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World War II devastated Europe’s major economies. The destruction of roads, water pipes and train networks during the war years left Europe with little functional basic infrastructure. Even worse, the chaotic immediate post-war era encouraged lawlessness and corruption; no effective modern economy can exist without the rule of law. The U.S. economy, while certainly affected by the war, remained strong and vibrant by comparison. The U.S. decided to rejuvenate a crippled Europe with an aid program dubbed the Marshall Plan. Between 1948 and 1951, total aid from the US to Europe totaled $13 billion--a sum equivalent to more than $100 billion in 2004 dollars when adjusted for inflation. Even more importantly, the U.S. tied direct and indirect reform requirements to aid money; these restrictions were designed to promote the development of democratic political and legal traditions. As a result of this aid, as well as a number of other important factors, most European economies stabilized and economic growth finally began to accelerate. Unemployment fell from above 50% in the immediate aftermath of the war to under 10% throughout most of the Continent within just a decade or so. Even better, many countries developed stable political systems and modern legal codes. The U.S. also benefited from the Marshall Plan. Politically, a stable Europe was a bulwark against the looming threat of the Soviet Union, a menace that was all-too-close to home for most Europeans--the Soviet-controlled Eastern Bloc was literally right next door. In addition, a more-vibrant European economy offered America a key trading partner and an important export market for its goods. This isn’t just a meaningless history lesson: fast-forward 60 years and Europe is set to benefit once again from a form of modern-day Marshall Plan. On May 1, 2004 European re-unification became a reality when 10 countries in all, 8 from central and eastern Europe, joined the European Union (EU). Latvia, Estonia, the Czech Republic, Slovakia, Slovenia, Poland, Hungary and Lithuania all formally joined the EU on that date. On top of this, two additional members, Romania and Bulgaria, are scheduled to join the Union in May, 2007. All 10 once-communist states are expected to adopt the euro currency over the next decade or so. This feat was hardly imaginable just 15 years ago. Much like Western Europe in 1945, Eastern Europe was devastated in the early 1990s. This time it wasn’t a global war that caused the chaos, rather decades of totalitarian communist rule. Also like Europe in 1945, the combination of reform, enhanced trade and direct aid is finally beginning to rejuvenate the East. Myriad opportunities abound for the well-placed investor as these countries enter a modern era of peace, prosperity and growth. The Reform Movement But Eastern Europe has made great strides in the little over a decade since the fall of the Soviet system. In particular, the concerted push to become part of the European Union (EU) served as an impetus for reform. In their zest to join the EU, countries have accepted sometimes-painful economic and political reforms mandated by the EU. Most of these policies would have been difficult, if not impossible, to push on the population under normal circumstances. In particular, prior to accepting a new member, the EU requires the acceptance of a body of laws known as the “Acquis Communautaire.” This encompasses around 80,000 individual regulations that are harmonized across the EU covering legal, political and economic issues. The EU started monitoring the effectiveness of each country’s adoption of the Acquis in the 1990s. These laws helped to establish modern legal and political systems in the new Member States. And even though organized crime has been a problem throughout most of Eastern Europe since the fall of communism; recent surveys suggest that a more rigorous legal framework is starting to have a positive effect. On the economic front, the EU pushed even larger reforms. These include the reduction of government debt and institution of a policy of fiscal and monetary prudence. In many cases, that required countries to completely dismantle the sclerotic bureaucracies and centrally planned infrastructure that existed in Eastern Europe as part of the Soviet legacy. Under the centrally planned economies of yesteryear many businesses were run as nationalized, inefficient behemoths. Telecom and financial services, for example, were run by the region’s individual governments prior to 1990. As nationalized business was exposed to little or no competition, either domestically or from abroad, service levels tended to be poor. A weak, uncompetitive financial system is particularly damaging for an economy; access to credit from banks was non-existent for small businesses and consumers alike. But as part of their accession mandate, many businesses have now been privatized and a culture of competition has replaced the old Soviet system. But, perhaps most importantly, the EU is a free-trade area and barriers have been rapidly dismantled since the early 1990s. Tariffs on exports and imports were effectively eliminated in the 90s. And as part of joining the EU, new Member States get complete access to the common market; restrictions on the movement of capital, goods and even people are gradually being dismantled. Not surprisingly, exports from key economies in the region have been rapidly on the rise. As you can clearly see in the chart below, Hungary and Poland, two of the region's largest economies, have seen dramatic jumps in export volume since 2001 despite a weak global economy.
The easiest way to see this is to glance at bond prices for Eastern European governments over the past several years. The yield on government bonds reflects the risk of default and the perceived political risk of a certain country. As you can see in our chart below, bond prices have been rapidly on the rise among the major new EU member states. Rising bond prices, of course, lead directly to falling yields; interest rates now approach the levels seen in a more developed economy like Germany or the U.S. The bond market tells us that economic reforms in the east are for real.
Finally, growth in the region has been impressive. On average, the new Member States posted GDP growth of +3.7% in 2003, a whopping ten times the pace logged for the rest of the EU. In some smaller countries that have seen particularly high foreign investment, the growth rate is even higher. In particular, check out our chart of Slovakia’s GDP growth since 1994. In that 10-year period, the country has seen only one quarter of negative GDP growth and growth has averaged close to 4.5%, an impressive record.
For starters, Eastern Europe sports a large, skilled workforce that's often available to work at a fraction of the cost of Western European workers. One of the only positive legacies of the communist era is a focus on universally good education--most of the area’s population can read and write, and a large percentage of people speak foreign languages such as English. That’s an advantage most emerging markets don’t have. On the labor front, let’s take a few examples. The average salary of a Slovakian worker is approximately 20% of what’s common in neighboring Austria for an equivalently skilled worker. Meanwhile, Polish laborers are becoming an increasingly prevalent sight in Germany--construction workers can be hired for about 30% of the cost of domestic labor. In fact, in many regions, labor costs are roughly equivalent to what’s available in China while regulations and taxation are far more attractive. Not surprisingly, the region has become a center for new factory construction and development. Volkswagen, Hyundai, and Peugeot have all opened major factories in Slovakia, producing cars for both the western market and for delivery elsewhere in the east. Meanwhile, Japanese carmaker Toyota has also gotten into the act by opening a factory with Peugeot in the Czech Republic; the plant will focus solely on the production of smaller cars for sale in the EU’s newest member states. American companies aren’t being left out in the cold either. For example, American Standard--a US-based manufacturer of toilets and other bathroom appliances--has opened its largest international factory in Bulgaria. In addition, Ford and GM are also likely to soon become investors in the region. Adding to the region’s attractiveness is an extremely business-friendly climate. The region’s leading markets have gone far beyond the reforms mandated by the EU--in some cases even surpassing their more-developed neighbors in terms of tax reform. For example, Estonia started a 19% flat-tax regime on corporate profits in the mid-90s, a progressive policy that is still largely a pipe dream in the west. In addition, Latvia, Poland and Hungary have now cut taxes under 20% for corporations while Slovakia has instituted a 19% flat tax on all income, corporate and personal. And like the U.S. of the post-war era, Western Europe is benefiting from a push to the east. So too is the U.S., as well as a number of other nations that are investing in the region. Growth from the former Eastern Bloc isn’t just a boon for western companies looking for a cheap, nearby labor pool. Eastern Europe is actually becoming an exciting and rapidly growing consumer market in and of itself. Higher employment, increasing wealth and rapidly-growing economies tend to spark consumer spending. With this in mind, a host of European retailers have already set up shop in Eastern Europe, including British supermarket giant Tesco and France’s Carrefour discount stores. Given the slow economic growth seen throughout most of Western Europe, the east has become the EU’s primary domestic growth engine. EU Aid While EU aid programs remain controversial, there’s been a positive benefit for countries like Ireland and Spain that once lagged the rest of the region economically. Take Ireland as an example. When Ireland first joined the EU in 1973, per capita GDP stood at just 63% of the EU average. By 2002, the nation had made such huge strides that it actually ranked among the richest countries in the EU, sporting a GDP of about 120% of the EU average. And the lion’s share of that improvement came after 1987, when the EU began to more aggressively address Ireland’s economic troubles. The EU helped this process dramatically by offering direct aid to Ireland. Between 1993 and 1999 Ireland received almost $1 billion in aid from the EU’s "Cohesion" fund. That included the building of fresh-water reservoirs and a total of 330 kilometers of modern roadways. Such infrastructure was sadly lacking in Ireland prior to that investment. The EU also tied its aid and the prospect of euro membership to some aggressive reforms in Ireland. Corporate taxes were slashed from 40% in 1987 to 12.5% by 1992 and a number of government spending programs were cut. All of this certainly caused some short-term pain in the country. However, the EU’s funding helped to cushion that blow. As a result, unemployment plummeted from 40% to less than 5% over the same period as economic growth accelerated. Europe’s 10 new states are by far the poorest in the EU. As such, they’re scheduled to be the largest recipients of EU aid money (just as Ireland was in the 1990s). Between 2004 and 2006, for example, the EU has earmarked over 26 billion euros for regional infrastructure improvements. That too is set to enhance the region’s attractiveness to both foreign and domestic investors. Investment Opportunities in Eastern Europe With the above analysis as a backdrop, my staff and I recently scoured the investment landscape in search of companies and funds that are well positioned to profit from the EU’s most dynamic region. Below we review five of our favorites... CENTRAL EUROPEAN DISTRIBUTION CORP. (CEDC, $22.75) If there’s one product that just about any bar, restaurant, nightclub or convenience store needs to sell to be profitable, it’s alcohol. That’s where CEDC fits in. The company is Poland’s largest importer and distributor of alcoholic beverages, including beer, wine and spirits. In total, the company distributes these products to about 31,000 different Polish businesses of all sizes. In 1997 when the company started operations, liquor distribution in Poland was controlled by a patchwork quilt of small mom-and-pop operations. In addition, the main supplier of domestic liquors was the Polish government itself, a legacy of the centrally planned communist era. As you might suspect, that was an extraordinarily inefficient way to do business. Government run distillers were encumbered by excessive bureaucracy and poor management. And costs for the distributors were high because none had the scale to negotiate favorable contracts with foreign or domestic suppliers. But CEDC changed all that, garnering $12 million in funding from Wall Street and buying Poland’s liquor distributors one by one. In each case, CEDC left in place some of the existing management team to help maintain local market knowledge. As a result of its aggressive acquisition spree, the company’s growth has been impressive. Over the past five years CEDC has posted annual revenue growth close to +50%. Meanwhile, profit margins have risen in the process, leading to earnings that have grown even faster than revenues.
But CEDC isn’t just resting on its laurels. Instead, the firm's savvy management team has opened up several new avenues of future growth. First, the company’s main business, which currently accounts for about 70% of revenues, has been the distribution of domestically produced products--a profitable business. However, the company has recently been moving aggressively into the market for imported spirits, which carry significantly higher profit margins. CEDC has distribution contracts with some of the world’s best-known brands, including Johnny Walker Scotch, Jose Cuervo tequila and Budweiser beer. Prior to May 1st, all of these brands had been subject to import tariffs; with accession to the EU all such tariffs were permanently removed. The result: CEDC drastically cut prices and saw a 40% jump in sales. Because of this, the company’s high-margin imported liquor business is set to garner a larger slice of the revenue pie. That’s one reason the company recently raised guidance for the full year. In addition, CEDC is exploring the distilling business as a new avenue of growth. Until recently, most distilleries in the country had been government owned. However, as part of the nation’s privatization program--spurred by EU reform--most are in the process of privatization. CEDC recently received approval from the government to bid for Palmos Bialystok, the nation’s largest such distiller. Vodka remains a fast-growing segment of the spirits market. With that in mind, we wouldn’t be surprised to see CEDC attempt to build an export business to other parts of Europe over the next few years. With the popularity of Polish vodka, that could turn out to be yet another profitable addition to the firm's business mix. Trading at less than 16 times forward earnings and with almost no debt, CEDC looks poised to continue its recent winning streak thanks in large part to the recent EU expansion. With all of these factors in mind, my staff and I have decided to add the shares to our "Watch List" for possible future inclusion into our Aggressive Growth Portfolio. Important Note: To
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