Betting on Europe's Emerging Markets

Soeren Rytoft, a top strategist for Metzler/Payden Funds, points out that the expanded EU will outstrip the U.S. in GDP and population

As many equity markets across the globe swooned in March, Eastern Europe weathered the turbulence fairly well, says Soeren Rytoft, the lead strategist for European and international equity portfolios for Los Angeles-based Metzler/Payden Funds. Rytoft, who was born in Copenhagen and came to the U.S. in 2002, says some of the emerging markets in Eastern Europe, particularly Russia, have been performing better than the U.S. and mainland Europe thanks to surging oil and commodities prices.

Through Feb. 29, the Metzler/Payden European Emerging Markets Fund rose 11.2% year-to-date, and surged 67.9% in the last 12 months. BusinessWeek Online's Karyn McCormack recently spoke with Rytoft about his investing approach. Edited excerpts from their conversation follow:

Q: How have the European markets been performing vs. the U.S.?

A:

The European markets performed very well last year -- better than the U.S. Performances were helped not only by good equity performance but also by the strong performance of the euro vs. the dollar. The euro appreciated something like 17% vs. the dollar during 2003.

Q: How have the markets fared so far this year?

A:

We had a downturn in the market starting in mid-March. First, we got some job reports from the U.S. that sparked a bit of concern about the recovery of global economies. And then we had the bombing in Madrid. Investors started looking more for defensive investments, such as fixed income or more defensive equity sectors. The markets found a bottom on Mar. 24 and have started to climb back in the last three days. European markets had been doing better than the U.S. since the beginning of the year, but the returns are not as high now.

One positive exception is the Eastern European emerging markets. Our European emerging markets fund didn't see any downturn. The reason is very high prices for high and raw materials.

Q: Which countries do you favor most?

A:

The emerging markets in Europe. It's no more than 14 years ago since borders opened to Eastern Europe with the Berlin Wall coming down. It's a very exciting time for these countries.

Q: You oversee five European equity funds. Tell me about the Metzler/Payden European Emerging Markets Fund and why it's doing very well.

A:

I would take the lead from what I just said about emerging markets, and stick with that. First of all, on May 1, you have 10 new countries entering the European Union. The major ones are Poland, Hungary, Czech Republic, and Slovak Republic -- and those four countries are all members of the European emerging markets.

Of course, the status of those countries will change from emerging-market to developed-market countries. It's the best condition that you can get. There's a convergence play of Eastern Europe trading at a very high discount to Western European markets -- we really see opportunities going in and buying some of these countries.

Q: Why should Europe be important for U.S. investors?

A:

First of all, the task is telling U.S. investors about diversification. Admit that you have to do diversification in your portfolio to achieve the best performance over time. So if you do diversification, Europe as a region could definitely be among the ones that you should choose. You have several other ones -- Asia, Japan, Latin America -- to choose from, but Europe could be one of the more interesting ones, based on several facts.

Q: What are those facts?

A:

First of all, you have the same quality as you buy in the U.S. If you look at U.S. stocks and European stocks, they have the same quality. It's very known names. We own known the car manufacturers, like BMW and Mercedes (DCX ), or the luxury groups like Vuitton (LVMUY ).

Also, if you look at Europe as a region, Euroland, which is the part of Europe that uses the euro as the currency, is the same size in gross domestic product as the U.S., and it's the same size in population. Now, with the extension of 10 new countries, we're going to see that the European Union is by far, larger than the U.S. It's definitely one of the only developed regions of this size that you can invest in. That's why I believe that Europe is a very important region to diversify into over time.

Also, in the economic cycle, you have seen some very good growth numbers in the U.S., and they are coming up in Europe now. So Europe seems a little bit behind, and that leaves some scope for getting additional performance in Europe.

Q: Why do you prefer Eastern Europe over other emerging markets?

A:

I would claim that the European emerging markets are by far a better quality than what you have in Asia or some of the other Latin American countries. In terms of infrastructure and closeness to the developed world of Western Europe, it by far has the best advantage right now. So we believe that the outsourcing and the foreign direct investments justifies that you can almost call this "European Asia," and that region is going to be developing vastly over the next 5 to 10 years.

Q: Why is the quality better?

A:

The regulations are similar to what we have here. Eastern Europe countries have been built on a whole new system, and very many of them are inspired by Western European countries. It's very modern. They all have electronic stock exchanges. They all have the latest technology in terms of wireless communications, etc.

You combine that with one of the best assets of the former communist world in Eastern Europe, where education was so high and people are very well-trained. At the same time, if you look at the salary levels, and if you put Western Europe as being 100, you would probably have something like 60 to 70 in the Eastern European world. So there is a significant difference, and that is probably enough to justify that you make foreign direct investments into these countries and outsource production to these countries.

Also, the sovereign debt ratings of Eastern Europe countries by the established ratings agencies are on the way up, which reiterates the better quality vs. the other emerging markets.

Q: What stocks do you like?

A:

If I stick with the emerging-market fund right now, there are two dominating countries that we're investing in. First of all is Poland. In Poland, you have a very diversified stock market, with a combination of communication stocks, financial stocks, and raw material stocks.

Russia is much more dominated by energy, due to the oil and gas resources. So as long as you have the oil price hovering around $30 a barrel or even higher, then you have Russian energy companies making a lot of money. Companies like Lukoil and Gazprom are attractive now. We are invested in the major oil and gas companies in Russia.

Communication companies like Vimpelcom -- that's one of the leading mobile technology producers in Russia. If you look at the penetration ratio of wireless communication in Russia, it's how it looked in Western Europe 10 years ago. So we foresee an explosion in terms of wireless penetration not only in Russia but in the entire region, and that makes all the wireless or mobile-phone companies in the region very, very interesting.

In Poland you have a communication company called Telecommunication Poltska. It's a combination of land lines and mobile technology, and it's a very important development for Poland that they can offer all these different opportunities.

One of the other ones in Poland is a company called PKN, which is the country's second-largest company. It dominates Poland's oil market with a 40% retail market share, and it's a very important company in terms of the distribution in Poland.

A raw-material company in Poland is Gropaketty. That's the largest European copper producer and actually the No. 6 in the world. Raw material prices are exploding. That's why I quoted the diversity of Poland before, saying that they have diversified, and the opportunities you have there perhaps are better than any of the other Eastern European countries.

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