The Other Europe Plays Catch-Up

Central European equities could soar as countries there gear up to join the EU. Plus, how to get exposure to the region.
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Convergence plays.

That's the catch phrase for investors trying to make money off Central European countries "converging" into the

European Union

.

Hungary, Poland, the Czech Republic, Slovenia and Estonia are the five countries from the region first in line to join the EU.

Long seen as nations held back by their communist pasts, these five have all made great progress since 1989 -- in building democracy, freeing up their economies and shaking off associations to ailing Russia.

So why the excitement over their joining the EU? Just look at the equity returns for other recent convergence plays like Finland, Spain and Portugal, which are scheduled to adopt the euro in January.

The lower interest rates and greater fiscal discipline that come with being part of the single currency have helped equities in Finland soar 158% in dollar terms from the beginning of 1997 to the end of November this year, according to the

MSCI

index for the country.

Spain and Portugal climbed 101% and 81%, respectively, over the same period, according to MSCI, while Greece, scheduled to join the eurozone in 2001, has seen its stock market rocket 68% this year alone.

Unsurprisingly, return-hungry fund managers are stock-picking among Central Europe's "EU-5" and beginning to add on to blue-chip holdings in the region, much as they did in Spain 10 years ago.

Even better, it's still early in the game. These markets are still recovering from the collapse of Russia and trade at just 7 to 10 times 1999 earnings (see chart).

But "the worst of the Russia scare is over," says Drew Collins, a money manager overseeing five

Federated Investors

international funds. When buying, he's adding Central and Eastern European telecoms and banking stocks to Federated's international funds invested in the region.

But the convergence will not be without its bumps. Not all of these countries may make it as early as 2002, the year in which the optimists hope most of the five will accede to the EU.

Countries joining the EU have to comply with a range of economic, legal, political and environmental requirements aimed at making them compatible with nations already in the club. Each of the five will have trouble complying with all of these membership rules. In particular, all fall short on exchange-rate, interest-rate and environmental criteria.

Hungary's government has yet to do the necessary fiscal belt-tightening. The Czech Republic still has a weak banking sector, and its large industrial enterprises still need a lot of restructuring. Poland needs to speed up its privatization program.

Nevertheless, some are expected to join before others. The consensus holds that Hungary and Poland will likely join together in 2002, the Czech Republic in 2003 and Slovenia and Estonia in 2005.

Of course, investors want the five to join the single currency soon after getting into the EU, as it would radically reduce foreign-exchange risk for outside investors and attract further capital.

Pundits expect Poland, Hungary and the Czech Republic to join EMU roughly two to four years after being accepted into the EU, assuming they all enter by 2003.

One other threat to the EU-5 has cropped up very recently. Left-leaning Western Europe's leaders, worried chiefly about a massive influx of cheap labor from Eastern Europe, may try to push back the entry date.

"There have been some negative signs from the new political order in Germany, a certain unwillingness to specify a target date" for new members, says

Flemings

equity strategist John Orford, referring to the recently elected government of Chancellor

Gerhard Schroeder

.

At the end of November, Schroeder cautioned against hasty eastward expansion of the European Union, adding the EU shouldn't set deadlines for enlargement. "That has annoyed the EU-5 countries, especially Hungary," says Orford, particularly since Germany will hold the EU presidency next.

But, despite mutterings about postponement from Europe's new leaders, the Central Europeans have their feet too far in the door to be left out of the EU for long.

So, if you are convinced, how might you play convergence?

Unfortunately, there's hardly any U.S.-listed Central European stocks. But one does stand out: Hungary's telecom behemoth

Matav

(MTA)

.

Investors tend to buy a country's dominant telecoms as a proxy for that nation. This has certainly been the case with

Portugal Telecom

(PT) - Get Report

, which has risen 117% since the beginning of 1996.

Another route is through

New York Stock Exchange

-listed closed-end or mutual funds.

Four closed-end funds offer exposure to Central Europe, but only two --

Central European Value Fund

(CRF) - Get Report

and

Central European Equity Fund

(CEE) - Get Report

-- are essentially "Russia-free," according to

Everen Securities

analyst Mariana Bush.

According to the latest filings, the first fund is heavily weighted to the Czech Republic and the second is heavily weighted to Germany.

The closed-end

AIM Eastern Europe

(GTF)

fund is heavily weighted to Hungary, but it also still has some Russia exposure.

Morgan Stanley Russia & New Europe Fund

(RNE)

had the largest allocation to Russia.

And mutual fund investors have the

(VEEEX)

Vontobel Eastern European Equity fund and the

(EUROX) - Get Report

US Global Regent East Europe fund, neither of which had more than a tiny portion of its portfolio in Russian assets.

A word of caution, though: Central European markets, despite the growing stability of the region, are still highly volatile -- and will probably remain sensitive to developments in Russia.

In August and September this year, when shock waves from the Russian devaluation and default were at their strongest, the

MSCI Emerging Europe and Middle East

index lost 35% of its dollar value.

But Central Europe is looking less and less like the old Eastern Bloc and more and more like the EU. It may be time to pour a healthy shot of slivovitz and plunge in.

This story was originally published on Dec. 10.