Central and eastern Europe: the new 'tiger' economies?
Today's Trivia Question:
Which country has a larger trade surplus, China, or Russia?

In this issue, I'll examine the surprising investment merits of Central and Eastern Europe. My clients know of my special experience in foreign markets, where there are tremendous variations in value. For example, in the late 80's, Japanese stocks were grossly overpriced, with average Price Earnings Ratios of 70 times, while Hong Stocks were very cheap, at 5 times earnings. In the 90's, Japanese shares fell 80%, while Hong Kong shares quintupled. It pays to be invested in the right country at the right time!

What country are you invested in? I'd guess predominantly in North America. Unfortunately, North American stocks are now valued at about 30 times last years' earnings. To my mind, there are just far better opportunities elsewhere. And I'm not alone. Warren Buffett is considered the world's greatest investor, and the second richest person in the world. Manulife Securities Incorporated Hathaway holds over $16 billion in cash. Buffett can't find great bargains in North America. Last year, he began investing internationally for the first time in his life. So where should you invest?

I'd suggest you take a careful look at Central and Eastern Europe - Poland, Hungary, the Czech Republic, Slovenia, Slovakia, Russia, and the Baltic states. You probably haven't considered investing there before, but I have done so for several years, and I suspect that soon, investing in Eastern Europe will be as commonplace as investing in France, Germany, or the UK. Right now, though, most investors don't know the region well enough to invest. That's tremendously good news, because - listen carefully - it is in the very process of an investment transforming itself from the unknown and foreign to the known and commonplace that spectacular gains can be made.

For a decade, the countries known as either Eastern or Central Europe have engaged in painful reforms designed to modernize their post-communist economies. Poland, eschewing a gradual approach, implemented the Balcerowicz Plan in 1990, best described as radical economic shock therapy without anaesthetic. Wages were moderated, the Zloty devalued, credit tightened, capital markets created, and price and import controls lifted. Poles decided to get the economic pain over with quickly rather than drag it out. (Japan took a slow approach to its problems, and suffered for a decade.)

Unemployment and inflation in Poland soared initially. Inefficient state-controlled enterprises had to be shut down. There were many painful ramifications of the transition to a free economy. But markets eventually began to function, private enterprise sprang up, inflation subsided, and, most importantly, investment began to pour in.

And not just in Poland. Throughout Eastern Europe, foreign investors noted that a skilled workforce, with wages about 30% that of Western Europe, proximity to the huge European Market, and a growing domestic market, was a recipe for industrial success.

"Car industry investment has been a success story across much of post-communist Central Europe. Volkswagen is the top exporter from Slovakia, the Czech Republic, and Hungary. Fiat and Daewoo are the biggest foreign investors in Polish manufacturing industry. The main attraction for investors has been the combination of low wage rates and guaranteed access to European Union markets. The countries of Central Europe will join the EU in May."

The Economist, March 6th 2004

EU membership will bring many benefits: market access, new investment, harmonization of taxes and accounting, and access to aid packages. For recent EU entrants - Spain, Portugal, and Ireland - the pattern is one of rapid convergence with the EU. Spain had an economy about Poland's size prior to joining the EU in 1986 - now, it's twice as big.

Are there any problems in Eastern Europe? Of course! Farming is inefficient, with price-distorting subsidies, and entrenched interests. There's a history of corruption, and bureaucratic roadblocks. However, the trend is improving. Economic figures are surprisingly good: Polish inflation is 1.6%. Russia, the world's largest oil producer, has a trade surplus of $60 billion; China's is $18 billion. Commenting on corruption in foreign countries, Jean Marie Evaillard, a respected international fund manager, said this:

"I do not understand the reluctance of American investors to invest outside the U.S. Haven't the past few years revealed tremendous scandals, accounting fraud and even worse than accounting fraud, accounting tricks - I mean intellectual dishonesty - and more among a great number of American companies? So what's to fear outside the U.S. ain't going to be worse than what we've seen inside the U.S. for the past three years…"

Interview by Barbara Kollmeyer, CBS.MARKETWATCH.COM, July 6, 2003

In the 90's, there was great investment interest in the Asian 'Tigers' - Singapore, Hong Kong, Taiwan, Korea, Thailand, and Malaysia. What they lacked was close proximity to their main markets. Poland and Germany are neighbours, like Ontario and Michigan. As the auto industry flourishes on both sides of our borders, so too in Eastern Europe.

What about valuations? As usual, investors fear that which they are unfamiliar with. Price/Earnings Ratios in Eastern Europe average 12 - 14X, half that of Western Europe and North America. Growth is forecast at 5% per year over the next decade - twice Europe's expected growth. So you have twice the growth at half the price.

Call me today to learn more about investing in Central and Eastern Europe, and other international areas. I have over 15 years experience in the financial services industry, both in Canada, and overseas in Singapore and London. Together we can discuss the potential merits and suitability for your portfolio.

Sincerely,

Scott Swallow, HBA, MBA, CIM