings impact from their Eastern European activities, while Asian and North American companies are generally not as well positioned in these markets. Austria’s stellar stock market performance since 2000 can largely be attributed to its strong stake building and pioneering investments in this area. Continental European financials stand to benefit disproportionately. Likewise utilities, industrials, technology, life science and media companies and retailers to name only a few will see their growth rates increase disproportionately from European Union expansion.

On the macro-economic level, the additional labour pool will keep wage pressure in check in some sectors. Lower than average tax rates, such as in Slovakia and the Baltic States, leave more for shareholders and increase pressure on neighbouring Western European states. Demographic trends in some Eastern European regions are now far healthier than in the fully developed nations. Moreover, stagnant Europe now has a sizable region experiencing 4% to 5% GDP growth for the foreseeable future. Likewise, these new markets should increase economies of scale and should positively impact corporate profitability in “old Europe” while reducing the often one dimensional historical dependence on their local markets.

Winners and losers

For global investors this means that the European playing field as such is becoming larger and more attractive and should continue to attract better than average capital inflows. A further re-rating and relative out-performance of many European companies benefiting from this scenario is likely.

However, it is obvious to us that not all companies will benefit from Eastern European expansion. Many German construction companies have failed because they could no longer compete with their low cost competitors from Poland and the Czech Republic. EU transfer payments to these less developed areas are also a drain on already strained government budgets and hidden costs such as more criminal activity, tax evasion,increased social costs and black labour are becoming more apparent. Overall, however, Eastern European expansion is a clear net positive for European equities.

The playing field for long/short funds specializing in both Eastern and Western European equities offers outstanding prospects. Eastern European equities are both more volatile and frequently mis-priced relative to their Western European peers. There are a number of reasons for this such as: questionable shareholder rights and regulation, higher than average correlation to other developing markets rather than to more stable established European markets, currency fluctuation, non-existent derivatives markets, poor transparency and disclosure, lack of fiscal discipline, poor research coverage, substandard liquidity and so forth. As currencies converge increasingly towards the Euro and budget discipline becomes more visible this volatility should decrease, offering numerous long short plays between the old and new Europe. Frequent exogenous shocks like political turmoil in Russia often lead to sudden sharp but purely temporary corrections providing buying opportunities in Eastern European equity markets. The region as such seems to correlate more with western European markets but during periods of heightened uncertainty the region’s equity markets behave more like those of high-risk emerging economies. On the other hand, there are periods when global investors get too excited about these regions sending shares into overbought and overvalued territory. As always, a harsh correction is inevitable, making these shares once again too cheap as global investors exit the region like lemmings.

Market evolution creates ample opportunities

Market Inefficiencies are substantial. For many years eastern European generic companies were trading at 50% valuation discounts to their western peers while growing their earnings twice as fast. Outstanding Hungarian banks were half as expensive as their less dynamic Austrian peers. The valuation anomalies today are not quite as obvious as they were five years ago, but the evolution of deeper and broader markets leaves plenty of opportunities for pair trading, arbitrage, short selling and disciplined total return investing. Our very own Absolute East West Fund is stacking up compounded annual returns of about 30% with a 3.8 Sharpe ratio. Draw-downs have been minimal and volatility has been successfully contained. Moreover, these results have been achieved with relatively modest net long or net short exposure and minimal leverage. As derivative markets develop in the region hedging is becoming much easier. These attractive risk-adjusted returns are much harder to come by in the far more competitive Western European markets with such low volatility. Moreover, few investors actually engage in short selling in Eastern Europe giving those analysts an open playing field for identifying overvalued and less formidable companies. Even fewer investors are going long dynamic Eastern European growth companies while shorting their lackluster, less dynamic Western European peers.

2007 may become the unprecedented sixth year in a row of positive performance of equity markets in Central Eastern Europe. However, the returns could be lower, while volatility could run higher than in the previous years. Therefore, Eastern Europe, dominated by top down allocators in the past, is becoming more and more of a stock pickers market. Indeed, I strongly believe that fundamental, bottom up stock picking, together with downside protection offered by disciplined hedging and limited net long exposure are becoming crucial in order to succeed in these markets.

Long only exposure will not be enough to deliver acceptable returns. Yet, even now about 90% of so-called ‘hedge funds’ investing in Central Eastern Europe are in fact ‘long only in disguise’, having net long exposure of 90% and more. This is not the case with the Absolute East West Fund, which is one of the very few true hedge funds operating in this space. It is structured tomake money even in down markets, which could inevitably come after 2007. While most of the long only crowd may run for the exits at the first sight of trouble in CEE, the Absolute East West Fund is there to stay and deliver attractive risk-adjusted returns.

Given thirty years of European investment experience I fully believe that these opportunities will persist for many years to come. As the first wave of Eastern European companies begin to look and be valued in a more efficient manner, other less developed Eastern European nations will provide new investment opportunities. This process will take years and provide lots of opportunities not for those who try to run the largest fund in the region but rather the most nimble and flexible one.