Oct. 4, 2004 — Unlike most funds that invest in the nascent markets of Eastern Europe, the T Rowe Price Emerging Europe & Mediterranean Fund (TREMX) includes such outlying countries as Turkey, Egypt and Israel in its mandate. London-based Christopher Alderson and his team of six analysts invest in stocks of these regional companies, regardless of market-cap size, using a bottom-up, growth-at-a-reasonable-price (GARP) methodology.

Alderson has delivered impressive returns during his tenure. For the one-year period through August 31, the fund gained 28.9%, versus 25.5% for the average emerging markets stock fund. For the three-year period, the fund climbed 28.0% annualized, versus 16.1% for its peer group. In short, this portfolio has beamed as developing markets in the regions it invests in were strong in 2003.

However, investing in emerging markets is tricky, with high volatility and questionable liquidity more the norm than the exception. To illustrate the volatile nature of these markets, consider that the portfolio is up 2.7% year-to-date through August 31, after soaring 69.2% in calendar 2003, and rising a tepid 3.7% in 2002. The variability of returns among emerging markets funds, generally, means that they should be approached with caution.

Alderson says he seeks to control risk by keeping a concentrated portfolio of his ‘best ideas’ generated from in-house research and meetings with company managements. The fund currently has only 33 positions out of a universe of investible stocks that numbers around 250. Highly concentrated offerings, however, can carry a lot more risk. It should be noted that the fund is more volatile than its peer group based on its higher three-year standard deviation.

As of August 31, the fund’s top ten holdings are Lukoil, the Russian oil giant, 10.5%; Teva Pharmaceutical Industries Ltd. (TEVA), an Israeli drugmaker, 9.2%; AO VimpelCom, a Russian wireless telecommunications provider, 5.1%; Bank Hapoalim, an Israeli bank, 4.9%; Orascom Construction Industries, an Egyptian building contractor, 4.6%; Mobile TeleSystems OJSC (MBT), a Russian mobile cellular firm, 4.5%; PetroKazakhstan Inc. (PKZ), a Kazakh oil and gas company, 4.4%; Orascom Telecom Holding, an Egyptian telecommunications firm, 4.3%; MMC Norilsk Nickel, a Russian mining concern, 4.1%; and Makhteshim-Agan Industries Ltd., an Israeli agrochemicals business, 3.5%. These ten stocks represented more than 55% of the fund’s total assets.

As of August 31, the fund’s top sectors are telecommunication services, 21.9%; financials, 19.8%; energy, 17.7%; information technology, 10.3%; health care, 10.2%; materials, 7.6%; industrials and business services, 4.6%; consumer discretionary, 3.3%; and consumer staples, 1.4%.

The countries Alderson can invest in present a variety of economies in various stages of development. Israel and Russia currently dominate the fund, accounting for 32% and 27%, respectively, of the its assets as of August 31. However, Alderson is quick to move money around if he sees better opportunities. Indeed, one year ago, Russia (36.6%) and Turkey (23.1%) owned the lion’s share of the fund’s assets.

Alderson’s exposure to Israel has more than doubled over the past year. The country is enjoying a boom in the domestic economy, despite the pervasive threats of political chaos and terrorism. An “emerging market” in name only, Israel boasts an array of well-run companies, particularly in the high-tech sector. Given that many Israeli stocks are dual-listed on NASDAQ, corporate governance is impeccable here.

The stock markets of the former Soviet Union have been the crown jewel of emerging markets in recent years. High demand and high prices for commodities, particularly oil, have turned into gold for Russian equities. But this year, things soured when the oil behemoth Yukos nearly collapsed under the weight of a massive multi-billion tax bill and an ongoing conflict between company officials and Russian President Vladimir Putin. Yukos is now on the brink of bankruptcy as its former chairman, Mikhail Khodorovsky, languishes in prison.

Despite all the turmoil, Yukos was one of the fund’s top holdings as recently as June 30, when it accounted for 7.4% of its total assets. Alderson disposed of the stock entirely thereafter, and concedes it was a “mistake” to hold onto it for so long. But he also points out that the oil giant’s problems are principally political in nature. The stock has plummeted nearly 75% since the start of the year, despite historic high crude oil prices.

Alderson also notes that there has not been any appreciable negative spillover effect from the Yukos crisis, nor has it hurt foreign investors enthusiasm for Russian stocks. While corporate governance needs to improve, the Russian economy is humming along with a healthy account surplus and growing consumer spending power. In fact, Alderson’s top holding currently is Russian oil producer Lukoil, which makes up a sizable 10.5% of the fund’s assets. Lukoil is such an attractive company that ConocoPhillips (COP) is reportedly seeking to acquire a stake in it, and enter into a strategic partnership.

Alderson currently has zero exposure to the dynamic Central European markets of Hungary and Poland because he feels the benefits of convergence with the European Union has already been discounted in their equity prices. The fund had about a 12% stake in these two nations a year ago. “In a sense, it’s ‘game over’ for these countries,” Alderson said. “Joining the EU and integrating into the wider European economies led directly to falling interest rates and higher stock prices. So, we took our profits there and moved our money elsewhere.”

Alderson is particularly bullish on Egypt, an economy largely ignored by Western investors. Cairo’s stock exchange is surging, recently ascending to an all-time high, buoyed by the government’s privatization program, cuts in customs tariffs and tax reform. Alderson has hiked his exposure in Egypt from 2.2% in August 2003 to nearly 15% currently.

While Alderson is also generally bullish on Turkey, he has reduced his stake there by more than half over the past year, taking profits along the way. Economic fundamentals remain surprisingly strong in Turkey, a nation long accustomed to political and economic crises. The country’s economy is growing every year, inflation is moderate, and foreign investment is strengthening. Although interest rates remain high — in the 20% range — they have been falling from a peak of about 44% just two years ago.

Turkey presents a long-term, growth story: The country is poised to benefit tremendously from possible convergence with the European Union. But, due primarily to political and cultural barriers, Turkey’s membership in the EU may be a long way off, perhaps as much as ten years, Alderson estimates. Another major risk is that rising interest rates in the U.S. and tightening global liquidity may imperil the financial stability of deeply indebted economies like Turkey.

Contact Bob Keane with questions or comments at: bkeane@investmentadvisor.com.