Central Europe & Russia Fund (NYSE:CEE) is categorized as a non-diversified closed-end Exchange Traded Fund [ETF] and is managed by the Deutsche Bank Group. It is non-diversified as its investments are focused exclusively in Central Europe and Russia. As a Closed-end ETF [CEF], it has the characteristics of both stocks and mutual funds. It trades like a stock but like mutual funds the dividends and the realized capital gains are distributed to shareholders. The benchmark index of the fund comprises of Composite Eastern European Index [CECE] – 45%, Russian Traded Stock Index [RTX] – 45%, and the Istanbul Stock Exchange National – 30 (ISE-30).
Investment in CEE is essentially a bet on the economic prospects of Russia, Poland, Turkey, Hungary and the Czech Republic. For an understanding on how the allocation aligns with the valuations a look at the GDP growth projection, the overall market P/E ratios, and the Market-cap to GDP ratio of the countries concerned is required at the minimum. Here is a look at those parameters:
GDP growth in both Russia & Poland is projected to be in the 7% range, which makes them the leader among the countries under consideration. Turkey, and the Czech Republic are closely behind at 6%, with Hungary coming in as the damper with a 3% projected growth. All these are still below the fast pace in GDP growth set by China (11%) and India (9%). On P/E ratio basis, Czech republic is richly valued at 25, and Poland shows fair valuation with 17. Russia, Turkey, and Hungary are undervalued with P/E between 11 and 12. Market-Cap to GDP ratio is considered a good measure for evaluating a country’s market as a whole. Note that anything above 100 is considered overvaluation. Per this measure, both Poland and Turkey can be graded as being undervalued while Russia shows up as being fairly valued.
The table below summarizes CEE’s current Top Ten investment allocations along with historical comparisons:
(NITT – Not in Top 10)
(In 2003, CEE had 4.7% allocated to Yukos which was later auctioned and the assets ended up with Gazprom & Rosneft.)
The major revamp from a year-ago is the shift in allocation away from oil and gas. (Surgutneftegaz, which had accounted for 11% allocation in 2006, is no longer in the top 10 holdings). The realized funds were channeled into investments in the banking sector. There was also a minor geographical shift in allocation during this period, which was the transferring of about 5% of assets from Turkey to Poland. Compared to allocations from 4 years ago, this change can be viewed as more dramatic. Telecoms, Banks, and Oil & Gas each had accounted for about 30% in allocations then with substantial investments in Telekomunikacja Polska (11.5%), OTP Bank (8.3%), and Matav (7.8%). Many of these allocations have since then been liquidated. Geographically speaking, Poland (40%), Hungary (30%), and the Czech Republic (13%), which combined had accounted for more than 80% of the allocations back then, currently accounts for only 30% (Poland – 20%, Hungary – 5%, Czech Republic – 5%). Russia, which had accounted for only 16% of the allocations earlier, has now surged ahead to 57%.
Comparing to the benchmark (CECE-45%, RTX – 45%, ICE-30 – 10%), the Turkish allocation (10%) is very much inline. There is roughly a 10% divergence in the CECE and the Russian allocations – Russia accounts for 57% of the assets while the benchmark allocation is only 45% and CECE accounts for 30% while the benchmark allocation is 45%. This divergence is a fairly recent phenomenon within this fund. The fund had followed the benchmark, which was established in April 2003, closely in the years through 2005. The divergence happened early in 2006 and since then the allocations have been steady at those levels. Generally, such divergence occurs when the fund manager seeks benchmark out-performance by moving away from the index or if the fund plans to switch to another benchmark going forward. Given the history of CEE, it is likely that the fund will announce a new benchmark (CECE – 35%, RTX – 55%, ICE-30 – 10%) in the future.
To summarize, the shift away from oil and gas into the financial sector is very much in par with the fund manager’s stated goal to diversify into consumer sectors. Another major change for CEE was to venture more into Russia. This move is also in accordance with the fund’s long-term shift in focus to Russia that was initiated four years ago. Lastly, the withdrawal from Telecoms over the years is a result of the fund acting on the projected slow growth in that sector.
Geopolitical risks, certain systemic factors, and reliance on growth in world economy are the major risk areas encountered by stocks in the Russian and Central European markets.
The major geopolitical risk factor is the Russian election scheduled for March 9, 2008. Given the popularity of President Vladimir Putin within Russia and also that the political power base in Russia revolves around a few key people close to President Putin, it is likely for one of the Kremlin backed candidates to win the election in a landslide victory. Should this happen, the attributed risks will cease to be a cause for concern. Any other scenario can be categorized as a major political event with serious ramifications for the stock market. The political tension with the West is always a wild-card risk factor.
Low individual participation, increasing wages, liquidity issues, and poor governance are the major systemic risks. Individual participation in the stock market is still in the single digits, which is very low. Until this situation changes, global perception of the area will remain the strongest predictor of the direction of the stock market. Increase in wages will offset the profit margin of the growth industries in the areas of Technology and Outsourcing. The vulnerability of the US Dollar against the rising local currencies is another risk factor. The liquidity problems stem from concentration of market capitalization in a handful of energy related businesses and low volumes outside of the top few stocks in the energy sector. Low stock market participation along with the nascent state of the mutual fund industry, paves way for the heavy reliance on foreign volume.
Oil and gas related businesses account for about 40% of the market capitalization of the stock markets in Central Europe and Russia. Metals and Timber related businesses account for another 10%. These businesses are big suppliers to the global market place and so rely heavily on global prices for these commodities. It is no surprise that a recession in the global economy will translate directly onto these markets. The reliance is more prominent for Russia, making the impact more pronounced on the Russian stock market than Central Europe.
A new investor should pay attention to the Distribution effect and the Geopolitical factors. As the shareholders are inline for a large distribution in December, it makes sense to consider purchasing the fund after the distribution date to avoid taxes. Further, Russia has elections coming up next March and the stock market is holding back due to the associated political risk. For this reason, a prudent investor could consider entering the position as the election outcome becomes clear.
For an investor who purchased the fund sometime this year, the unrealized return is roughly in the range from –10% to 10% depending on the timing of the purchase. Maintaining status quo is indeed the best option as the short-term risks and the distribution effect are not sizeable enough to justify exiting the position.
For a long-term investor, the guiding criterion is the likelihood for out-performance in the future. Central European and Russian markets are still undervalued by most measures. As detailed above there are many risks, but the odds are low. There is no urgency in the offing to consider exiting the position.
Central Europe & Russia Fund (CEE) is trading at a significant discount to Net Asset Value (NYSE:NAV) and other funds focused in the same area. The fund has relatively low expense ratios and is one of the largest funds specializing in Central Europe and Russia. It maintains a low turnover ratio while also being aggressive in shifting allocations to growth areas as such opportunities arise. The stocks listed in the Central European and Russian markets are generally not available to US investors as they are not listed in the NYSE or Nasdaq markets. Thus, funds that specialize in those markets provide the best window to participate in the growth in those areas and CEE is a good choice.