Quick Take: With several Eastern European countries poised to join the European Union, Jack Arnoff thinks the region will soon offer compelling opportunities. Arnoff, manager of the Pictet Eastern European Fund (PTEEX), currently favors Russia, where he sees a major rebound underway, but he expects to focus on the EU’s new Eastern European members over the next few years as they move closer to developed market status.
Eastern Europe is likely to avoid the bust that hit Russia after its 1998 boom, according to Arnoff, because many companies in those markets have adopted accounting and corporate governance models that are up to international standards. These reforms have led Arnoff to stress western-style investing criteria, such as valuations or price-to-book ratios, rather than previous concerns, such as currency stability or inflation.
Arnoff and fellow manager Jura Ostrowsky were relatively adept in investing in Eastern Europe last year, when the fund climbed 26.7%, while its benchmark, the FTSE Eastern Europe Turkey Index edged up 2.48%. So far this year, the fund has been held back because Arnoff can’t match the index’s Russian oil company weighting (about 30%). Through May, the fund gained 10.8%, while the index rose 19.2%.
The Full Interview:
S&P: What is your investment universe?
ARNOFF: We invest in Eastern Europe (Poland, Hungry, and the Czech Republic), the Balkans (Rumania, Bulgaria, and Croatia), and the Baltics (Estonia and Latvia). These countries are becoming part of the European Union through a fairly predictable process with strictly defined deadlines and targets.
We also invest in Russia, which has a different risk profile than Eastern Europe, and in Turkey. Turkey’s risk profile falls between those of Eastern Europe and Russia because it needs to sort out certain political issues.
All these countries are emerging markets, but the prospect of joining the EU for Eastern Europe and possibly Turkey will upgrade those countries to become part of European markets.
S&P: What effect will joining the EU have on Eastern Europe and Turkey?
ARNOFF: It’s a fairly complicated process, but becoming part of the EU will reduce the risk profiles of these countries, leading to an appreciation in assets. When risk declines, asset valuations go up. The best examples are Greece and Portugal, whose equity markets saw a strong rise before joining the EU. Eastern Europe hasn’t reached that stage yet, but there should be plenty of investment opportunities over the next six to seven years.
S&P: Tell us about your stock selection process.
ARNOFF: We are bottom-up investors who look for companies undergoing triggers to unlock value and spur appreciation. We divide the investment universe into three groups: stocks screened on their enterprise value; banks, which we screen based on price to book, return on equity, and cash flow adequacy ratios; and growth stocks with unique products or unique market positions. The latter we analyze on a case-by-case basis.
S&P: Why do you take a value approach to investing in Eastern Europe?
ARNOFF: Because stocks there are trading at significant discounts to the major world markets, and it’s very important to identify the possible triggers for price appreciation.
S&P: Do you apply any top-down criteria?
ARNOFF: Initially, we start with a value approach, identifying the cheapest stocks and triggers for appreciation. Over that, we apply top-down risk controls along country and sector lines. For instance, we look at the macroeconomic profile of each country to determine whether stocks are trading at a discount due to the country’s macro picture or to the company’s profile. The best example currently is Turkey which offers lots of good, undervalued companies, but it’s macro profile is rather negative.
S&P: Do you have any minimum or maximum country weightings?
ARNOFF: We can’t invest more than 50% of the portfolio in any one country, but otherwise, we don’t place any other country restrictions on ourselves.
S&P: How much weight do you put on a country’s macro profile?