24 10/19 24/10/2019

Steve Gorelik on Value Investing in Eastern Europe

24-10-2019 16:10,
Steve Gorelik

Enjoy the following exclusive interview with Steve Gorelik, portfolio manager at Firebird Management, based in New York. In this conversation, Steve shares his thoughts and experiences related to fundamental investment analysis of Eastern European businesses.

Firebird Management has been investing in the region since it was founded in 1994. Firebird manages funds dedicated to equity investment in emerging markets, with an emphasis on the former Soviet Union, emerging Eastern Europe, and exotic sectors worldwide. Firebird conducts extensive research on companies in Eastern Europe, which includes numerous meetings with management teams to discuss fundamentals like capital allocation and competitive advantage. The firm has done significant work on the banking industry in the region, which indicates that well-run Eastern European banks can benefit from organic growth, relatively simplistic banking business models, and differentiation in customer service.

Steve joined Firebird in 2005 from Columbia University Graduate School of Business while completing education from a highly selective Value Investing Program. Prior to business school, Steve was an operational strategy consultant at Deloitte. He holds a BS degree from Carnegie Mellon University as well as a CFA charter.

The above interview was recorded in May 2019.

We are pleased to provide the following transcript as a courtesy. The transcript has been edited for space and clarity. It may contain errors.

Tyler Howell: Joining me is Steve Gorelik, portfolio manager at Firebird Management in New York City. The topic of our conversation is value investing in Eastern Europe. Walk us through your background and how you became interested in investing in that part of the world.

Steven Gorelik: I’d like to start with a bit about my firm because it has been investing in Eastern Europe longer than I have. Firebird Management has been around and investing in Eastern Europe since 1994. We started investing in Russian voucher privatizations. It was set up by four people who saw an opportunity. Their background didn’t have anything to do with Eastern Europe or much to do with finance, but they saw an opportunity there. I don’t know if you’ve heard the stories, but it seems like the whole Russian economy was valued in those voucher privatizations at around $6 billion to $8 billion, which is an amazing number if you think about it. That represents 1/6 of the Earth’s surface, and everything included was valued at just $6 billion to $8 billion. The people who saw an opportunity – and there weren’t that many of them – dropped whatever they were doing and said, “We have to figure out how to get involved in that,” which is what the founders of our firm did. That was the beginning. As a firm, we continue to invest in Eastern Europe and Russia, but over time, as other countries and equity markets have developed, the firm has developed along with them. We were one of the first investors in places like the Baltic countries and Georgia, as well as one of the first institutional investors in Romania, Bulgaria, and other places in Eastern Europe.

I joined the company back in 2005. Prior to that, I was an operational strategy consultant after college, and then I went through the Columbia Applied Value Investing program. The idea was that I wanted to switch to the buy side. When I found out there was a place in New York investing in a way that appealed to me from a fundamental point of view but also in a region I had a natural interest in because I am originally from Eastern Europe, I kept calling them until they picked up the phone. I started out working on some of the private equity stuff we used to do and then got more involved with portfolio companies and private equity. Over time, I was doing more and more on the public equity side, and I eventually became a portfolio manager and head of research at the firm.

Howell: Maybe this piggybacks a little off of your original point about the undervaluation in Russia, but historically, people maybe have been skittish about that part of the world. Perhaps someone as knowledgeable about the region as you are has a unique perspective on the state of geopolitical risk or capitalism in that area. How do you see that?

Gorelik: In terms of undervaluation in Russia and Eastern Europe, the thing about it is it has always been cheap, but it’s been cheap for various reasons over time. You started out with the whole economy being valued at a ridiculously low number, but that’s because it was just the start of capitalism. You went from a communist system where everything was owned by the state, and when it was being redistributed, it was hard to put a price on it, and it was extremely volatile. Initially, investing was, at least for the first 10 to 12 years of our firm’s life, very much focused on macroeconomic top-down analysis, trying to figure out which countries are more investable and have the rule of law that protects minority rights. Eastern Europe, places like Russia and Kazakhstan, are not being given enough credit because of the headlines out there. If you pick up the newspaper, you don’t find anything good about Russia, but it doesn’t get credit for a lot of the improvements done over time and also for a lot of the fundamentals that are there in the first place.

For example, Russia and Kazakhstan have some of the best minority rights protection in the world. They’ve been crafted based on best practices back in the early 1990s, and there is a law which truly protects the rights of minority shareholders. The question is how it gets enforced. Over the history of our firm, there have been times when we had to defend our rights. We would go to court in Russia and win if it was clear, based on the letter of the law, that these are our rights, and they should be protected. This is more of an exception as opposed to a rule in terms of investing because investing in Eastern Europe has become, over time, much more about fundamentals.

When I joined the firm, capitalism in Eastern Europe had been around about 13-14 years. Now it has doubled in time, and there’s a lot of learning that comes with it from the point of view of capital allocation and understanding what it means to have minority shareholders. Russia went from being cheap on a fundamental basis back in the early 1990s to where you now have opportunities which are quite different in the sense that you have much higher quality companies that have learned how to operate and allocate capital over the years. They do it much better than they used to 20 years ago, but they still trade at the same multiples.

One of the examples we give to illustrate the point is that back in the mid-2000s, the Russian market would trade at 5p-6p, and the dividend yield would be 1% or 2%. What was happening to the rest of those earnings? Some of them were being invested appropriately, some inappropriately. It was part of our job to figure out which one is which and find the right firms. Right now, the Russian market is still at 5p to 6p, but the dividend yield is 6%. When you speak to companies in Eastern Europe and ask them how they allocate capital and what they do to protect their competitive advantage, these questions are less and less weird for the people we talk to because they understand more what that means. If I’m talking to a retailer in Russia, it will talk to me about its hurdle rate and cost of capital and how it decides whether to open a new store from that point of view as opposed to just the need to grow. This is a fascinating change which has not been reflected at all in the multiples we’re paying for the companies.

We operate in a part of the world which has grown at a reasonably decent rate. Not like South Asia, but the real rate of growth for most of the countries we invest in is somewhere between 2% and 5%. If you add inflation, the nominal growth is a little higher. We’re buying companies at single-digit PEs which are excellently run and are leaders in their industries. Without changing the multiple, we expect 15% to 20% per year. If the multiple goes up, that’s great. If it goes down, we have a year where we don’t perform that well, but the fundamental value, the intrinsic value gets built. We are long-term investors, and our average holding period is seven years, if not longer. There is a lot of volatility there. There are years when the market is up 50%, and years when it is down, but if you look at the fundamentals of what is happening to the earnings of the companies and their intrinsic value, it goes up. It’s been a great place to invest. It’s very interesting, and the opportunities today are probably as good as they have been since I joined the firm.

Howell: What do you think about the lack of multiple expansion? Do you have a sense of what is driving that? Is it not important for that to change for an investor in the region to realize some return based on multiple expansion? If not, how does it flow to you in the fundamentals?

Gorelik: You touched on two different things, and both of them are essential. From the point of view of lack of multiple expansion, if we reverse the P/E multiple, what does it mean to have a P/E multiple of 6? It means you’re making about 17%-18% per year. Is that good enough for you as an investor or not? A lot of the time, it’s in local currency, so you should expect some devaluation in certain cases, but this is the inherent return. If nothing else happens, you’re going to make that. If the multiple did not change, and you have growth, you’re going to make somewhere in the teens. Half of it is going to get paid out to you in dividends, so it’s not just theoretical. It’s there.

Is that good enough or not? Part of the reason why the P/Es in places like Eastern Europe are lower is that the cost of capital is higher. If I’m an interested individual in Russia and have choices of how to invest, my default choice is to put the money in the bank in rubles, and I’m going to get 8% to 10%. That’s not bad. I think it’s a little lower now, but it used to be double digits. As inflation has been coming down, many things have been changing for the better. It’s 6% to 8% now, but it’s still the default for most of the population. That’s risk- free. That’s the opportunity cost. If I’m putting money to work in government paper, it’s around the same level. That’s the opportunity cost. In order for me to invest in equities, the returns have to be higher. I don’t live in Russia. I live in the United States. If I want to put money to work in a bank, I’m going to get 0.0-whatever, so there’s that opportunity, that arbitrage coming into play. Whether that’s enough or not, there are a couple of different things happening. One, we have the arbitrage from the point of view of the cost of capital because it is much higher in emerging markets. We can arbitrage that. The second thing is that I’m getting much higher growth rates. These returns I’m getting in places like Eastern Europe are good enough, even without multiple expansion, to be comfortable to hold the shares.

As to why there has been no multiple expansion, I think it has a lot to do with who invested or who is willing to invest in the market. Fortunately or unfortunately, depending on where you stand, Eastern Europe as an index has been a bad place to invest in since 2007. MSCI Eastern Europe, the index we look at, is still down 40% since its peak in 2007, so there wasn’t a cost for you as a foreign investor not to participate in Eastern Europe. What we do at Firebird is different. A lot of the things we have are not in the indexes, so our performance was quite different. As an institutional allocator, if you have to think about investing in Eastern Europe or not, there was no cost to you of not doing that like there was with a lot of other emerging markets. Meanwhile, we have all of these different headlines telling you not to do it. You would be taking a huge career risk by putting your foot down and saying, “Yes, I want to be putting money to work in Eastern Europe.”

Another reason the multiple is low is that if you don’t have the foreigners coming in, you need to have a domestic component. Some countries, like Poland, have a very well- developed pension fund system. They did it right from the early 1990s. They’ve developed a pension fund system and a domestic REIT. That led to a number of companies listing and knowing there is a way to raise money in the public market if you’re an entrepreneur. Poland, which one of the biggest countries in the region, has 800 companies listed on its stock exchange, far more than any other country out there. It is because there were a lot of IPOs being sold to these pension funds that have grown up over time. Poland’s multiple has always been higher as a result.

If you look at the Baltics, Russia, Georgia, and other places, they did not have any domestic demand component coming from the pension funds for various reasons. In the Baltics, you do have pension funds, and they are quite large relative to the size of the market or the economy, but because they’re managed by Scandinavian banks that own the banking system, they’re managed extremely conservatively – essentially, all of that money goes into government paper, either local government paper (which is in euros and pays almost nothing) or Scandinavian government paper. The money does not go into the equity market.

With the savings deposit rate going down, high net worth individuals are starting to look outside if they’re not to the point where they’re moving money outside of the country altogether. To them, starting to put money to work domestically is getting to that in a lot of the places where we invest. Because of that, you had the multiple expansion back in the 2000s as the foreigners were coming in. From the point of view of active management, we have had net outflows since 2007, which explains the low multiple. Will it change? I hope so, at some point in my lifetime, but we don’t bet on that as a firm because we want to make 15% to 20% without the multiple change. If we get the multiple change, that’s great.

Howell: Can you describe to us an example in the region that fits that bill, where you’re getting the yield you’re interested in regardless of the expansion?

Gorelik: One of the things I like to bring up when talking about the region is investing in banks. When you invest in a good Eastern European bank, you get exposure to the whole economy. If I’m investing in a Lithuanian bank, I’m investing in what it does from the point of view of supporting SMEs and whatever industry is strong. Often, I cannot do this via public markets. There is a base effect because these countries have been underbanked for a long time, so if the GDP is growing at 4% per year (closer to 7% in nominal terms), the banks will be growing 10% to 15%. If I’m buying into an Eastern European bank, what I usually buy is not the same thing as in many places in Western Europe because I make my money the old-fashioned way, on net interest margin.

In Georgia, the net interest margin is somewhere around 5%, and in Russia, I think it’s 4.5%-5%. Lithuania is a eurozone country, but the net interest margin for the bank we invest in there is still about 3%, which is pretty good. If you have that type of margin, good loan discipline, and an efficiently run bank, it’s not that hard to make an ROE of between 18% and 25%, depending on the conditions. In the United States, based on the studies we’ve done, you usually pay 1x book for about 8% of ROE if you buy a bank. If you buy Bank of America, Goldman, or even specialty finance companies, you usually pay a significant premium to book. If they are making 25% ROE, you’re probably going to pay 3x book for that. In Eastern Europe, for a bank generating 18% ROE, I’m going to pay a slight premium to book. I’m getting 15% per year plus growth. They retain some of the capital to sustain that growth, but they pay out a dividend of about 5% or 6%. Examples are Siauliu Bankas in Lithuania, Sberbank in Russia, Banca Transilvania in Romania, and Bank of Georgia in the country of Georgia. All of these banks have their own competitive advantages and reasons why they exist and why we love each of them. The bottom line behind all of these investments is that without any multiple expansion, because of the ROE and the growth, I’m getting somewhere between 15% and 25% per year.

Howell: How would you describe the threat or lack thereof of Western European banks taking some of that market?

Gorelik: They already have, but if you take a look at Lithuania, for example, Siauliu Bankas is the only locally owned bank. Over 90% of the banking system is foreign-owned. Scandinavian banks came in and bought out the biggest banks back in the late 1990s and early 2000s, paying big multiples of earnings and book. They took over the system, and this was the growth engine for them prior to the 2007 crisis. In Eastern Europe, and especially in places like the Baltics, the crisis was much more severe than what we saw in Western Europe or the United States because they’ve taken the pain to restructure their economy. In order to keep the pegs to the euro and eventually make it into the eurozone, they’d taken the pain. In the Baltic countries, GDP fell anywhere between 14% and 17% in 2008-2009, which is a huge change. At the same time, all of these foreign banks had problems back home. Instead of putting more and more money to work in Eastern Europe, as they had been doing in the 2000s, they needed to bring back as much money as possible.

The other thing is that these local subsidiaries no longer had unlimited funding, and the decision power behind making big loans moved back to the head office – in Sweden, Austria, France, or wherever the main ownership was. This step was taken to ensure the loan book stayed healthy, but it made it almost impossible for a local entrepreneur to get the loan because the decision doesn’t take two or three weeks but two or three months. Banking is about understanding the company you are financing, what the business is, and whether you’re going to support it or not. It was easier for all of these foreign-owned banks to say no than to say yes, which opened up an opportunity for what remained small, high-quality lenders in places like Romania and the Baltics to come in. They knew how to work with the SMEs, which turned out to be much better credits than the large companies, and they knew how to work with local currencies. Oftentimes, they were the only game in town.

Right now, these guys are gaining share. Clients are happy to work with these banks. Yes, they pay a slightly higher interest rate, but we live in the age of fairly low interest rates. If you have a difference between paying 2% to 3% or 3% to 4%, you will pay that extra 1%. It’s not going to make or break your project, but you will pay the extra money so you know the bank and you know how it works. If it’s a well-run bank – and that’s what we spend time trying to figure out – they can benefit from the system. In a lot of the places we invest in, foreign banks had net outflows of loans between 2007 and 2015-2016. They only started growing their loan books in the last couple of years, but at the same time, Banca Transilvania in Romania went from a 2% market share to, I think, 10% and is now the biggest bank in the country. Siauliu Bankas in Lithuania has also tripled its market share in the last four or five years.

In Russia, Sberbank is essentially the banking system, with a 50% market share. There are a lot of problems with banks in Russia, but Sberbank is too big to fail in a good way. It’s a government-owned lender, but it has to be run in as clean a way as possible because if it goes down, it’s a problem for the country. It’s a political problem, not just a financial one. Because it’s so big and dominant, it’s difficult for a lot of the foreign banks to come in and start chipping away. They don’t have much interest in the first place because of the headlines.

Howell: Are there other industries that are attractive to you in the region for similar reasons?

Gorelik: I think banks are unique in that the situation there is so clear. There are quite a few very high-quality companies in different industries. We invest in different things. In Russia, there are many peculiarities about doing business, trying to figure out the supply chain, and various other things, but a few high-quality retailers have come up over the years. Some of the Baltic countries also have a very healthy consumer environment, and the companies we invest in over there are retailers, construction companies, and banks, among others. Many businesses we buy into are strong materials manufacturers, oil and gas producers, or steel companies. In a lot of places in Eastern Europe, you have a tremendous resource base which allows you to be the lowest cost producer in the world. From that point of view, if it’s a well-run company – and over the years, those companies have become increasingly better run – you can invest in a world-class company at a fraction of the multiple you would pay here.

One of the companies in our portfolio fitting the criteria is Russia’s VSMPO-AVISMA, which is the biggest and best-integrated titanium manufacturer in the world. It is a supplier to Boeing and Airbus and has absolutely the best industrial complex in the world. This company is trading at a single-digit multiple. I think the dividend yield is something like 6% or 7%. Western companies with a similar position in the value chain trade at 15% or 20% EV/EBITDA, which are ridiculous multiples because there’s so much value being generated within these companies. Because this is a Russian company, it only trades in Russia, and it has a relatively low free float, it trades at a very different multiple.

We are generalists in terms of what we do, and there are opportunities in the oil and gas sector. Not every oil and gas company is great, but there are some phenomenal ones in the region. You can say the same thing about steel, retail, and banks, so there are a lot of different opportunities. In places like Romania, there are interesting opportunities in supply chain manufacturing for Western Europe because it has become an outsourcing hub for the automotive industry. A lot of tier two and tier three suppliers will have some factory set up in Romania. There’s a Romanian company in our portfolio which is an aircraft MRO. It services Lufthansa planes, and it is a great business. These are not huge companies, but they are really well-run.

A lot of the companies in Eastern Europe are still majority owned by their founders. Over the years, it’s been shown that family-owned companies do better around the world. Most of the companies we deal with have a majority shareholder. If it’s the type of majority shareholder that understands why it’s good to have minority shareholders and to make good decisions about allocating capital, then you don’t have the principal agent problem you have in many places in the West.

We’re able to find these opportunities by being there for 25 years. By talking to the people, we know which companies are run better or worse. It’s not rocket science. In many cases, you can see it from the financials. When I started, I had to become an expert on reading Russian accounting standard financials. It was weird and 150 pages long, a lot of it gibberish. It was my competitive advantage, in a way. However, that advantage went away because all of these companies now report in IFRS, which is the European version of GAAP. On the other hand, it’s great because you don’t need to be an expert anymore to try and comprehend what a company does. You can see how they make decisions, and they make better decisions.

Howell: To go back to the resource base, does it translate into just lower input costs for all these industries? Is that what makes it attractive?

Gorelik: It does. For example, if you go with oil and gas in Russia, the extraction cost for oil there is like $5 or $6 per barrel. It’s not much more expensive than in Saudi Arabia, which is the cheapest place in the world. If you’re selling oil at $70 per barrel, it’s fairly easy to make money. Yes, the state will take away a large chunk as it does in any country, but there you have a resource base which allows you to make a lot of money. We used to have this company in our portfolio which is no longer public, Uralkali, one of the biggest potash producers in the world. Potash is an interesting fertilizer resource because there are three major fields in the world – one in Canada, one in Belarus, and one in Russia. If you have access to one of those three fields, you are the lowest cost producer. There’s other potash around the world, but you’re definitely higher up in the cost curve. You have this in Russia. There is a company called Norilsk Nickel, one of the lowest cost producers of copper, palladium, and precious metals because of the nature of the deposit that it has. There’s a number of similar examples with integrated steel companies because they have access to cheap iron ore and coking coal. They also have massive factories, some built in Soviet times and upgraded over the years, which also helps these companies to be the cheapest producers in the world.

Going back to what I said in the beginning, the resources that were there and were completely undervalued back in the 1990s are still undervalued. They’re being utilized much better now. Before, you would be investing in a company pumping out oil without knowing how to process it properly. If it was a steel manufacturer, it would be a producer of slab. Over the years, these companies have built up the capacity to produce many value-added products, integrating and capturing a lot of the value and knowledge. This has not been reflected in the multiples we’ve been paying.

Howell: We appreciate your perspective and your ideas. Thanks for joining us.

Access other articles and investment idea presentations by Steve Gorelik.


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