Fund capitalises on price inefficiencies

The Nevsky Fund will aim to capitalise on pricing inefficiencies resulting from inaccurate consensus forecasts of growth rates and the cost of capital.

At the macro-economic level seven factors are vital: growth, liquidity, assets and liabilities, currency, management, valuation and technical factors such as sovereign risk premia. These factors also operate at the micro level when used as a framework for disciplined company analysis: growth, for example, can be assessed via earnings, liquidity via internal cash generation and share volumes, currency via foreign exchange debt and exports, and valuation on cross-border and sector comparisons.

In practice the process begins with company meetings, meetings with macro policy makers, and a collation of macro statistics and company accounts. This feeds into a proprietary database which attempts to identify pricing anomalies by making macro and company earnings forecasts and comparing these to the consensus view. The final step of the process is portfolio construction, which takes into account stock selection, asset allocation and a risk overlay.

Taylor says: "Our investment process depends on rapid, fundamentally-based decision making. The process is highly dynamic. We are constantly on the alert for catalysts or 'trigger events' in response to which we will rework our own earnings expectations and compare these to the market consensus and to valuation benchmarks, as well as doing a certain amount of technical analysis to determine whether this is in the market."

According to Taylor there are two main themes in the region on which the fund can capitalise: EU convergence, which should include the Czech Republic, Hungary, Poland, Greece, Estonia and Slovenia, and structural reform most notably in Russia, Turkey, Romania, Bulgaria and the Ukraine. Both of these trends, he believes, should result in falling risk and rising asset values.

Taylor says: "Convergence should lead to a positive environment for equities. Strong economic growth will be positive for earnings while falling interest rates should see multiples expanding."

In addition, interest rates have already begun to fall as a result of reducing political risk and rising credit quality all of which should provide a bullish environment for equities.

The structural reform theme is already underway. "In Russia, for example," says Taylor, "Putin is re-imposing government authority and there is real economic reform. This, together with a resumption of economic growth, has been recognised by the debt market: the JP Morgan EMBI+ Composite Russia index is nearly back to its pre-crisis levels. However it has yet to be fully recognised by the equity market- Russian equities remain very cheap. For example, Surgutneftegas, the country's second largest oil company, has expanded its production by 50% and is now sitting on a lot of cash which we think it will use to buy other oil companies and yet it currently trades on a P/E of 2.9x, with an EV/Ebitda of 0.4. Investors are currently unnerved by perceived risk at the corporate level but we expect this to fall, as a result of factors such as the reduction in oligarch influence and Putin's eagerness to foster FDI."

Taylor is less confident about Turkey, however. "We are bearish about the market and will take advantage of this by selectively shorting companies there. We think the IMF P page 17

PP programme is flawed because the exchange rate is over-valued. This has led to a widening current account deficit which will mean interest rates remain at higher-than-anticipated levels. This is bad news for the equity market."

In general the fund will not use index shorts, Taylor says. "They are expensive and are also inefficient you go short the good companies as well as the bad. If, for example, we were to take an index short on the Turkish market we would in effect be betting against a number of exporters which should be the beneficiaries of devaluation." The maximum net gearing level will be 130% on the long side and 30% on the short side.

"We also like platinum producer Norilsk Nickel. Demand for plarinum is going through the roof at the moment. The outlook is strong and at a P/E of 1x earnings it is very cheap.

"Around late autumn people realise the market is oversold and this leads to a bizarre swing every year. In more efficient markets such as the US or the EU markets, this process would be better recognised and as a result canny investors would discount it away. But these markets are dominated by domestic investors who take a relatively parochial stance. As a result this obvious inefficiency is not arbitraged away. However, I think that Eastern Europe's markets are becoming more efficient in 10 years' time this opportunity will no longer exist."