Play Chinese commodity demand via Kazakhstan, says Charlemagne

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, all of which is distributed in Asia. In the second of two Q&As, he talks about why Asian investors should be looking at Eastern Europe.

Why should Asian investors consider Eastern Europe for example, when the fundamentals of emerging countries in their own region would seem significantly stronger?
The Manulife Emerging Eastern European fund is entirely distributed in Asia, with Hong Kong forming the largest part of the asset base of $220 million. For Asians, Eastern Europe is a very interesting story. If you look at the construction of the Manulife Eastern European fund, close to 50% is in Russia, close to 20% in Turkey, 5% in Kazakhstan and the rest in Eastern Europe. So it's very much a Russia-plus-Turkey story.

The Russia and Kazakhstan angle in particular is very interesting for Asian investors, because in many ways it's a derivative of the China growth story. A lot of the stocks -- many being commodity-related -- in the fund are beneficiaries of the economic growth out of China.

It makes a lot of sense for Asians to look at Eastern Europe, particularly if you consider that Chinese equity markets have not really kept up with the GDP performance of the country.

The attractions of Russia are obvious, largely as a natural resource play, but what about other Eastern European economies? For example, many feel that Eastern European economies are small, not very attractive and don't offer much potential for growth.
Kazakhstan is the market to mention here [besides Russia and Turkey]. Bulgaria and Croatia, for instance, have not really developed as equity markets. There's no liquidity there, so we don't have any investments in the Balkan region at moment. And we don't think that's likely to change -- we don't get the sense that companies are rushing to IPO in these markets.

It's the same with the Baltics: Estonia, Latvia, Lithuania. They're markets that have really disappeared off the radar screen and we have no investments there.

Russia is an exciting story, and Turkey is possibly the most exciting story in the region.

And then there's Kazakhstan, which makes up 4.8% of the fund -- this is an off-benchmark allocation, as the country's not part of the MSCI Eastern European index. Kazakhstan is interesting because of the commodity story; it's a very direct play on Chinese demand for resources across the spectrum of commodities -- oil, copper, iron ore, nickel.

We're also seeing more direct invest by China into Kazakhstan: [Chinese oil and gas company] CNPC owns 67% of PetroKazakhstan, there's a JV to build a nuclear power station, there's a joint pipeline being built down to the Caspian Sea, there was a $10 billion loan granted by China to Kazakhstan in April 2009.

So on the one hand you have the export story to China, on the other you have more FDI by China. This is the simplest way of playing the China GDP growth story in China within Eastern Europe.

Whether China grows at 7%, 8% or 9%, that's kind of marginal to the equity story we're playing here. The fact is there's a huge demand for natural resources and Kazakhstan's very well placed to take advantage of that. 

They have stocks like [exploration and production company] KazMunaiGas and Kazakhmys, the copper producer. And these companies are all listed in London, they're all very liquid investments. So this is a country that will grow in importance within the portfolio. As Kazakhstan develops as an economy, we'll see more consumer stocks come into play, meaning we can tap more into the domestic growth story as well as the China story.

To what extent would a much-talked-about potential slowdown or crash in China hurt Kazakhstan stock prices?
If you saw a very dramatic slowdown in the China growth story, then yes I would agree. But if you're talking about a slowdown for a couple of quarters or so, I'd suggest that's not going to have a significant impact.

Ultimately, in Eastern Europe and all emerging markets, you have to be there for the long term, identify the long-term stories where there's structural change, where an economy will benefit from long-term changes in the region.

So the question is whether China is going to remain one of the fastest-growing opportunities over the next few years -- if so, then Kazakhstan will continue to be a good opportunity.

Which part of the portfolio has performed the best, and why, in the past six months or so? And which do you expect to perform best in the coming six months or year, and why?
If I look at attribution, we don't really publish stock-specific contributions to the portfolio. It's been fairly broad.

But as a trend, where we've done well is that we've very much switched in Turkey more towards consumer stocks than the banks. Turkey has traditionally been a market that people play via the banks -- which make up 60% of the domestic equity market. There are some very high-quality banks -- for example, Garanti, Isbank and Akbank -- and a strong banking system and regulator.

However, we felt that at some point this year interest rates are going to move up in Turkey, probably in the third or fourth quarter; that's clearly going to hit the banks first and foremost. We also felt the valuation of the banks was no longer that attractive.

And the domestic consumption story has really been driving growth there this year. If you talk to auto and white-goods manufacturers, across the board everyone tells you the first quarter was phenomenal, and April and May have continued in the same vein, posting numbers well above what was budgeted at the start of the year.  

So the fund's very much been trying to tap into the consumption story; that's worked very well and I think we'll continue to see that working in the coming months.

Can you give me any specific examples of how you've played the consumption story?
One example would be TAV, the aviation authority in Turkey. Turkish Airlines has had some of the highest passenger growth numbers in the world; it's one of the most profitable airlines in the world. But we don't really like investing in airlines, because there are too many imponderables that are very difficult to forecast.

TAV has enabled us to play the passenger growth without taking direct exposure to Turkish Airlines. Istanbul is now a major hub, and that's being reflected in the revenue growth we're seeing from the operator. We're also seeing more and more duty-free spending -- both by outgoing and incoming passengers.

Another example is Koç Holding, the second largest conglomerate in Turkey, which gives us access to a broad range of consumer stories. It is the majority owner of Tofas, a JV car maker with Fiat, and of Ford Otosan, the Turkish Ford producer, they own Arçelik, one of the leading white good makers in the country.