By Colin Croft, manager of the Jupiter Emerging European Opportunities fund.
Given recent events, Eastern Europe could well be the last place that springs to mind for income investors. But for those who take a long-term view, I believe 2015 could present an opportunity to buy into quality businesses in the region with sustainable and growing yields
A decade ago, companies in the region were generally reluctant to pay dividends. In some cases, this was for good reasons: many needed to reinvest profits in businesses that were doubling in size every two years. In other cases, it was for less enlightened reasons that reflected serious corporate governance issues.
The new reality
A lot has changed over the last ten years. Many of the businesses that were then in the early stages of breakneck growth have now, in my view, matured to a stage where they can increasingly fund their expansion plans from cash flows, while paying progressively higher dividends.
A good example of this is Magnit, Russia’s leading food retailer. This is still a company with considerable growth potential, in my view, due to the highly fragmented and under-penetrated nature of Russian food retail. Although it is the largest player, it still only has a single-digit market share. I believe it has significant scope to grow at the expense of weaker rivals that cannot match its best-in-class logistics and scale advantage in purchasing power. Magnit began paying dividends in 2009, paying a total of around $18m to shareholders. By 2013, this had grown exponentially, to just under $300m. While rouble weakness is likely to provide a headwind this year, this could reverse if, as I expect, the oil price recovers to a normalised level.
Moreover, this is a company whose top line has been growing by almost a third each year as it consistently rolls out its expansion plan. It currently yields less than the average for the portfolio, but I expect that over time it will eventually have an above-average yield, due to a combination of structurally-driven earnings growth and a payout ratio that I think has further scope to climb as the business matures.
At the same time, we have seen several instances where corporate governance has improved, even at the state-owned enterprises that are not typically noted for being investor friendly. Of course, political risk with regard to Russia remains high. Nonetheless, it is worth noting that the Russian government has encouraged several of the companies that it controls to increase their payout ratios, and while the blue-sky scenarios have not materialised, there has nevertheless been meaningful progress in this respect. Gazprom, for example, had a single-digit payout ratio in the pre-crisis years, and paid barely $1.2bn of dividends in 2006.
Yet by 2013, its payout ratio had climbed into the mid-teens and it paid around $4.3bn to shareholders. Relative to its earnings, these were still not overly generous figures, and there is room for improvement in other areas of governance, but share prices are so oversold, that provided payouts meet market expectations, at these levels they can nevertheless provide a solid dividend yield – in the case of Gazprom, this would be 5%
Private-sector companies such as Lukoil have been raising their payout ratio, as part of a broader movement in the direction of best practice. Of course, it is important to consider how sustainable oil company dividends may be in the wake of a near 50% fall in the price of crude. There are certainly legitimate concerns about the ability of western oil companies, operating in countries whose currencies remain strong in a weak oil price environment, to maintain their dividends.
I think Russian oil companies are different. When oil prices fall, they can benefit from a silver lining in the form of a weaker currency, as most of their operating costs are denominated in the rouble, which typically falls in line with the oil price. Their biggest cost items – mineral extraction tax and export duty – automatically fall, as they are set by formulae linked to the oil price. Russian oil companies generally have significant scope to cut capital spending, and are typically able to negotiate better prices from oil-field service providers, meaning that cash flows seem likely to prove even more resilient than earnings. Payout ratios have improved, but from a very low base, giving some scope to maintain dividends in absolute terms by further increases in the payout ratio.
Moreover, share prices of Russian oil companies have fallen more or less in line with the oil price. So even if dividends were to fall in line with crude, the yield today appears attractive relative to other yield-producing assets. For example, Lukoil’s prospective yield is around 7.6%3. This offers some margin of safety currently. Even at half these estimates, the yield would still be attractive, in my view.
For other exporters, the weaker rouble has been even more favourable as the prices of non-oil commodities have fallen by less than the oil price. Nickel, for example, has fluctuated around an average price of about $15,000/ton for the past couple of years, yet the operating costs of Russian nickel miner Norilsk have tumbled along with the rouble. Combined with its hard-currency export revenues, this should help to sustain the cash flows that underpin a dividend that is expected to yield just over 12%
More than just an oil play
Eastern Europe has always been about far more than commodities and Russia. About half of the Jupiter Emerging European Opportunities Fund is invested in markets such as Turkey, Poland, Greece, and the Czech Republic – all net importers of oil – and this tends to provide a natural hedge against commodity price fluctuations.
There are plenty of solid dividend stories in this part of the portfolio, such as the Czech bank Komercni, which currently yields over 5%. I think this is an extremely well-capitalised bank operating in a country with a sound financial system that has avoided some of the excesses seen in other countries. The relatively low mortgage penetration should provide scope for sustainable growth in the medium term.
Turkish automaker Tofas is also expected to yield 5%6 in 2015. In my view, it has good earnings visibility due to “take or pay” contracts with its partner and shareholder FIAT i.e. FIAT has to take its products or pay a penalty. Tofas is not just a contract producer, but one of the three global strategic manufacturing centres for FIAT, and has moved up the value chain by developing in-house R&D capabilities that gave it a leading role in developing its latest models.
The fund holds a range of ‘dividend payers’ from across the region, including insurers, telecoms, stock market operators, manufacturers and retailers. The diversified nature of the portfolio aims to help insulate the dividend flow from country, sector and stock-specific risks.
In a world where it appears that certain asset prices are being driven to unsustainably high levels by loose monetary policy, supposedly low-risk income opportunities such as western government bonds look increasingly overpriced. In my view, this overpricing is transforming them into assets that are potentially riskier than one might think.
While East European markets can be volatile, especially in relation to western markets, this can create opportunities for long term investors in the context of a well-diversified equity income strategy. Provided that dividend streams can be maintained, the low price of assets such as those of quality companies in Eastern Europe can potentially deliver high yields to investors, with increasing scope for payments to rise in the future as markets develop.
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