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Central Europe and Russia Fund (CEE) Investor Recommendation: Buy Shares 900 Stop-loss $42.00 Position size 3.5% Risk to Fund 0.55% Pricing: (As of 3/30/07) Closing Price $50.10 52-week high $59.90 52-week low $35.27 Market Data: Shares 14,002,505 Avg. Volume 113,700 Market Cap. 701.5M Beta 1.87 NAV $772.7M Dist. Rate 1.21% Derek Schmidly [email protected] Central Europe and Russia Fund (CEE) Fund Stated Objective The Central Europe and Russia Fund Inc. is a non-diversified closed-end investment company seeking capital appreciation primarily through investment in Central European and Russian equities. Its benchmark is comprised of 45% CECE (Central Europe) 40% RTX (Russia) and 10% ISE National 30 (Turkey) effective April 1 2004.1 Basic Information The Fund's portfolio includes investments in Russian, Polish, Hungarian, Czech Republic, Turkish, Austrian, Dutch, Cyprus, Bermuda and Virgin Islands common stocks. The Fund invests in various industries, including commercial banks, diversified telecommunication services, food products, metals and mining, personal products, wireless telecommunication services, building products, diversified telecommunication services, media, pharmaceuticals, automobiles, and oil, gas and consumable fuels. The Fund is managed and advised by subsidiaries of the Deutsche Bank Group. The Fund's investment advisor is Deutsche Asset Management International GmbH. The Fund's manager is Deutsche Investment Management Americas Inc.2 Selection Criteria Due to the recommendations of the MIF committees, I thought it would be good to give the fund more exposure to emerging markets. For several years BRIC (Brazil, Russia, India, China) have been the fastest growing emerging markets. After examining all the opportunities and risks associated with these countries, I decided that CEE would be the best fund at this time. The following are the main reasons I did not choose the other countries: Brazil (EWZ): The economic data projects slower growth comparatively India (IFN; IIF): The funds do not follow the India Index close enough China (FXI): FXI is extremely overextended, 24% above the 300MA. 1 2 Etfconnect.com Google.finance.com 1 Russia Overview (Since 56% of the ETF is allocated to Russia, my report will focus primarily on the opportunities and risks in that country.) The economic and business landscape in Russia has changed drastically over the last 15 years. After the fall of communism, the economy changed to a free-market society, which is still developing. Economic risk in Russia is relatively low compared to the primary risk, which is political. The Russian economy has been performing well for several years – recovering from the ruble devaluation of 1998 – and it should continue to perform well for several years to come. Overall, inflationary pressures have been very high. Each year chronologically from 20022006 inflation was 15.8%, 13.6%, 10.9%, 12.5%, and 9.7%. Forecasters expect these numbers to slowly decline in the coming years – 8.9% in 2007, and 8.7% in 2008, and 8.4% in 2009 (See Appendix).3 In developed countries, inflation levels this high would be very damaging to the economy, but the Russian economy has been growing so quickly that living standards have remained relatively stable. Even with such a loss in purchasing power, private consumption has been robust. Data suggests that living standards are poor, but the actual living standards have held up much better than the official data suggests. This discrepancy is due to underreporting of wages in Russia. In other words, corruption, and specifically tax evasion, is a serious problem in Russia, and it is making some statistics less reliable.4 Unemployment has decreased sharply from an average of 14.2% in 1998 to 7% this year and is expected to decline to about 6.5% within the next five years. GDP is expected to continue to grow at a strong rate. In 2003 and 2004, GDP growth rates were more than 7%, and this year it is expected to finish at 6.8%. It is expected to continue to grow at a strong pace above 5.5% each year for the next 3 years. According to Business Monitor International (BMI), the short term economic rating for Russia is great, designated at 81.0 which is well above the emerging market average of 60.3. The long term BMI economic rating for Russia is also strong.5 “Russia: Macroeconomic Data and Forecasts,” Russia Business Forecast Report; 2007, p. 2. “The Economy: Regional Trends,” Counrty Profile: Russia; 2005, p. 46. 5 “Chapter 2: Economic Outlook,” Russia Business Forecast Report; 2007 Q1, p 11. 3 4 2 Recently, much of the economic growth in Russia has been the result of high oil prices. Russia is rich in natural resources; thus, its oil supply has brought windfall profits into the country. The government has been saving much of the money, but it has also used some of it to pay down the huge debts from the former USSR. As a result, Russia’s credit rating has improved, and slowly it has earned investment grade from every major investment agency, with S&P being the final agency to upgrade them (Jan 2005). Exports have also been consistently higher than imports, giving Russia an incredible balance of trade. This aspect has helped reduce its deficit. From 2003-2008 past data and forecasts give the following trade balances (in billion $): 59.9; 85.8; 118.3; 139.6; 134.0; 120.2. The ruble to dollar exchange rate is expected to fluctuate between 27 and just below 26 in years to come. Overall, the economy has been and looks very promising; however, there are many threats to prospect investors. Risks The biggest problem for businesses thinking about operating in Russia is corruption. Tax evasion is a bad problem both for individuals and companies. Bribes are the norm in Russian culture, paid to get out of speeding tickets, to avoid the government’s corporate regulations, and even to receive favor in judicial proceedings. Last year, the average Russian company paid $135,000 in bribes every year. Five years ago, the average was only $23,000. These bribes are primarily used to pay off inspectors in order to keep them from reporting problems to the government. 6 Furthermore, Russia has one of the largest markets for counterfeit products in the world, second only to China. It is especially problematic in the pharmaceutical industry in which 60% of drugs sold in Russia are counterfeit.7 These facts reflect a deficiency in Russian law and enforcement. The second biggest threat is the vulnerability of the Russian economy to oil prices. The market for commodities has been driving the Russian economy and many other resource-rich economies around the world. Though this aspect has been one of Russia’s greatest strengths, it also Renee Montagne, “Analysis: Corruption on the Rise in Russia,” Morning Edition NPR (11 Nov 2005). http://search.epnet.com/login.aspx?direct=true&db=nfh&an=6XN200511251102. 7 “Chapter 4: Key Economic Sectors,” Russia Business Forecast Report, 2006, p. 32. 6 3 makes its economy vulnerable. The forecasts presented by economic analysts for Russia are all based on the assumption that oil prices will stay near their current levels.8 However, if oil prices do fall, the actual economic data will be substantially lower than the current forecasts. The ways the Russian government has been spending its surplus profits from oil is the third largest threat. Instead of using the excess to boost legislation and enforcement (which would reduce corruption and attract foreign investments), the government has been spending the oil wealth on wages, pensions, and other recurrent expenditures.9 Because of Russia’s high level of corruption, the government has had difficulty gaining membership in the World Trade Organization (WTO), although recent news is saying that it should be able to join by the end of the year.10 Reducing corruption to tolerable levels, thereby attracting new investments, would also make its economy less vulnerable to oil prices. Currently, Russia’s economic situation presents an opportunity for foreign companies to capture huge market share, growth, and diversification; thus, with less corruption, DFI would drive growth across all sectors instead of commodities alone. Another risk to consider is that this is an election year for Russia, and the country is waiting to see who will replace President Putin. Strengths and Opportunities Despite some threats, Russia presents some great opportunities. The best one is Russia’s tax system. In 2001, the government passed a tax overhaul introducing a new flat tax system. The previous system imposed a top rate of 30% on taxable income exceeding $5000; the new system presents a 13% flat-rate on personal income.11 A tax this low seemed radical to many in the US, but just one year after the new system was implemented, real ruble revenues increased 28%, and after two years, a total of 50%. Those who support supply-side economics say this happened because “people are willing to produce more and pay their taxes when the system is fair and tax rates are low.”12 Corporate taxes were also lowered from 35% to 24%, and small businesses are now given the choice of either a 6% tax on gross revenue or a 15% tax on profits. Because of rising incomes, a middle class is emerging in Russia. 13 This fact presents opportunity for retailers to introduce household convenience items. However, in order to achieve growth, businesses must be able to persuade Russians about the “need” for convenience. Unlike American culture, there are still many stay-at-home moms in Russia and also grandparents who live in the home. Because of this, there has not been a high demand in the past for convenience items, which are big sellers in the US. If retailers are successful in marketing, then the growth potential in retail markets are high. Another opportunity is the government’s use of oil revenues to safeguard the future and improve the country’s infrastructure. Recently, oil revenues have been used to help construct roads, start regional housing projects, and pay the military’s fuel bills. The government has also established an Oil Stabilization Fund (OSF), which essentially is a savings account for excess profits that safeguards the economy against the risk of a sharp fall in the oil prices. In October 2006, the OSF stood at $71 billion.14 “Chapter 2: Economic Outlook,” 10. “Russia – Concluding Statement of the 2005 IMF Mission,” International Monetary Fund (6 June 2005). http://www.imf.org/external/np/ms/2005/060605.htm. 8 9 10 http://www.themoscowtimes.com/stories/2007/03/30/046.html Alvin Rabushka, “The Flat Tax at Work in Russia,” (21 February 2002). http://www.russianeconomy.org/comments/022102.html. 12 Daniel J. Mitchell, “Russia’s Flat-Tax Miracle,” The Heritage Foundation (24 March 2003). http://www.heritage.org/Press/Commentary/ed032403.cfm. 13 “Chapter 3: Business Environment,” 21. 14 “Russia diversification talk hurts dollar, boosts yen,” http://www.marketwatch.com/News/Story/Story.aspx?dist=newsfinder&siteid=mktw&guid=%7B5ED60E5B-920E-4D11-A5A2AA5995D7EE25%7D 11 4 Russia and Eastern Europe vs. Other Emerging Market Investments India: There are several reasons I chose CEE over India. The first is that there is not as much macroeconomic data readily available to compare with the other countries. But the primary reason is that none of the India funds track the BSE 30 (India Index) closely enough. Looking at the chart below you’ll see the three India funds available to choose from and how they compare to the index. IIF and IFN do not follow it closely enough, and although INP does seem to track it, the fund has too little history to judge for sure. It was just launched late last year.15 Another reason I favor Russia over India is due to the Sector allocation of each fund. IFN favors technology and finance; IIF favors Industrials and Financials; whereas CEE is heavily weighted in Energy. As I’ll demonstrate later, CEE performs exceptionally well when oil prices rise, and as the summer months approach, I believe the allocation of CEE will see much greater price appreciation than the allocation of the India funds. IFN 15 IIF CEE Comparing India Funds: INP is Clearly the Best Option,” http://india.seekingalpha.com/article/30466 5 Brazil: Brazil was a close second choice to Russia. Brazil also looks very favorable because its allocation, which has the heaviest weight in Metals, Mining, and Oil, would be in line with the recommendations of the economic committee. However, compared to Russia, Brazil has about half as much growth in GDP and half as much inflation (See Appendix). Looking at the data, it seems to be a country that is approaching more stable growth compared to the other BRIC countries which still have many years of rapid growth. Brazil has also has had a significant increase in its perceived level of corruption in the last year (See Appendix). Brazil (EWZ) China: China clearly has the fastest growing economic trends due to real GDP growth at 10.7% and an inflation rate at 1.4%. However, the Chinese fund (FXI) is very extended right now and suffered about a month ago from a 9% single day decline, which will take some time to recover from. For that reason, I think it would be good for the class to look into an investment in China sometime later this year, but now is not the time to buy because the risk is too great. The current price is a whopping 24% above the 300MA, and will likely be running into strong resistance at $105. 6 Central Europe/Russia Unlike China, the time is right for this area of the world. Take a look at the chart below. The green line is the price of oil. Clearly, whenever oil prices increase or decrease, the price of CEE moves strongly also. However, if you notice the most recent run up in oil starting in the beginning of 2007, the price of CEE has not responded. I believe this is only a delay. Based on its history and heavy allocation in Energy, an increase in oil prices should lead to price appreciation. The increase has probably been delayed because other emerging markets were overextended at the end of last year, and investors have been avoiding emerging markets since the beginning of the year. So, they have probably lumped CEE in along with the other emerging markets and have overlooked it. So, based on its correlation to oil prices, and the projection that oil prices will rise as we head into the summer, I think now is an opportune time to purchase shares in this fund. Stockcharts.com Another reason I favor long term investment in Russia is due to its huge amount of land and natural resources. As more countries are becoming industrialized the demand for natural resources should continue to increase. So, as long as there is growth somewhere in the world, chances are, those countries will be looking to Russia for the natural resources needed to drive that growth. Also, because there is still so much undeveloped land in Russia, there are opportunities for exploration and discovery of new resources. On the other hand, most other countries are running out of land that has not yet been explored. Central Europe and Russia Fund (CEE) vs Templeton Russia Fund (TRF) Because the corruption levels in Russia are so high (See Appendix for corruption rankings by nation) and because the country’s leadership can be unpredictable at times, I decided that CEE would have less risk than TRF because of its exposure to other Eastern European nations like Poland, Turkey, Austria, and Hungary, which have much lower rating on corruption. I also think that CEE’s very heavy weight in Energy makes it more attractive than the current allocation of TRF, which has its largest allocation in Telecom. The projections for growth in the Eastern European countries are good, but not as strong as the projections for Russia (See Appendix). However, I believe the reduction in political risk and better diversification are worth giving up some allocation to Russia. 7 Russia (TRF) Russia (TRF) CEE CEE Another downside to TRF is that its management fee is almost twice as much as CEE’s management fee: 1.91% verses 1.09%. CEE Largest Holdings Gazprom Lukoil Unified Energy JSC MMC Norilsk Nickel Surgutneftegaz Erste Bank Ceske Energeticke Telekomunikacja Polska Bank Polski Polski Koncern Naftowy Etfconnect.com 12.1% 8.7% 6.5% 5.6% 4.8% 4% 3.9% 3% 3% 2.9% 8 Key Stats & Ratios: Gazprom Quarterly (Sep '06) Annual (2005) Annual (TTM) Net Profit Margin 26.13% 22.84% 26.29% Operating Margin 33.36% 32.81% 34.30% EBITD Margin - 41.83% 41.98% Return on Average Assets 10.87% 8.37% 12.63% Return on Average Equity Finance.google 16.52% 13.33% 19.04% Quarterly (Sep '06) Annual (2005) Annual (TTM) Net Profit Margin 13.51% 11.68% 12.13% Operating Margin 18.21% 16.70% 16.78% EBITD Margin - 19.04% 19.31% Return on Average Assets 21.57% 18.73% 19.63% Return on Average Equity Finance.google 31.67% 27.06% 28.52% Key Stats & Ratios: Lukoil Valuation Unfortunately, there is not enough data available to calculate a meaningful valuation. This is the case for most international ETFs, which is why there has been so much information in the other sections. Beta was calculated using a regression of 3 year monthly returns against the S&P 500 SUMMARY OUTPUT Regression Statistics Multiple R 0.43906897 R Square Adjusted R Square 0.19278156 Standard Error 0.07761335 0.16903984 Observations 36 ANOVA df Regression Significance F SS MS F 8.11995 0.007384 1 0.048913217 0.0489 Residual 34 0.204810311 0.006 Total 35 Coefficients 0.253723528 Standard Error t Stat P-value Lower 95% -0.0833 0.0136 6.1156 0.0000 -0.1110 -0.0556 -0.1110 -0.0556 1.8738 0.6576 2.8496 0.0074 0.5374 3.2101 0.5374 3.2101 Intercept 0.0033 Upper 95% Lower 95.0% Upper 95.0% 9 Recent News16 Central Europe and Russia Fund Inc. Announces Distribution 2006 Dec 11 | 11:14 PM The Central Europe and Russia Fund, Inc. announced that its Board of Directors declared a distribution of $0.584 per share payable from net investment income, $1.94 per share payable from short-term capital gains and $2.992 per share payable in long-term capital gains for a total distribution of $5.516 payable in stock with an option to receive cash. The record date is December 21, 2006, and the payable date will be December 28, 2006. The shares will trade 'ex-dividend' on December 19, 2006. Summary Positive Aspects Flat Tax is good for business Resource rich country Benefits from high oil/gas prices The timing seems good Growing middle class The government is saving money (OSF) and paying off debt Huge trade surplus Growth forecasts are well above average compared to other emerging markets Financial strength of largest holdings Negative Aspects High corruption in Russia High inflation Presidential changes Management fee of 1.09% Based upon this report, I think an investment in Central Europe and Russia is the best investment opportunity in emerging markets right now. I am recommending a holding of 3.5% in CEE and also that we sell 3.5% of our position in EFA to keep our international allocation balanced. 16 Reuters.com 10 11 12 13 India “Political Outlook,” Asia Monitor: South Asia Monitor of Business Monitor International, p 3. 14 Corruption Index 2006 CountryCountry Rank 1 1 1 4 5 Finland Iceland New Zealand Denmark Singapore 2006 SurveysConfidence CPI used range Score 9.6 7 9.4 - 9.7 37 Cyprus 5.6 4 5.2 - 5.9 39 Oman 5.4 3 4.1 - 6.2 40 Jordan 5.3 7 4.5 - 5.7 9.6 9.5 - 9.7 41 Hungary 5.2 8 5.0 - 5.4 9.4 - 9.6 42 Mauritius 5.1 5 4.1 - 6.3 9.4 - 9.6 42 South Korea 5.1 9 4.7 - 5.5 9.2 - 9.5 44 Malaysia 5.0 9 4.5 - 5.5 Italy 4.9 7 4.4 - 5.4 9.6 9.5 9.4 6 7 7 9 6 Sweden 9.2 7 9.0 - 9.3 45 7 Switzerland 9.1 7 8.9 - 9.2 46 4.8 8 4.4 - 5.2 8 Norway 8.8 7 8.4 - 9.1 Czech Republic 9 Australia 8.7 8 8.3 - 9.0 46 Kuwait 4.8 5 4.0 - 5.4 9 Netherlands 8.7 7 8.3 - 9.0 46 Lithuania 4.8 6 4.2 - 5.6 11 Austria 8.6 7 8.2 - 8.9 49 Latvia 4.7 6 4.0 - 5.5 11 Luxembourg 8.6 6 8.1 - 9.0 49 Slovakia 4.7 8 4.3- 5.2 11 United Kingdom 8.6 7 8.2 - 8.9 51 South Africa 4.6 8 4.1 - 5.1 51 Tunisia 4.6 5 3.9 - 5.6 8.0 - 8.9 53 Dominica 4.5 3 3.5 - 5.3 7.7 - 8.8 54 Greece 4.4 7 3.9 - 5.0 7.8 - 8.4 55 Costa Rica 4.1 5 3.3 - 4.8 7.0 - 8.1 55 Namibia 4.1 6 3.6 - 4.9 6.7 - 7.8 57 Bulgaria 4.0 7 3.4 - 4.8 El Salvador 4.0 5 3.2 - 4.8 14 15 16 17 18 Canada Hong Kong Germany Japan France 8.5 8.3 8.0 7.6 7.4 7 9 7 9 7 18 Ireland 7.4 7 6.7 - 7.9 57 20 Belgium 7.3 7 6.6 - 7.9 59 Colombia 3.9 7 3.5 - 4.7 20 Chile 7.3 7 6.6 - 7.6 60 Turkey 3.8 7 3.3 - 4.2 6.6 - 7.8 61 Jamaica 3.7 5 3.4 - 4.0 6.3 - 7.2 61 Poland 3.7 8 3.2 - 4.4 6.0 - 7.2 63 Lebanon 3.6 3 3.2 - 3.8 6.1 - 7.4 63 Seychelles 3.6 3 3.2 - 3.8 5.4 - 7.1 63 Thailand 3.6 9 3.2 - 3.9 5.9 - 7.3 66 Belize 3.5 3 2.3 - 4.0 5.4 - 7.3 66 Cuba 3.5 3 1.8 - 4.7 Grenada 3.5 3 2.3 - 4.1 20 23 24 24 26 26 28 USA Spain Barbados Estonia Macao Portugal Malta 7.3 6.8 6.7 6.7 6.6 6.6 6.4 8 7 4 8 3 7 4 28 Slovenia 6.4 8 5.7 - 7.0 66 28 Uruguay 6.4 5 5.9 - 7.0 69 Croatia 3.4 7 3.1 - 3.7 31 United Arab Emirates 6.2 5 5.6 - 6.9 70 Brazil 3.3 7 3.1 - 3.6 70 China 3.3 9 3.0 - 3.6 32 Bhutan 6.0 3 4.1 - 7.3 70 Egypt 3.3 6 3.0 - 3.7 32 Qatar 6.0 5 5.6 - 6.5 70 Ghana 3.3 6 3.0 - 3.6 34 Israel 5.9 7 5.2 - 6.5 70 India 3.3 10 3.1 - 3.6 34 Taiwan 5.9 9 5.6 - 6.2 70 Mexico 3.3 7 3.1 - 3.4 36 Bahrain 5.7 5 5.3 - 6.2 70 Peru 3.3 5 2.8 - 3.8 37 Botswana 5.6 6 4.8 - 6.6 70 Saudi Arabia 3.3 3 2.2 - 3.7 15 70 Senegal 3.3 5 2.8 - 3.7 99 Mozambique 2.8 7 2.5 - 3.0 79 Burkina Faso 3.2 5 2.8 - 3.6 99 Ukraine 2.8 6 2.5 - 3.0 79 Lesotho 3.2 5 2.9 - 3.6 105 Bolivia 2.7 6 2.4 - 3.0 79 Moldova 3.2 7 2.7 - 3.8 105 Iran 2.7 3 2.3 - 3.1 79 Morocco 3.2 6 2.8 - 3.5 105 Libya 2.7 3 2.4 - 3.2 79 Trinidad and Tobago 3.2 5 2.8 - 3.6 105 Macedonia 2.7 6 2.6 - 2.9 105 Malawi 2.7 7 2.5 - 3.0 84 Algeria 3.1 5 2.7 - 3.6 105 Uganda 2.7 7 2.4 - 3.0 84 Madagascar 3.1 5 2.3 - 3.7 111 Albania 2.6 5 2.4 - 2.7 84 Mauritania 3.1 4 2.1 - 3.7 111 Guatemala 2.6 5 2.3 - 3.0 84 Panama 3.1 5 2.8 - 3.3 111 Kazakhstan 2.6 6 2.3 - 2.8 84 Romania 3.1 8 3.0 - 3.2 111 Laos 2.6 4 2.0 - 3.1 84 Sri Lanka 3.1 6 2.7 - 3.5 111 Nicaragua 2.6 6 2.4 - 2.9 90 Gabon 3.0 4 2.4 - 3.3 111 Paraguay 2.6 5 2.2 - 3.3 90 Serbia 3.0 7 2.7 - 3.3 111 Timor-Leste 2.6 3 2.3 - 3.0 90 Suriname 3.0 4 2.7 - 3.3 111 Viet Nam 2.6 8 2.4 - 2.9 93 Argentina 2.9 7 2.7 - 3.2 111 Yemen 2.6 4 2.4 - 2.7 93 Armenia 2.9 6 2.7 - 3.0 111 Zambia 2.6 6 2.1 - 3.0 93 Bosnia and Herzgegovina 2.9 6 2.7 - 3.1 121 Benin 2.5 6 2.1 - 2.9 93 Eritrea 2.9 3 2.2 - 3.5 121 Gambia 2.5 6 2.3 - 2.8 93 Syria 2.9 3 2.3 - 3.2 121 Guyana 2.5 5 2.2 - 2.6 93 Tanzania 2.9 7 2.7 - 3.1 121 Honduras 2.5 6 2.4 - 2.7 99 Dominican Republic 2.8 5 2.4 - 3.2 121 Nepal 2.5 5 2.3 - 2.9 121 Phillipines 2.5 9 2.3 - 2.8 2.5 - 3.0 121 Russia 2.5 8 2.3 - 2.7 2.5 3 2.3 - 2.6 2.5 3 2.2 - 2.7 99 Georgia 2.8 6 99 Mali 2.8 7 2.5 - 3.3 121 Rwanda 99 Mongolia 2.8 5 2.3 - 3.4 121 Swaziland Countries with a significant worsening in perceived levels of corruption include: Brazil, Cuba, Israel, Jordan, Laos, Seychelles, Trinidad and Tobago, Tunisia and the United States. Countries with a significant improvement in perceived levels of corruption include: Algeria, Czech Republic, India, Japan, Latvia, Lebanon, Mauritius, Paraguay, Slovenia, Turkey, Turkmenistan and Uruguay. 17 17 http://www.finfacts.com/corruption.htm 16 17 18 19 20 21