Fundamentals of emerging markets remain healthy

ARKET corrections can be sudden and painful, but they should not distract investors from the bigger picture. While Europe's emerging markets have been hurt by higher volatility in recent weeks, the fundamentals underpinning stock market valuations in countries such as Russia, Poland and Hungary have not changed in any way.

Markets may have become more volatile in the short term, but the investment case for Eastern European and Russian stock markets is, in our view, as strong as ever.

The most important point we would stress is that even after several years of strong equity market returns, stocks in Russia and many parts of Eastern Europe still look reasonably priced, because of strong earnings growth. In Russia, the market is currently priced at about 10.3 times profit forecasts for 2007, compared with about 15.6 times for emerging markets as a whole and about 14.9 times for global developed markets.

One myth we are keen to dispel about Russia is that it is merely a petro-economy. Russia's huge natural resources certainly make up a significant portion of its exports, but the most important driver of economic growth now is domestic demand in areas such as household consumption, construction and infrastructure investment.

Oil and gas have certainly helped the Russian economy evolve rapidly in the post-Communist era, but their actual impact on economic growth is limited by the fact that 85% of every dollar made by oil companies over $40 a barrel is taxed away and the majority of the money raised from this is put into a stabilisation fund, which currently stands at around $104bn. This ring-fenced fund is essentially a rainy day fund and is a source of stability and confidence in the Russian economy, but it is not a driver of stock market returns.

While we do hold stocks in the oil and gas sector that meet our strict investment criteria, such as Gazprom (the world's largest gas producer) and Lukoil (Russia's largest oil producer), our Russian holdings are focused on stocks that are well placed to capture growth in domestic demand. Sberbank, for example, is by far the largest bank in Russia and is in an excellent position to benefit from growth in financial services such as mortgages and credit cards. Consumer loans currently stand at only about 5% of GDP, compared with 14% in the Czech Republic or 98% in the UK; so this has the potential to become a very significant market.

In Eastern Europe, our current preferences are for stocks listed mainly in Poland, Hungary, Austria, Turkey and the Czech Republic, though we do also hold small positions in countries such as Kazakhstan and Romania.

Again, valuations in these countries are attractive, all the more so given the recent market correction.

Their investment story is different to Russia. Membership of the EU is having a dramatic impact on recent entrants. Many countries in the region will benefit from EU development funds over the next five years. Between 2007 and 2013, EU development fund disbursements will total €60bn for Poland, €24bn for the Czech Republic and €22bn for Hungary.

Agricultural funds could double these figures. The EU estimates that structural funds will increase GDP by 7%-12% by 2013. Falling interest rates are also spurring domestic demand in a number of countries, most notably Poland, where retail sales, for example, increased on average 13% in 2006, a result of interest rates falling from 20% six years ago to 4% now.

A further benefit for these countries lies in their proximity to western European markets. 'Nearshoring' - outsourcing to locations close to home - is a rapidly growing trend among European companies looking to benefit from the region's low taxes and flexible, highly qualified and much cheaper labour forces.

For investors looking to access this growth, there are various approaches. In the UK, there are unit trusts that specialise in this region and you can typically invest in them with lump sums of between £500 and £1,000 or set up a regular savings scheme for a minimum of £50 to £100 a month.

Our portfolios tend to be run with relatively few holdings, but this is the way we endeavour to ensure that we only hold the very best companies operating across the region. The way we see it, there are some great companies operating in Eastern Europe at a time when most economies are powering ahead and stock markets are looking very good value.

Source: By Elena Shaftan, business.scotsman.com