Quick Take:With a significant exposure in Russia and Eastern Europe, the Driehaus European Opportunity Fund (DREOX) has been outperforming its European stock fund peers by a wide margin. Managed by Ivo Kovachev, the fund delivered an average annualized return of 13.7% for the three years ended October 31, versus a loss of 11.3% for stock funds that invest specifically in Europe.
Year-to-date through November 15, the fund has edged down just 0.30%, while its benchmark, the MSCI Europe Index, has lost 18.9%. In calendar 2001, it dropped 21.5%, just about paralleling the index, which gave up 21.2%. The $26-million portfolio typically holds 70 to 80 stocks.
Kovachev has managed the fund since April 2001. A Bulgarian by birth, Kovachev is based in Prague, Czech Republic, the geographical heart of Europe. The fund began operations on Dec. 31, 1998, and is rated 5 Stars by Standard & Poor’s.
The Full Interview:
S&P: How do you select stocks for the fund?
KOVACHEV: We are bottom-up growth investors, seeking stocks with such classic growth characteristics as accelerating sales and earnings growth and upward earnings revisions, etc. It has been difficult to find such stocks in this current climate, but we have had some success in finding high-growth companies in certain niche industries.
S&P: Can you invest without regard to cap size?
KOVACHEV: We are an all-cap fund, but based on our investment criteria, it is easier to find `growth’ among the smaller and mid-cap sectors, so we tend to be focused there. However, we do contain such notable large-cap stocks like Vodafone Group (VOD) and Koninklijke (Royal) KPN.
Our focus on small and mid-cap stocks has helped our performance in 2002. During the first half of the year, small and mid-cap stocks outperformed their larger-cap counterparts. This was partly because large caps were fully or over valued, forcing investors to look elsewhere for growth, namely in the smaller-cap arena.
S&P: What are your top country allocations?
KOVACHEV: As of Sept. 30, 2002: Great Britain, 28.2%; France, 9.0%; Russia, 6.8%; Spain, 6.1%; Netherlands, 5.7%; Italy, 5.3%; Germany, 4.5%; Switzerland, 3.9%; Israel, 3.4%; Finland, 3.3%; Austria, 3.2%; Belgium, 2.9%; and Sweden, 2.8%.
Although Britain is our largest allocation by far, our exposure there actually represents a slight underweight relative to our benchmark, the MSCI Europe Index. However, we think the U.K. economy is quite strong, especially compared to France and Germany, each of which are underweighted in our fund. In Britain, the currency is robust and retail sales numbers are impressive. We have performed very well with some small and mid-cap British retailing names.
S&P: Relative to your benchmark, in what countries are you significantly overweighted?
KOVACHEV: Given that Russia and Eastern Europe are not components in the index at all, we are most overweighted in these regions.
S&P: Russia has a small stock market, but it has performed well.
KOVACHEV: The recent success of the Russian stock market has been based largely on its oil economy. The price of oil has been high since they emerged from their economic and currency crisis of 1998. Thus, with a relatively cheap ruble and high oil prices, a lot of hard cash has entered the country, creating a very attractive macro-economic backdrop. Russian energy companies have benefitted greatly from high commodity prices, radical restructuring, and increased production.
In addition, the Russian president Vladimir Putin has successfully persuaded Russian corporations to adopt Western-style business management practices, such as restructuring, corporate governance, and accounting policies — that is — everything that is designed to improve earnings and to attract the interest of foreign investors.
Even more important, as the Russian economy has appeared to stabilize, Russian consumers have started to show some confidence in their country. We also like Russia’s burgeoning telecom sector, which can be viewed as a `consumer play.’ In fact, telecoms represent our largest industry exposure in Russia.
S&P: Tell me about the emerging European countries like Poland, the Czech Republic and Hungary?
KOVACHEV: The fundamental premise of investing in these countries is that they will soon be allowed entry into the European Union (EU). In fact, these countries are already benefiting tremendously from the convergence of their economies with those of the EU. Officially joining the EU will continue to be a positive development for them.
Hungary, Poland and the Czech Republic, which will likely join the EU in 2004, are enjoying a low interest rate environment, low inflation, high equity valuations and increased foreign investment. We have already seen how convergence with EU has helped the markets of Spain, Portugal and Greece.
S&P: Do you consider Turkey and Israel as part of your investment universe?
KOVACHEV: Yes, we do. In 1999, Israel was a great place to invest, particularly their high-tech stock sector. But since then, they have faltered badly, partially due to their deepening political situation as well as the blow-up of technology.
I generally like the Turkish economy, however, one of their major problems is that there is much sentiment in Europe against the Turks joining the EU.
S&P: Why do you have such an underweight position in Germany, Western Europe’s most important economy?
KOVACHEV: From a bottom-up perspective, we have not found many high-growing German companies. From a top-down view, the macro-economic picture in Germany is poor and not improving. I think Germany looks like a prime candidate to go through a Japanese type of recession.
S&P: What are your top individual holdings?
KOVACHEV: As of Sept. 30, 2002: Erste Bank der Oesterreichischen Sparkassen AG [an Austrian bank], 2.8%; Grupo Ferrovial, [a Spanish construction firm], 2.6%; Koninklijke (Royal) KPN NV [the Dutch telecom giant] 2.3%; Wavecom SA (WVCM), [a French digital wireless company], 2.3%; Taro Pharmaceutical Industries Ltd. (TARO) [an Israeli pharmaceutical firm], 2.2%; Willis Group Holdings Ltd. (WSH) [the British insurance broker], 2.2%; EGG plc [a British insurance and financial services company], 2.0%; VimpelCom (VIP) [a Russian telecommunications provider], 2.0%; Merloni Elettrodomestici S.p.A [an Italian household goods producer], 2.0%; and Saipem S.p.A [an Italian manufacturer of oil field equipment], 1.9%.
S&P: Could you discuss one of your favorite holdings?
KOVACHEV: Merloni has been one of our biggest winners this year. They are growing sales by 30% each quarter. Their profits are growing even faster, but the stock is still only trading at about 10 P/E. They sell goods primarily to Western Europe, but they have recently opened up markets in Russia, which will help them even more.
S&P: In what industrial sector are you most overweight?
KOVACHEV: Relative to the index, we have a double-weighting in the telecommunications industry. Although that sector has been battered around the world for the past few years, we have actually discovered some telecom firms which have posted better-than-expected earnings and are exhibiting solid growth. One example would be Mobistar, a small Belgian-based mobile operator which is delivering 20% annual growth.
Telecom firms in Europe are dealing with the problems in their industry by cost-cutting, restructuring, and enacting such measures as moving from pre-paid customers to contract subscribers.
One must be careful with the European telecom industry, however. Keep in mind that in the markets of Western Europe, the penetration rate is very high — 70%, or even greater in many places — so you will not find much sales, revenue and subscriber growth there.
S&P: What about Russia’s telecom industry?
KOVACHEV: The Russian telecom industry is poised for tremendous growth. The penetration by the telecom market in that country is only about 10% as a whole — even in Moscow it’s only about 40%, and in St. Petersburg, 25%. My top Russian mobile operator stock is VimpelCom (VIP) — revenue and profits are flourishing for this company, and there is so much more room for them to grow, especially in the Russian provinces. We also like Mobile Telesystems, where we keep a smaller position.
S&P: When do you sell a stock?
KOVACHEV: We will most typically sell when we forecast decelerating growth for a company.
S&P: What is your portfolio turnover rate?
KOVACHEV: In 2001, it was over 500%; this year we have reduced it to about 300%. Our high turnover rate reflects the extreme volatility of European stocks markets. Hedge funds have been particularly active here in Europe. They have aggressively moved into high-performing sectors and engaged in short-selling. This has exacerbated the situation.
S&P: How has the weakening U.S. dollar affected European stocks?
KOVACHEV: The faltering U.S. dollar and the stronger euro has particularly hurt the big European multinational companies, which depend much on exports to the U.S. However, the weak dollar has clearly helped European firms who focus on local markets and derive most of their revenues in euros.
Another aspect of the weakening U.S. dollar is that is has attracted American investors into European markets — they are making quick profits as a result of the dollar falling against the euro.
S&P: What is your outlook on Europe for 2003?
KOVACHEV: We are more bullish on Eastern Europe, but somewhat cautious on Western Europe. Many are hoping that The European Central Bank will take the necessary step of cutting interest rates later this year, following the lead of the U.S. Federal Reserve. However, we feel that once the American economy and stock market rebounds, Europe will likely follow suit.