No smoke without fire in Hungary, says Charlemagne Capital

Stefan Herz is a portfolio adviser at London-based Charlemagne Capital, where he has been since September 2004. He advises on the $220 million Manulife Global Fund Emerging Eastern Europe Fund, a long-only fund that is entirely distributed in Asia, mostly ($193 million) in Hong Kong.

Herz previously spent 11 years as an analyst, most recently at brokerage Bryan Garnier & Co and including eight years at Dresdner Kleinwort Wasserstein, where his focus was on emerging markets.

After gaining 95.4% in 2009, the MGF Emerging Eastern Europe Fund is down 7.95% for the five months to May 31, amid a difficult market environment in Europe. (Russia/Eastern Europe hedge funds, for example,were down 7.75% in May alone, according to Singapore-based Eurekahedge.)

Your fund has presumably been affected by the turmoil surrounding European sovereign debt -- can you talk about to what extent?
In terms of inflows and outflows, the fund's been pretty stable over the past few months, with no significant outflows at all. Ultimately, performance was very strong in 2009 and in the first quarter of 2010. I don't think the setback we're seeing now is sufficient to spook investors yet.

But your clients must be concerned about the eurozone sovereign debt issues -- to what extent and is that concern justified?
There's obviously a big concern -- the big issue is whether there's going to be a lot of contagion from what's happening in the eurozone into Eastern Europe. With the Hungarian comments over the past few days, investors are clearly concerned, and we spend a lot of time pointing out to them they should look at the fundamentals. [Local officials in Hungary last week made suggestions that a debt crisis could be looming in the country.] 

Eastern Europe is fundamentally in a much stronger position than the eurozone countries. The debt levels -- sovereign or private -- are signify lower than in eurozone. To give you some examples, government debt as a percentage of GDP in Russia is 7%, Turkey 46%, the Czech Republic 36%. That compares to levels of 110% in Greece and 85% in Portugal, for example.

So there's no issue with indebtedness [in Eastern Europe], the banking systems in most of the countries we invest in are very solid, they have very little exposure to eurozone sovereign debt, particularly the main markets if you look at Turkey and Russia. We continue to see relatively strong loan growth and low NPL [non-performing loan] levels in these markets. 

If anything, this crisis highlights the strength of Eastern Europe and its economy and the strength of the investment case of the region.

In spite of the comments last week by Hungarian officials about a potential debt crisis? That hasn't helped, presumably?
No, it hasn't helped. If you read the papers today, they're realising they were really rather foolish. It was one guy who made a comment, and very quickly the rest of the government distanced itself from these comments. If you look at the fact there's an IMF package in place, and Hungary's debt numbers relative to Greece, it's not in a Greek situation, that's obvious.

I think the comments were politically motivated; maybe there was some attempt to shift more blame onto the previous administration.

But there's usually no smoke without fire -- surely there must be some concern that major problems could surface in Hungary?
Obviously this is not a time to be complacent, and Hungary has the highest debt levels of any of the East European countries, leaving aside the Balkans, such as Bulgaria and Romania, which are not really part of our investment universe.

The other thing that distinguishes Hungary is that there's a lot of foreign-currency debt within the private sector. A lot of Hungarians took out Swiss franc mortgages, so the private individual is much more exposed to currency weakness than in most of the other countries in the region.

So [government officials] have to be careful not to undermine the currency any further, because further weakness is clearly going to have an immediate and significant impact on the private sector's ability to service that foreign-denominated debt.

That's also been one of the big issues in terms of not being able to reduce interest rates maybe as much as they should have to stimulate economic recovery, because they had to keep an eye on the currency. That's a hangover from the good old days when nobody thought we were going to see the currency volatility we've seen over the past couple of years or so. But in the Czech Republic and Russia, for example, that's much less of an issue.

So, as you say, there's no smoke without fire, but we have to keep it in perspective. Hungary is very small in terms of the European region, so even if things were to deteriorate in the country, I don't think there'd be a significant direct economic impact on the rest of Eastern Europe.

How have you re-allocated/repositioned the portfolio as a result of the debt turmoil, or how do you plan to do so?
It's been more tweaks than major changes. It's important to remember our process here -- we're very much bottom-up stock-pickers; we don't asset-allocate or market-time. We think that in emerging markets, the only way to exploit inefficiencies that still exist in these markets is to do that. As a result, we don't tend to make major changes in portfolio to reflect shorter-term market concerns.

Of course, as things like the Greek situation unfold, we see more currency volatility, more currency estimates changing, more consensus forecasts on commodity forecasts change, these obviously feed into our valuation models, and on the back of that we may see some changes coming through in the portfolio. But we haven't seen any significant changes really on the back of this [situation].

Hungary has been a very small part of the portfolio anyway -- historically it's about 3% of the fund. We have some exposure to Matav, the Hungarian telecoms company, which we're very happy with because it's a strong dividend-paying stock -- with a dividend yield of over 10%. It's actually proving to be relatively defensive in the current environment.

We've also hold some of OTP, the leading Hungarian bank, which we think has been over-punished now. It has suffered a lot because it's been used as a proxy for the market, but we think that's been overdone.

So you haven't reduced your holding in OTP?
No. We had a good look at it last week and felt that at current levels there was no need to reduce our holding. Until the last few weeks, Hungary has actually been a pretty good market. We had the change of government [with prime minister Viktor Orban coming to power in late May], which everyone was very excited about.

Ultimately, the current focus on Central and Eastern Europe in the media does not reflect the reality of investing in the region.

The big story continues to be Russia and Turkey; it's been the large number of IPOs coming out of Russia and to some extent out of Poland. If you think what's happened in central and Eastern Europe in the past 10 years, Czech and Hungary have become very marginalised markets. There are very few stocks that are investable in these markets. They've really been marginalised as equity markets in the region.