I recently spoke to the head of one of the largest financial funds active in Central Europe, who thought that Central Europe was in a state of denial, not recognizing that we are in the midst of a global financial crisis, with sellers generally still asking unrealistically high prices for companies, assets and real estate (hence offering correspondingly low returns).
Why should I be satisfied with a 9 percent yield on real estate in Central Europe, when I can achieve a 13 percent (unleveraged) yield on real estate in the UK? Or why should I buy companies at relatively low yields in Central Europe when I can generate an 18 percent (government guaranteed!) yield on a PPP (Public Private Partnership) project in Western Europe? If there are bargains in Western Europe, why shop in Central Europe?
The question of equity risk premium appropriate for Central Europe is a topic that every serious investor in the region, along with potential sellers of assets, must be pondering. We are in the midst of a financial crisis where the world is still undergoing large-scale deleveraging (e.g. declining volumes of debt financing). Credit default swap rates for government debt remain high, particularly for those countries with large fiscal deficits and external trade imbalances. Owners of assets, whether companies or real estate, often choose to “hold,” rather than sell significantly below prices of a year or two ago.
Equity investment in Central Europe has always entailed additional risk compared with North America or Western Europe. This is due to additional factors such as comparatively weaker government institutions, more opaque financial accounts, less transparency, corporate governance and currency risks, etc.
Prior to tackling the issue of equity risk premiums in Central Europe, it needs to be understood that the financial crisis is a global phenomenon affecting more than just the region. For example the United States is also a riskier place to invest than a year or two ago; as the least risky country in the world, risk premiums of other countries are often benchmarked against it.
Due to the scale of difference in economic performance of the countries within the region, the perceived equity risk premium should be viewed separately for each country, rather than assuming a single homogeneous rate for the region. It is quite clear, for example, that Hungary, with its homegrown malaise (its enduring and very sizable twin budget and current account deficits), will present a higher risk compared with Slovenia which has lower deficits and has mitigated its currency risk by adopting the Euro.
Source: Damodaran Online
The above chart assumes that revenues in each country may be generated in U.S. Dollars. Where income streams are generated in local currency, the risk premium would need to be even higher.
It is striking that the relative risk of each of the above countries vis- à -vis the U.S. has increased over the past two years. This is evidence of the so-called flight to quality effect. The above numbers should not be applied blindly to all companies, but should take into account company-specific matters: for example, a Central European company earning the majority of its revenues from exports to the U.S. or Western Europe would have a lower premium than one generating earnings locally.
In short, risk premiums for Central Europe have increased substantially over the past two years and may well come down again when confidence returns to global financial markets. This may represent an excellent buying opportunity, as risk premiums tend to rise or even overshoot during turbulent financial markets.
To answer the financial investor quoted at the beginning of the column, he should not compare the pricing of distressed assets in Western Europe to non-distressed assets in Central Europe.
If, however, there are enough distressed assets snapped up by investors in Western Europe at bargain prices, this may sap funds from Central Europe, driving yields up and prices down. A market always requires two protagonists: buyers and sellers.