Fund manager Markus Brück says European emerging markets still have room to grow.

When Vladimir Milev was growing up in Bulgaria, many goods common in the United States and Western Europe were extraordinarily difficult to find. "As a young child I was allowed to buy Coca Cola only for special occasions," he recalls. "At one point I hoarded about two gallons of the stuff in my house so I could stock up."
    By the time he left Bulgaria in 1999 to move to the U.S., Milev, now an analyst for the Metzler/Payden European Emerging Markets Fund, could buy his favorite beverage whenever the mood struck. That small freedom represented just one of the vast cultural and economic changes that swept his country in less than a decade. As the new millennium began citizens of Bulgaria, Poland, Hungary and other Eastern European countries had caught the shopping bug. Sony and Nokia cell phones became a status symbol and fashion accessory in trendy coffee shops and bistros.
    The growing ranks of middle-class families compared recently acquired designer clothes and new cars. Companies seeking a well-trained and relatively inexpensive work force, particularly those in the automotive industry, began locating their manufacturing facilities in the region.

The corporate world also evolved. "Seven years ago, most Eastern European companies were government owned," says Markus Brück, a 43-year-old German who has co-managed the fund out of Frankfurt, Germany, with Hungarian-born Zoltan Koch since its 2003 inception. "Now, they are aware that they must compete to get attention from investors. While energy and electric companies are still impacted by government controls, privatization is taking hold in other industries. If companies have to fire 5,000 people to raise profitability, that is what they will do."

At the same time, the region's problems remain severe. A slowdown in demand from Western Europe threatens the many Eastern European companies that derive most of their revenue from those countries. Stocks are regularly whipsawed by local government monetary policies, fears of inflation and political instability, and tightening by the U.S. Federal Reserve Board. Companies are still learning the ropes when it comes to shareholder friendliness and disclosure. In Hungary, a ballooning budget deficit recently prompted Standard & Poor's to downgrade the country's debt from A- to BBB+.

Still, the combination of cultural and economic changes has translated into huge gains for investors over the last four years. In 2003, its first full year of operation, the fund gained 45%. In 2004 and 2005, it rose 53% and 38%, respectively. As of mid-September, it was up 26% year-to-date.
    But time may be running out on the market's ebullience. "The ground floor in Eastern Europe was the early stages of the convergence play," says Brück, referring to plans in those countries to adopt the euro over the next few years. "The easy money in Eastern Europe has already been made."

Now he is eyeing new frontiers for investment in countries such as Serbia and Bosnia-Herzegovina, although he says it's too early to invest. "It's still hard to get information, but companies in those countries are learning how to open up to visitors," he says. "It's like Romania was five or six years ago."
    New investments have focused on Turkey, a more established market but one that is still new to most investors. In May, concerns about high inflation and the country's monetary policies led to a severe correction in that market, and most analysts made downward adjustments to their earnings forecasts.

Brück saw the reaction by investors as too severe, and decided to do some buying at what he considered favorable valuations. When the downturn began in May, Turkish stocks accounted for about 3% of fund assets. Today, about 10% of the fund is invested there.

Much of the money for new purchases came from a large cash war chest, which represented about 20% of assets in early May. "We outperformed our competitors in May and June mainly because we were correct in raising our cash position, then buying again when the opportunity presented itself," he says. Today, with most of that money deployed, cash accounts for about 3% of fund assets.
    Many Turkish companies the fund loaded up on are family-owned conglomerates with a long history in the region, he explains. "These companies often trade at a large discount because investors focus only on core businesses without considering other company holdings," he says. "One or two years ago, managements wanted to hang on to their conglomerates. Now, Turkish companies are working on raising shareholder value by shedding noncore business through sales to strategic investors."
    Despite dabbling in countries whose markets are a mystery to most investors, the fund remains solidly positioned in more established Eastern and Central European markets such as Russia, Poland and Hungary. Brück believes those markets will end the year in positive territory, despite concerns that a weakening U.S. economy could affect markets worldwide in the second half.

A break from market whipsaws would be a welcome respite for investors, who endured a sharp decline in May and the beginning of June as Eastern Europe responded to global concerns about economic growth and Fed tightening. While the indiscriminate sell-off almost completely erased high double-digit gains for the year, it began to reverse towards the second week of the month. Discounted valuations and the impression among investors that the magnitude of the selling may have been an overreaction brought some market participants back. Prices started to recover, albeit with increased volatility.

    Even with that volatility corporate profits have risen, with booming share prices keeping valuations at what Brück considers fairly reasonable levels. By his estimate, Hungarian stocks are the cheapest, selling at about 11 times earnings. He considers equities in Poland and the Czech Republic, which sell at an average of about 15 times earnings, to be reasonably priced as well.
    During the May downturn, Brück increased exposure to Russian oil company stocks, which be believes still have room to grow. "The profitability of Russian oil companies is lower than their U.S. counterparts because most of them haven't invested enough in infrastructure changes that would increase efficiency. But that is changing. In many ways, it's better to invest in companies that are taking steps to increase profitability within the next two or three years, versus companies with high profit levels that may be difficult to sustain."
    Production increases appear likely for Lukoil, a longtime fund top ten holding. The oil giant is expanding its production activities outside of Russia into the Caspian Region, an area of huge undeveloped reserves. The growing need for gas from a large European customer base should help balance the political risk faced by Russia's Gazprom, a major holding since the fund opened its doors.
    The fund's universe includes 350 stocks. The backbone of the portfolio consists of the top 20 holdings, most of them large companies in the energy, financial and telecommunications sectors. But smaller stocks have become increasingly common. The normal roster of about 55 names has expanded to 75, reflecting Brück's desire to explore relatively new markets like Romania and Turkey a little bit at a time. To test the waters, he usually limits investments in smaller companies to a modest 0.25% of assets.

According to Milev, "The interesting growth stories over the next five to ten years will be in sectors that are not dominant in Eastern Europe at this point. Compared with traditional developed markets, the region has relatively few companies in the consumer sector. That will change as standards of living and personal incomes catch up to those in the U.S." A possible beneficiary of the trend is Pyaterochka, a Russian grocery store chain. Founded in 1999 in St. Petersburg, Pyaterochka has been one of the pioneers of modern grocery retailing in Russia. Its format of neighborhood discount stores has been well received by Russian consumers, offering a competitive alternative to open markets and Soviet-era outlets. Listed on the London Stock Exchange in 2005, it is the largest grocery retailer in Russia in terms of sales.

Fund holding Cesky Telecom, the Czech Republic's largest telecommunications company, is poised to ride the wave of rising ownership of personal computers and increased Internet use by that country's citizens. "Cell phone companies are moving toward the latter phases of growth, but the Internet is still in the earlier stages," says Milev. Created by the privatization of the Ministry of Posts and Telecommunications of the Czech Republic, the company was acquired by Spain's Telefonica in 2005. The stock sports a 10% dividend yield.