European convergence

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Eastern European stock exchanges have soared ahead in the past few years. However, we believe that they still offer good long-term potential, thanks to the beneficial impact of European convergence. This does not only apply to the countries that joined the EU last year, but also future applicants and neighbouring countries. We established our new fund, PAM Equities European Convergence, to invest in these regions in a balanced and diversified manner. It should, of course, be remembered that greater risks are entailed in this fund which may therefore fluctuate more widely than other European equity funds.
Over the last 10 years, economic growth in eastern European countries has been higher than that of the EU, with the exception of 1999 following the Russian crisis. This is easily explained by the rapprochement and, for some countries, the recent integration into the EU, as well as the general improvement in the key macro-economic indicators. Clearly, not all fears have dissipated.
However, there is every indication at this stage, that there have been structural improvements in a good many of these countries. Their wealth, expressed in terms of gross domestic product (GDP) per capita is currently fairly low. However, with higher growth, the long-term trend should converge with the EU average.
Consensus forecasts seem to us realistic given that this growth can be attributed to strong internal demand and not to more random export-driven performances. It is clear that the standard of living in all these countries is significantly lower than in our own and that many of their needs which could not be met in the past will be met increasingly in the future.
This is why, in spite of the generally accepted view, the EU stands to benefit from this integration since we export more to these countries than they export to us. This phenomenon is not likely to be reversed for several years.
However, their trade deficits must continue to be financed if serious economic problems are to be avoided; we believe that this situation will continue without too many difficulties in coming years. Cheap labour and a particularly favourable tax environment are powerful incentives for European investors.
In addition, numerous European companies will continue to make acquisitions in these countries where the markets are more buoyant than our own. Recent examples abound, not least of which is the recent acquisition of a Turkish bank by Fortis.

The objective of PAM Equities European Convergence is therefore to take advantage of European convergence. What does this mean in concrete terms? What countries are taken into consideration? We take two elements into account:
q Geography: the country must be situated in Europe, in the broadest sense;
q Economics: the country must be in the process of economic convergence with the EU. We shall explain this below.
Unlike other continents, Europe has no clear natural borders and therefore its limits cannot always be precisely defined in international law. Where exactly is the border with Asia?
In order to establish a clear and precise framework, we have chosen to refer to the definition given by the Council of Europe in Recommendation no 1247 on the process of enlargement. Europe is therefore also open to states whose national territory lies wholly or partly in Europe and neighbouring countries that for cultural or historical reasons can be deemed to form part of the same geographic or economic unit, for example, central Asian countries or those around the Mediterranean basin.
By this, we mean that an economy, starting from a lower base, draws closer to the average for the 15 EU member states (ie, those that were already members prior to the enlargement of May 2004). We use the GDP per capita as a criterion on the basis of the parity of purchasing power and the growth of the GDP. We invest solely in European countries in which the GDP per capita is at least 15% below the average for the EU 15 and whose growth is higher than the EU 15 average. (See figure).
Based on the criteria set out above, the list of eligible countries comprises all the member states of the Council of the Europe that meet the prerequisite (GDP/cap), namely: the ten new Members States of the EU, the applicant countries (the Balkans and Turkey), Russia, Ukraine but also, and perhaps more surprisingly, Greece.
The inclusion of Greece is one of the unique features of the fund and one of its assets. It significantly increases the size of the investment zone which, if restricted to only the 10 new members, would be too limited.
Furthermore, Greece improves the risk profile: better quality of corporate management and greater liquidity for securities. In addition, this gives us access indirectly to the Balkans. Indeed, Greek companies overall have a significant presence in these markets. However, it is very difficult to invest there directly at the moment, due to the almost total absence of listed companies.

Another unique feature of the fund’s strategy is is its flexibility. Depending on political and economic developments, we will also be able to invest, in the long term, in neighbouring countries, such as Egypt or Kazakhstan, although they are not a priority in the short term.
Russia? Yes, but to a limited extent.
As regards the composition of the portfolio, unlike most other funds that are active in this zone, we do not follow any particular index. In most eastern European stock market indexes, Russian securities are given a weighting of over 40% which, we believe, leads to higher risk. The Russian index is essentially made up of shares linked to raw materials: gas, oil, steel, etc. Investors are subject to the vagaries of oil prices which, although currently very favourable, tend to be cyclic in nature.
Strictly speaking, it is therefore very difficult to speculate on the convergence process by buying Russian shares. In addition to this, this country’s domestic policy does not always respect shareholders interests, as the recent Yukos affair shows. This is why we will limit the weighting given to Russia in PAM Equities European Convergence to 10-15%.
Some countries have virtually no stock market as yet. It is, however, now possible to invest in such countries through high yield bonds. A country like Turkey, which is in the process of disinflation, still offers very high yields on its government bonds (currently approximately 15%). In order to improve the risk-return ratio, the fund will be able to invest up to 20% in bonds.
The process of convergence applies to many aspects of everyday life. Consumers in these countries still spend very much less than we do on healthcare, food (less sophisticated products, poorer quality) and telecommunications (extent of mobile telephone penetration still very poor in some countries), etc.
We will therefore have a strong presence in these sectors but the emphasis will, however, always be placed primarily on financial services. Their extremely rapid development will facilitate access to property, made difficult or if not impossible by the underdeveloped mortgage market. In general, they will also have a positive impact on consumption (credit cards) and the local economy (construction).
Bertrand Veraghaenne is head of buy-side research at Petercam Institutional Asset Management in Brussels

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