Q:  How many investable companies are there in Eastern Europe?

A: I think that the number of listed companies exceeds 3,000. There was massive privatization in the middle and the late 90’s in all the countries, but many of the companies have very small free flow and we do not follow them.

The biggest liquidity is in Russia and Turkey because of a couple of large-cap companies and many mid-cap companies. In Central Europe, Poland is relatively liquid, but even in the WIG20 Index, which represents the 20 largest stocks, some companies would be considered small and micro-caps on a global scale. And Poland is among the biggest markets in the region.

In Hungary and the Czech Republic, there are probably only five to seven names with sufficient liquidity; the situation is similar in Romania and Bulgaria. In smaller markets like Serbia and Ukraine, you can hardly find companies with trading volume of more than $1 million a day. From a liquidity perspective, these markets are still true and risky emerging markets.

We always keep that fact in mind. With 15 years of investment experience, we have learned the hard way that liquidity is a huge issue in a bear market. For example, the mWIG40 Index in Poland had a tremendous run for five years because of dedicated mid-cap funds that were able raise a lot of money. Given the low liquidity, those inflows provided a huge boost to prices and everyone was happy. Between June 2007 and January 2008, however, the mWIG40 dropped from 5,700 points to 2,900 points.

Q:  What are the milestones of your portfolio construction process?

A: We don’t have specific country allocations because that doesn’t make too much sense. The portfolio construction is based on building significant positions in companies that we believe are extremely undervalued. To avoid building a portfolio that is too concentrated, we have limited our exposure to a country or a sector to 1/3 of the portfolio, regardless of how cheap this segment is.

We are not benchmark sensitive because we only care if the stocks are cheap or expensive. When the stock prices exceed our target prices, we would rather hold cash. In the beginning of the fourth quarter, for example, our cash position was almost 50%, because we viewed many of the companies as extremely expensive. That referred even to sectors that we liked, such as the Polish banks. The strategy paid off nicely because many of those stocks dropped about 30% in the last four to six weeks and we were able to redeploy part of our cash again.

Q:  Could you give us some specific stock-pick examples?

A: One of our successful stock picks was Open Investments, a Russian real estate company. It has a very smart business model of buying agricultural land close to Moscow, getting residential permits, and building closed communities for the affluent Russians. That still is an excellent business model, but the share price increased more than 6 times since 2004. We sold the stock last summer after enjoying 500% increase in the stock price.

Another example would be the Russian mobile phone sector, where we had big positions for a long time. When we bought them, those companies were trading at 80% to 85% below the current level. The mobile phone market in Russia is very attractive because there are only three licensed operators. The margins are very healthy, and the risk of new licenses is low. Despite the growth, the telecom spending per user is still very low compared to Western Europe, so there was a big catch-up potential.

We completely exited the sector in the fourth quarter because we thought that the stocks were becoming very expensive, even in the perspective of continued growth. Currently, these stocks are already down 20% to 25% from the top. If they drop another 10% to 15%, we will start to accumulate positions again.

Q:  What is your view of the investing risks in the Eastern Europe and how do you manage them?

A: Liquidity is among the biggest risks and we manage it by focusing on liquid names. Another risk is the high dependency on commodity prices for Russia and Ukraine, whose economies will suffer in the case of a global recession. We avoid those sectors, while other investors easily overlook the cost increase when commodity prices soar by 20% or 40% annually. In the case of a slowdown, however, there will be huge pressure on the margins and a large downside.

It will be also difficult to sustain the growth of the banking sector in Eastern Europe, which experienced a boom in the last seven to eight years. Due to the rising inflation in many countries, the growth rate in consumer lending may decline and some banks may have problems with the loan quality. It will become increasingly difficult for the banks to issue bonds and equity to keep up the loan growth rates and to maintain the legal requirements for the solvency ratio.

The growth and the lending boom also led to deterioration in the current accounts. The current account deficit exceeds 10% or 20% in some countries, such as Romania or the Baltic states. Financing the deficit was not a problem in the last couple of years because of the huge foreign direct investments and portfolio investments, but this situation might change in the future.