Rogue Missives -- Friday, March 14, 1997 -- Moving Abroad? by Jim Surowiecki

Rogue Missives

ROGUE ARCHIVES

Friday, March 14, 1997

Moving Abroad?
by Jim Surowiecki (Surowiecki)
Individual investors opening the pages of The Economist in any given week might be forgiven for wondering why they haven't been invited to the party that's being held in the stock markets of the countries of the former Soviet bloc. The last page of The Economist is given over to "Emerging-Market Indicators," and the latest issue shows that since the beginning of the year the Russian stock exchange is up 70%, the Polish stock exchange is up 27%, the Hungarian market is up 30%, and stocks in the Czech Republic have risen 12%. At a time when the S&P index is up just six percent, and analysts everywhere happily predict a correction to be in the offing, the returns offered by stocks in the newest of the emerging markets seem rather tempting.
As is always the case in capitalism, though, you can't get something for nothing, and in the case of Eastern Europe the potentially staggering rewards are inseparable from the tremendous risks that investors -- domestic as well as foreign -- run in putting their money into these new economies. The great irony about investing in Eastern Europe is that while the short-term gains have recently been impressive, it's only in the long run that these countries offer the prospect of reasonable security and substantial growth. For now, in other words, individual investors are probably better off looking through the windows and wondering if the orange punch is any good.
Still, the experience of the Eastern European economies in the years since the fall of the Berlin Wall offers some instructive lessons for investors in the United States. In particular, the path that privatization has taken in these countries can tell us important things about the value of shareholder activism and a coherent structure of corporate governance. At the same time, because of the way ownership rights were distributed in Eastern Europe, the percentage of citizens who own shares in public companies is much higher in the Czech Republic and Poland than it is in the United States. The experience of average citizens with the market abroad, then, may be relevant to the attempt to expand the base of ownership in the U.S. Finally, the difficulties that Eastern Europe has faced in regulating corporate behavior, especially when it comes to securities law, makes the importance of the SEC clearer than ever, and testifies to the need to keep the pressure on public companies to be as open and accountable as possible.
As a region, Eastern Europe has tremendous fundamental strengths that should propel growth over the next decade. (Though in this respect, as in every other respect, the case of Russia is much more problematic.) Poland, for instance, grew close to 7% last year, as fast as any economy in Europe, while the Czech Republic grew at close to 4% and Hungary seemed finally to turn the corner as well. Russia, by contrast, saw its GDP decline by 7%, even as its stock market, like Hungary's, doubled in 1996.
In fact, the dramatic rise in Eastern European stocks over the last two years has still left those markets undervalued, at least by comparison with the United States. While Poland, the Czech Republic, and Russia have p/e-to-growth ratios of somewhere between two and three, the United States' ratio is now more than nine. If the expected growth in these countries translates into increased earnings for Polish and Czech corporations, these markets could easily continue their steady upward rise.
"The long-run prospects are superb," Andrew Weiss, professor of economics at B.U. says. Weiss runs a hedge fund that is invested throughout Eastern Europe, in particular in the Czech Republic. "It's really just incredible. You have labor costs in these countries that are from a tenth to a twentieth of Germany's, and labor productivity that's about 70% of Germany's."
However poorly Communism worked in bringing about sustained economic growth, it did a marvelous job of educating its citizens and keeping them healthy. When the Wall fell, and the free market came to Eastern Europe, companies faced the paradoxical situation of having workers whose education and trainability were not completely inferior to that of most Western workers, but whose living standards were dramatically lower. In certain respects, Eastern Europe offers many of the benefits of developed countries with few of the attendant costs. Which is to say that wages are, in Weiss' words, "abysmal" when compared with those earned by American workers.
Eastern Europe was also unlike other developing countries in the sense that a sizeable portion of what would become the private industrial base already existed. Although the more successful transition economies -- notably the Czech Republic and Poland -- have seen a radical upsurge in the number of small businesses opened since the onset of the market economy, most productive activity still comes from former state industries, which have, for the most part, been privatized. What this means, though, is that domestic capital markets remain relatively unformed and unsophisticated. And since companies have not had to be responsible to potential investors in order to raise money, they have not, perhaps, assimilated the idea of the corporation's responsibility to its owners.
In other words, although a lot of people in these countries own shares in companies, it's not clear how well the managers of these companies understand who their employers really are.
The tendency for managers to act independently is in part, of course, a legacy of the Communist countries' ill-fated experiments with market socialism, when managers were allowed to run companies as self-standing enterprises, free from the central planning of the command economy. The experiment was intended to introduce market principles into the socialist economy, but since managers whose companies failed were always able to get subsidies or cheap credit, the managers never felt any real pressure to succeed. Something similar continues to be true today, particularly in Russia.
At the same time, it would be a mistake to assume that the insulation of managers from outside supervision is a problem that's confined to former Communist countries. On the contrary, the whole point of the work done by pension funds like CalPERS to improve corporate governance procedures is that the connections between shareholders and the companies they own are often tenuous at best and nonexistent at worst. The recent proxy challenge offered by a pension fund that owns shares in General Electric <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: GE)") else Response.Write("(NYSE: GE)") end if %> to the deferred-compensation plan GE gives CEO Jack Welch is a good example of the kind of interventions that take place only rarely in the U.S. and, so far, not at all in Eastern Europe.
"The charters of [the newly privatized companies] have no guarantees for the shareholders," Weiss says. "And because the investment funds in which many of the people put their shares were closed-end, they didn't really have an incentive to push for good performance. You saw a lot of self-dealing on the side by managers, a lot of inefficiency."
Still, it's telling that for the most part Eastern Europe chose to emulate the American model of joint-stock companies in its path to privatization. In contrast to the Japanese or German models, where large corporations or large banks tend to control a sizeable portion of corporate assets, Eastern Europe attempted to democratize ownership by distributing vouchers to citizens. (In certain cases, workers and managers were allowed to take companies private, and in most cases workers were given the chance to buy a percentage of shares in their own companies at a discount.) This was both the most equitable solution, since everyone in a sense owned these companies to begin with, and the most efficient solution. Initially, Poland wanted to privatize by doing a series of IPOs. But the absence of anything resembling a functioning capital market and the sheer size of the task -- more than 5000 enterprises needed to be privatized -- made a voucher system far more practical.
The result was, if only for a time, something much closer to a truly democratic capitalist system than anything the U.S. has ever approached, with close to 80% of the people in the Czech Republic owning stock in the mid-1990s. The fact that ownership has grown more and more concentrated as the years have progressed may illuminate a basic truth about the system, which is that those who have the resources to look to the long run have a much better chance of reaping huge rewards by buying out those who need -- or want -- the money in the short run. In the Czech Republic, for instance, individual accounts called depositories were created for voucher-holders. Close to forty percent of those depositories are now empty.
"The public is always selling shares," Weiss says. "If they want to take a trip, or they want to buy something nice, they sell the shares. And that creates buying opportunities for us."
If the long-term prospects for Eastern European economies are so bright, and if there are bargains to be had, why are more Western investors not flocking abroad? (Aside from the Templeton Fund in Russia, there are hardly any high-profile mutual funds investing in Eastern Europe.) The short answer is: fear. The long answer is: fear of corruption, fear about property rights, fear about the lack of information.
In Russia, for example, the possibilities of either a renationalization of certain enterprises or, more generally, an inflation-fueled collapse of the economy as a whole loom heavily in Western minds. The prospective return of the crowd of reformers who started Russia on the path to the market in early 1992 could diminish concerns about the country's long-term stability, but the obstacles in the way of a coherent and fluid corporate system are still formidable.
"Russia needs dramatic changes in the ways the laws are interpreted," says Richard Ericson, a professor at The Harriman Institute. "We need much greater clarity in the protection of property rights, and corruption has to be fought vigorously, probably with non-economic means. Right now these are all major barriers to entrepreneurship."
In a sense, while corruption is the spectre that haunts all Western investment in Eastern Europe, it's the question of clarity that may tell us more about how and why stock markets work successfully. The striking thing about Eastern Europe from this perspective is how little information corporations are obliged to disclose about their operations. Ironically, for countries in which everything was once supposed to be public, the concept of public disclosure remains an alien one. Indeed, regulation as a whole is difficult because it conjures up memories of the state's policing activities during the Communist period. It becomes easier to get away with corruption and fraud because the perils of over-regulation are seen as too high.
More to the point, though, it becomes easier to get away with questionable accounting practices and underperformance. In theory, the great virtue of a strong structure of corporate governance and a regulatory authority willing to enforce the rules of the game is that corporations become truly public entities. Relevant information cannot be hidden from shareholders. And major decisions always, in one way or another, have to be approved by the owners. In reality, of course, the American system works this way only rarely. Whether it be private conference calls with analysts or managerial compensation that gets rubber-stamped by boards of directors, the practice of capitalism rarely matches the theory. What's interesting about Eastern Europe, though, is that while they've adopted the trappings of shareholder capitalism, they don't even have the theoretical framework in place.
All of which means, of course, that investing in these emerging markets is a tremendously difficult and risky thing for an individual investor to do. As Weiss suggests, a hedge fund that can diversify across markets and has the resources to do serious research has the chance to make tremendous profits in Eastern Europe. (The fund's holdings in Russia are up 300% over the past 12 months.) But individual investors face a quite different reality. And even a mutual fund like Templeton's confronts the dangers enumerated above. The reward, in that sense, reflects the risk.
At the same time, in the long run -- and we mean here the very long run -- thinking of investing in purely national terms may come to seem short-sighted. If the economy is going to become truly global, after all, restricting one's investments to the domestic scene seems like an unnecessary limitation. But global reach will only make sense when global regulation becomes a reality. In the mean time, be grateful that EDGAR exists and that you can peruse those 10-Ks whenever the fancy strikes you.
-- Jim Surowiecki (Surowiecki)
(c) Copyright 1997, The Motley Fool. All rights reserved. This material is for personal use only. Republication and redissemination, including posting to news groups, is expressly prohibited without the prior written consent of The Motley Fool.

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ROGUE ARCHIVES

Friday, March 14, 1997
Moving Abroad? by Jim Surowiecki (Surowiecki) Individual investors opening the pages of The Economist in any given week might be forgiven for wondering why they haven't been invited to the party that's being held in the stock markets of the countries of the former Soviet bloc. The last page of The Economist is given over to "Emerging-Market Indicators," and the latest issue shows that since the beginning of the year the Russian stock exchange is up 70%, the Polish stock exchange is up 27%, the Hungarian market is up 30%, and stocks in the Czech Republic have risen 12%. At a time when the S&P index is up just six percent, and analysts everywhere happily predict a correction to be in the offing, the returns offered by stocks in the newest of the emerging markets seem rather tempting. As is always the case in capitalism, though, you can't get something for nothing, and in the case of Eastern Europe the potentially staggering rewards are inseparable from the tremendous risks that investors -- domestic as well as foreign -- run in putting their money into these new economies. The great irony about investing in Eastern Europe is that while the short-term gains have recently been impressive, it's only in the long run that these countries offer the prospect of reasonable security and substantial growth. For now, in other words, individual investors are probably better off looking through the windows and wondering if the orange punch is any good. Still, the experience of the Eastern European economies in the years since the fall of the Berlin Wall offers some instructive lessons for investors in the United States. In particular, the path that privatization has taken in these countries can tell us important things about the value of shareholder activism and a coherent structure of corporate governance. At the same time, because of the way ownership rights were distributed in Eastern Europe, the percentage of citizens who own shares in public companies is much higher in the Czech Republic and Poland than it is in the United States. The experience of average citizens with the market abroad, then, may be relevant to the attempt to expand the base of ownership in the U.S. Finally, the difficulties that Eastern Europe has faced in regulating corporate behavior, especially when it comes to securities law, makes the importance of the SEC clearer than ever, and testifies to the need to keep the pressure on public companies to be as open and accountable as possible. As a region, Eastern Europe has tremendous fundamental strengths that should propel growth over the next decade. (Though in this respect, as in every other respect, the case of Russia is much more problematic.) Poland, for instance, grew close to 7% last year, as fast as any economy in Europe, while the Czech Republic grew at close to 4% and Hungary seemed finally to turn the corner as well. Russia, by contrast, saw its GDP decline by 7%, even as its stock market, like Hungary's, doubled in 1996. In fact, the dramatic rise in Eastern European stocks over the last two years has still left those markets undervalued, at least by comparison with the United States. While Poland, the Czech Republic, and Russia have p/e-to-growth ratios of somewhere between two and three, the United States' ratio is now more than nine. If the expected growth in these countries translates into increased earnings for Polish and Czech corporations, these markets could easily continue their steady upward rise. "The long-run prospects are superb," Andrew Weiss, professor of economics at B.U. says. Weiss runs a hedge fund that is invested throughout Eastern Europe, in particular in the Czech Republic. "It's really just incredible. You have labor costs in these countries that are from a tenth to a twentieth of Germany's, and labor productivity that's about 70% of Germany's." However poorly Communism worked in bringing about sustained economic growth, it did a marvelous job of educating its citizens and keeping them healthy. When the Wall fell, and the free market came to Eastern Europe, companies faced the paradoxical situation of having workers whose education and trainability were not completely inferior to that of most Western workers, but whose living standards were dramatically lower. In certain respects, Eastern Europe offers many of the benefits of developed countries with few of the attendant costs. Which is to say that wages are, in Weiss' words, "abysmal" when compared with those earned by American workers. Eastern Europe was also unlike other developing countries in the sense that a sizeable portion of what would become the private industrial base already existed. Although the more successful transition economies -- notably the Czech Republic and Poland -- have seen a radical upsurge in the number of small businesses opened since the onset of the market economy, most productive activity still comes from former state industries, which have, for the most part, been privatized. What this means, though, is that domestic capital markets remain relatively unformed and unsophisticated. And since companies have not had to be responsible to potential investors in order to raise money, they have not, perhaps, assimilated the idea of the corporation's responsibility to its owners. In other words, although a lot of people in these countries own shares in companies, it's not clear how well the managers of these companies understand who their employers really are. The tendency for managers to act independently is in part, of course, a legacy of the Communist countries' ill-fated experiments with market socialism, when managers were allowed to run companies as self-standing enterprises, free from the central planning of the command economy. The experiment was intended to introduce market principles into the socialist economy, but since managers whose companies failed were always able to get subsidies or cheap credit, the managers never felt any real pressure to succeed. Something similar continues to be true today, particularly in Russia. At the same time, it would be a mistake to assume that the insulation of managers from outside supervision is a problem that's confined to former Communist countries. On the contrary, the whole point of the work done by pension funds like CalPERS to improve corporate governance procedures is that the connections between shareholders and the companies they own are often tenuous at best and nonexistent at worst. The recent proxy challenge offered by a pension fund that owns shares in General Electric <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: GE)") else Response.Write("(NYSE: GE)") end if %> to the deferred-compensation plan GE gives CEO Jack Welch is a good example of the kind of interventions that take place only rarely in the U.S. and, so far, not at all in Eastern Europe. "The charters of [the newly privatized companies] have no guarantees for the shareholders," Weiss says. "And because the investment funds in which many of the people put their shares were closed-end, they didn't really have an incentive to push for good performance. You saw a lot of self-dealing on the side by managers, a lot of inefficiency." Still, it's telling that for the most part Eastern Europe chose to emulate the American model of joint-stock companies in its path to privatization. In contrast to the Japanese or German models, where large corporations or large banks tend to control a sizeable portion of corporate assets, Eastern Europe attempted to democratize ownership by distributing vouchers to citizens. (In certain cases, workers and managers were allowed to take companies private, and in most cases workers were given the chance to buy a percentage of shares in their own companies at a discount.) This was both the most equitable solution, since everyone in a sense owned these companies to begin with, and the most efficient solution. Initially, Poland wanted to privatize by doing a series of IPOs. But the absence of anything resembling a functioning capital market and the sheer size of the task -- more than 5000 enterprises needed to be privatized -- made a voucher system far more practical. The result was, if only for a time, something much closer to a truly democratic capitalist system than anything the U.S. has ever approached, with close to 80% of the people in the Czech Republic owning stock in the mid-1990s. The fact that ownership has grown more and more concentrated as the years have progressed may illuminate a basic truth about the system, which is that those who have the resources to look to the long run have a much better chance of reaping huge rewards by buying out those who need -- or want -- the money in the short run. In the Czech Republic, for instance, individual accounts called depositories were created for voucher-holders. Close to forty percent of those depositories are now empty. "The public is always selling shares," Weiss says. "If they want to take a trip, or they want to buy something nice, they sell the shares. And that creates buying opportunities for us." If the long-term prospects for Eastern European economies are so bright, and if there are bargains to be had, why are more Western investors not flocking abroad? (Aside from the Templeton Fund in Russia, there are hardly any high-profile mutual funds investing in Eastern Europe.) The short answer is: fear. The long answer is: fear of corruption, fear about property rights, fear about the lack of information. In Russia, for example, the possibilities of either a renationalization of certain enterprises or, more generally, an inflation-fueled collapse of the economy as a whole loom heavily in Western minds. The prospective return of the crowd of reformers who started Russia on the path to the market in early 1992 could diminish concerns about the country's long-term stability, but the obstacles in the way of a coherent and fluid corporate system are still formidable. "Russia needs dramatic changes in the ways the laws are interpreted," says Richard Ericson, a professor at The Harriman Institute. "We need much greater clarity in the protection of property rights, and corruption has to be fought vigorously, probably with non-economic means. Right now these are all major barriers to entrepreneurship." In a sense, while corruption is the spectre that haunts all Western investment in Eastern Europe, it's the question of clarity that may tell us more about how and why stock markets work successfully. The striking thing about Eastern Europe from this perspective is how little information corporations are obliged to disclose about their operations. Ironically, for countries in which everything was once supposed to be public, the concept of public disclosure remains an alien one. Indeed, regulation as a whole is difficult because it conjures up memories of the state's policing activities during the Communist period. It becomes easier to get away with corruption and fraud because the perils of over-regulation are seen as too high. More to the point, though, it becomes easier to get away with questionable accounting practices and underperformance. In theory, the great virtue of a strong structure of corporate governance and a regulatory authority willing to enforce the rules of the game is that corporations become truly public entities. Relevant information cannot be hidden from shareholders. And major decisions always, in one way or another, have to be approved by the owners. In reality, of course, the American system works this way only rarely. Whether it be private conference calls with analysts or managerial compensation that gets rubber-stamped by boards of directors, the practice of capitalism rarely matches the theory. What's interesting about Eastern Europe, though, is that while they've adopted the trappings of shareholder capitalism, they don't even have the theoretical framework in place. All of which means, of course, that investing in these emerging markets is a tremendously difficult and risky thing for an individual investor to do. As Weiss suggests, a hedge fund that can diversify across markets and has the resources to do serious research has the chance to make tremendous profits in Eastern Europe. (The fund's holdings in Russia are up 300% over the past 12 months.) But individual investors face a quite different reality. And even a mutual fund like Templeton's confronts the dangers enumerated above. The reward, in that sense, reflects the risk. At the same time, in the long run -- and we mean here the very long run -- thinking of investing in purely national terms may come to seem short-sighted. If the economy is going to become truly global, after all, restricting one's investments to the domestic scene seems like an unnecessary limitation. But global reach will only make sense when global regulation becomes a reality. In the mean time, be grateful that EDGAR exists and that you can peruse those 10-Ks whenever the fancy strikes you. -- Jim Surowiecki (Surowiecki) (c) Copyright 1997, The Motley Fool. All rights reserved. This material is for personal use only. Republication and redissemination, including posting to news groups, is expressly prohibited without the prior written consent of The Motley Fool.