Why bulls are horning in on the Eastern Europe story

Former Soviet bloc countries provide thrills without the frills.

The countries of the former Soviet bloc are the latest recruits to the world's emerging markets and are seen by many as the most dangerous. This year they have certainly been the most exciting.

The Russian stock market rose 130 per cent in dollar terms, only to fall 40 per cent on the second presidential ballot. It is now consolidating. Such volatility is typical of Eastern European stock markets, which are tiny even by the standards of other emerging markets. The combined market capitalisation of Hungary, Poland and the Czech Republic is little more than that of Asda, Tesco and J Sainsbury. Russia can be bought for two- thirds of the value of Glaxo Wellcome.

Stock markets do not, however, reflect the size of the underlying economies and it is the economic story that bulls of the region are buying. Growth in GNP is forecast between 5 and 6 per cent over the next five years, more than double the rate forecast for developed countries.

Martin Taylor, co-manager of Baring Emerging Europe investment trust, says the only region with higher projected growth is South-east Asia, where stock markets are trading on multiples of 17 times earnings. Eastern European markets are trading at nine-and-a-half times this year's earnings and eight times next year's.

Eastern Europe has some of the strongest growth in the world, access to the vast market of the European Union and prices which are far too low relative to the decline in political risk over the past two years, he maintains.

Juergen Kirsch, co-manager of Mercury's Selected Trust Eastern European Fund, points out that unlike other emerging economies which have to make the transition from agriculture to industry, Eastern Europe has been industrialised for years. It also offers a highly educated workforce at a low price. Mr Kirsch says labour costs are just 10 to 15 per cent of those in Western Europe yet school enrolment is almost on a par.

Although viewed as one region, the markets are not the same. Poland and Hungary are most favoured as they have well developed securities legislation, minority shareholder protection and a good selection of well managed companies, particularly banks in Poland and pharmaceuticals in Hungary. The Czech economy is strong but the stock market is less popular, largely because of the way state companies were privatised by handing out tiny holdings to individual workers.

Slovakia also suffers illiquidity, but offers more attractive valuations. Russia lags well behind on most counts, including meaningful company accounts, but is stunningly cheap for those brave enough to buy.

Valuing companies is not straightforward, as Western methods are not always relevant. Nigel Yandell, East European fund manager with Hill Samuel, points out that many companies are investing heavily so profitability is low. Price-earnings multiples do not tell an investor whether a company is cheap relative to its history, as it has no free market history, he says. Of more importance are cash flow, market share, margins, quality of management and assets.

The apparent cheapness of companies in Russia is seductive. Rostelecom, the fastest growing telecoms company in the world, which produces accounts to International Accounting Standards, is trading on four times this year's earnings. Energy company Megionneftegas is priced at $3.70 per barrel of oil production against the equivalent in the West of $50.

But mistakes can still be made. Mercury admits it made a speculative investment in Star Mining in Russia, which now has a market value of pounds 700,000 against a book value of pounds 1.7m. The key is thorough in-house research and getting in early, says Mercury.

So how can adventurous private investors buy into Eastern Europe? Most global emerging markets funds devote only 5 to 10 per cent of assets to the region, although Mercury's Emerging Markets unit trust has close to 25 per cent and Abtrust's Frontier Markets unit trust expects to put about a third of its cash into Eastern Europe, with the balance in the Mediterranean and South Africa

Dedicated funds are few and far between and tend to be priced out of reach of small investors. There are a handful of investment trusts run by Baring, Fleming, Credit Suisse and Pictet as well as the single country Hungarian Investment Company, managed by John Govett. Offshore unit trusts are run by Mercury, out of Luxembourg, Schroders out of Guernsey ($10,000 minimum investment) and Hill Samuel out of Guernsey.

Track records are inevitably short. The net asset value of Mercury's fund rose 112 per cent in the first six months of this year. Baring Emerging Europe is up strongly this year, but its net asset value is only 15 per cent above launch values in January 1994, while Abtrust's Frontier Markets is up 8 per cent in eight weeks. But it is worth remembering these markets are still 40 per cent below their levels two-and-a-half years ago.

The risk factors of illiquid and volatile markets, political and economic uncertainty and currency fluctuations are lessening as communism recedes, fund managers maintain. Boris Yeltsin's win is being interpreted as a vote for reform. Mr Taylor believes the Russian economy, which has halved over the past five years, will start growing strongly from next year.

Central European countries, which went communist only after 1945, have switched their attentions from east to west, with two-thirds of exports now going to OECD countries compared with 90 per cent to Warsaw Pact countries in 1990.

Currency and inflation risks are being addressed in Central Europe by "crawling peg" devaluations, which gradually devalue the currency against a basket of European currencies and the dollar. Although still at 23 per cent in Hungary and 20 per cent in Poland, inflation is on the way down.

Capital inflows from abroad are also expected to continue. As more money is committed into dedicated funds, the destabilising effect of speculative money flows should lessen.

For longer-term investors, the potential rewards are reckoned to be high although the path is unlikely to be smooth.