Posted By: Margaret Pozzini

Wed Nov 15, 8:08 AM ET

When stocks roar ahead, as they have been in Eastern Europe lately, having a strict buy and sell discipline and holding cash can help ease the whiplash when they turn south. Thomas Neuhold navigates The World Funds -- Eastern European Equity Fund (NASDAQ:VEEEX - News) in Vienna as a bottom-up value investor who examines the profitability and valuation levels of companies before he dips in. He has loaded up on stocks in banking, real estate, and telecom that will benefit from consumers' rising incomes in Eastern Europe. And he's avoiding the "overheated" commodities and energy stocks in Russia.
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Neuhold has also boosted the fund's cash position to 40% given the steady climb from summertime lows for many Eastern Europe markets. "Even though we like a lot of companies and sectors, we think some of them have gotten expensive," says the 34-year-old Austrian. So far this year, the MSCI Eastern Europe index has risen 31.7%, with Russia and Poland markets leading the way with gains in U.S. dollars of 51% and 46%, respectively.

The World Funds -- Eastern European Equity Fund has gained 19.6% this year through Oct. 31, and has a 5-year annualized return of 33.4%. The fund sports very low volatility of 14.7%, thanks to its strict selling discipline, Neuhold says.

BusinessWeek.com's Karyn McCormack spoke with Neuhold on Nov. 9 in New York about his fund and favorite stocks. Edited excerpts from their conversation follow.

What's your investing strategy?

We're bottom-up value investors. We screen for the most liquid stocks -- they must trade at a market value of at least $3 million (in U.S. dollars).

We do not make country bets, especially with European Union (EU) member countries -- they have a stable political environment now, so it's not really the country environment that's driving companies but rather it's the sector.

What's your valuation process?

We follow roughly 100 companies and build our own models, and we regularly meet companies in Eastern Europe at least two or three times per year. We also talk to analysts about companies, but we want to come up with our own opinion if a stock is cheap or expensive.

In our approach, our model strongly focuses on long-term sustainable profitability levels. Looking at history and using common sense, we try to figure what could be the long-term sustainable margin and profitability levels in terms of return on equity (ROE) and return on capital employed.

A good example would be the oil and gas sector. There are a couple of global companies competing and commoditized products, so companies can't differentiate themselves. We found that in the long term, these companies have difficulty covering their cost of capital. In our model, the return on capital employed is converging with the cost of capital quite quickly, because now a lot of oil and gas companies earn tremendous money, especially the Russian ones. They have return on capital employed levels of between 25% and 40% at the moment.

A lot of people tell us Russian oil and gas stocks are very cheap, because they trade at a p-e of eight to 10. That may be true, but in our view, the problem is their profitability levels are irregularly high -- they are two or three times higher than historic levels and what we think will be the long-term achievable level. So if you normalize earnings, these companies, in our point of view, are relatively expensive.

What trends are you seeing in Eastern Europe?

We like the convergence story very much. In sectors like banking, insurance, and real estate, the countries in Eastern Europe will reach similar penetration levels of Western Europe and the U.S. In the banking sector, if you look at the ratios -- loans to GDP, mortgages to GDP, credit cards per capita -- a lot of countries in Eastern Europe are still very below the penetration levels that we see in Western Europe and the U.S.

We think with rising income levels -- we see real income levels increasing between 2% and 4% in the more developed markets like Poland and the Czech Republic and up to 10% to 12% in the less-developed markets like Romania, Ukraine, and Russia -- there's a good chance that these countries will show very attractive growth in products including loans, mortgages, insurance, and credit cards. This is an excellent long-term growth opportunity for banks and insurance companies.

What are your favorite stocks held in the fund?

Our biggest holdings are in the consumer-related areas. Our largest sector weightings are in banking, telecom, real estate, and then pharmaceuticals and a little bit of retail and food.

The real estate sector is an area with long-term growth potential, because if you look at ratios like office space per capita or retail space per capita, even the most developed cities in Eastern Europe have penetration rates of only 25% to 30% of the level in the typical Western European city. The rents in many cities are similar or lower than in comparable Western European capitals.

The valuations of the real estate sector are cheaper, as measured by yields -- which is average rents divided by purchasing price -- so the higher the yield the cheaper the real estate. The yields in Eastern Europe in the most developed countries are 50 to 100 basis points above the level we see in comparable Western European cities, and further to the east, in less developed countries, you have very attractive yields that are 300 to 500 basis points above what you see in Western Europe.

Yields come down in Eastern Europe as the countries become more secure, safe, and investable. And with falling yields, the asset prices are increasing and the companies benefit. In this area, we own CA Immobilien Anlagen and Sparkassen Immobilien.

Which bank stocks do you own?

We like the banking sector a lot. Two big holdings are Komercni bank (Czech Republic) and OTB (Hungary). At the moment, a lot of people are a little skeptical about OTB, because the currency is volatile and people feel that Hungary might have problems down the road because the country has a very high budget deficit and a rather high current account deficit. So a lot of people think OTB is a risky stock at the moment.

On the other hand, we think a lot of the risks are priced in because it trades at a discount of between 30% and 40% to other banks in the region. And if there are troubles in the Hungarian economy, we think that it would be a short-term event, and last only one or two years. The long-term prospects for the Hungarian economy are quite good, so we think people are a little too worried about what could happen to OTB.

What about telecom?

We own Vimpelcom because we think there are excellent growth opportunities in the Russian cellular market. The average revenue per user is only $9.

In the Russian economy, which is doing quite well at the moment, real incomes are rising more than 10%, so people have more money to spend on telecom services. And the competitive environment in Russia is very favorable -- there are only three operators countrywide, and a couple of regional operators. These companies will quickly start to generate huge free cash flows because they do not have to invest a lot of money for capex (capital expenditure) and revenues are continuously rising, and we think they will start to pay out nicely. Their network is established with state-of-the-art technology, even better than in many Western European countries, because they started operations five to six years ago on a big scale.

On the one hand, we like the Russian cellular companies very much because of their growth and excellent business model, opportunity to generate huge free cash flow quickly, and valuations are still reasonable. We also like the Central European telecoms, like Magyar Tavkozlesi (Hungary) and Cesky Telecom (Czech Republic).

In Poland, Hungary, and the Czech Republic, the telecom market is already quite developed, but the good thing is people don't like these companies because they hardly show any earnings growth at the moment. But these companies generate huge free cash flows. For instance, the free cash flow yield (free cash flow divided by enterprise value) for Cesky Telecom this year will be around 14% to 15%.

Plus, a lot of their free cash flow is paid out as dividends, so you have dividend yields of 7% to 10% for the Central European telecoms. That's a nice return, and we think this is a very sustainable cash flow. We don't think competition will increase significantly, and their ROE is only slightly higher than the cost of capital. We think they will be able to maintain their cash flows and dividends, so we think they're a safe bet.

Magyar and Cesky are large holdings in our fund, and we also own TPSA (Telekomunikacja Polska SA), the Polish incumbent telecom operator.

How many holdings are in the fund?

Currently, we hold a peak cash position of 40%, because even though we like a lot of companies and sectors, we think some of them have gotten expensive. We have a very strict selling discipline. If we think a company is overvalued, we do not want to hold the stock in our portfolio -- we'd rather have cash. Normally, we have 40 to 50 stocks, but now we have 20 to 25.

We had a high cash position in the beginning of the year also, and then we had the peak sell-off in May and June when the markets dropped on average 30%, and we invested almost all of the cash. But since the June lows, most of the markets are up 40% to 60% again.

When do you sell?

If our target price is hit and we think the stock is fully valued, we then look at the news flow and what could be the momentum. If we are convinced the stock will continue to rise, we won't sell immediately. But once the stock gets overvalued, by 10% or 15%, even when the news flow is excellent and momentum is great, we exit the position because we don't want to hold ones with downside potential. We'd rather hold cash.

The good thing is this leads to very low volatility. The fund in U.S. dollars has a volatility of 14.7% -- the lowest among all Eastern European equity funds -- which have an average volatility of 23% to 24%.

We don't have the same performance as other funds during some periods, but we catch 75% to 80% of the upside. We generate the returns with only half the volatility of other funds, so on a risk-adjusted basis we think we do quite well.

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