lombard odier eastern european, managed by coast sullenger, looks to have 40%-50% exposure to Russian equities
Russia has proved to be one of the most volatile markets in Europe, losing 90% of its value in the aftermath of the 1998 crisis.
Even so this does not deter Coast Sullenger, manager of the Lombard Odier Eastern Europe fund, from aiming to have 40%-50% exposure to Russia in his portfolio at all times.
The market has still not reached its pre-crisis peak but in the last three years to 30 June it has returned 193.77%, against a fall in the Dow Jones Eurostoxx of 50.43%.
Besides Eastern Europe's lack of correlation to major indices such as the S&P 500 or MSCI Europe, Sullenger adds the euro convergence theme is still gathering momentum and stocks in the region remain on a significant discount to their Western peers. Moreover, the region's burgeoning gold mining industry and underdeveloped banking and telecoms sectors provide a number of potential opportunities.
The fund, a euro-denominated Luxembourg Sicav, has returned 42.58% over three years to 4 July in dollar terms, compared to an average gain of 28.89% in the Equity Europe emerging markets sector average.
Does the convergence theme for Eastern Europe still have further to run?
More and more global funds are going to get into emerging Europe, because these countries are going to join the EU. It is like southern Europe again, when Greece and Turkey benefited from convergence.
There is a lot of statistical evidence to show the enlargement process results in an increase in GDP per capita and other measurements like earnings for those countries joining. These countries are 10-30 years behind the EU's top 15 in terms of GDP per capita, so a big catch-up will take place.
So how cheap are these emerging Europe stocks?
Generally speaking, stocks are on a 40% discount on a P/E basis to the West. There is the potential for an excess return of 10% per annum for several years looking at multiples, discounted cashflow, and the markets are definitely on a 30% discount to fair value. On the road to convergence, currencies have stabilised, inflation is down and everything has improved, although not in a linear fashion.
What are the negative aspects of convergence?
It will be negative for the cost of production although this will be offset by the removal of inefficiencies and other things like currency appreciation. Bond investors and foreign direct investment (FDI) drive the currency up and the region is getting up to $10bn in FDI per annum.
Is corporate governance still a major concern for investors in the region?
It is still an issue but no more so than anywhere else, particularly when you look at what has been happening in the US and Europe. It started from a low level but has been making steady progress. Corporate governance issues are always priced into Central European stocks and particularly in Russia, which is one reason the market trades on a P/E of six to eight times. It will narrow when people realise that not everyone in the region is a crook.
You can find early stage companies are outright hostile and non-transparent, but this is often because they feel threatened about the ownership of their company. Blue chips can turn to the capital markets in most cases though, so are more PR-oriented and welcoming to foreign investors to keep them happy.
Do you stick to blue chips?
We typically run 60%-80% large caps and 20%-40% small caps, with the freedom to go up to 15% into cash. We do actively invest in small and mid caps, mostly in Russia where we find the greatest divergence between economic and market value.
They can have critical mass in terms of revenue and are profitable but have a tiny market. Liquidity can be a problem, but the upside can be tremendous.
Most of the large caps we buy are owned by strategic investors. The banking sector is over 50% owned by Western banks, for example. This is great for us because these investors typically pay a premium to pre-acquisition price, but these stocks are getting more difficult to find because there are fewer large caps that are not yet foreign-owned.
What risk controls do you employ?
The best risk control is to buy at valuations that limit downside. Some of it is intuitive, but buying stocks on low multiples and with healthy balance sheets does reduce risk. I can invest freely in stocks and sectors but maintain a diversified portfolio. I use portfolio screening tools, but am more reliant on stockpicking.
Analysis of companies is slightly easier in our universe, because goodwill is not allowed under Russian accountancy law and these are primarily fairly simple stocks operating in a single market, rather than complex conglomerates.
Besides convergence, what other themes are you following?
Gold mining is a big theme in Russia, which has the fastest growing gold mining sector at 100% per annum. The stocks are cheap, low cost producers and we think it is a good consolidation play like the oil sector has been over the last couple of years, but on a smaller scale.
Gold is also a good play on a weak dollar and the dollar will remain weak for a while to promote US exports. With these companies trading at such a discount, you are effectively buying gold at $15 per ounce, whereas it would cost you $60 per ounce in South Africa.
FUND MANAGER: Coast Sullenger
Sullenger graduated in 1991 from the University of Virginia with a degree in Foreign Affairs.
He joined Lombard Odier Darier Hentsch in 1998 as an analyst and emerging markets fund manager.
Targeting intermediary market
Represents £8trn in assets
Simplify and modernise
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