Central Europe & Russia Fund Inc. (CEE) Analysis - Revisited

We did an analysis of CEE on 9/2007 and concluded for global diversification, it is one of the better ways to invest a segment of the stock portfolio in the Central European market. Since then, we lost about a quarter of our investment including the whopping $10.26 capital gains payout in December 2007. That performance is respectable considering the backdrop of significant stock market correction in the markets where the fund invests.

The table below summarizes CEE’s current Top Ten investment allocations along with historical comparisons:





































StockAllocation % - 6/30/2008Allocation % - 6/30/2007Allocation % - 4/30/2006
Gazprom RU Gas utilities13.29.79.8
JSC MMC Norilsk Nickel RU Metals and Mining7.47.04.5
Lukoil RU Oil and Gas77.310.7
Bank Pekao PL6.13.6NITT
Ceske Energticke CZ5.43.93.2
Powszechna Kasa Oszczednosci5.4NITTNITT
Rosneft Oil Company5.13.1NITT
Sberbank RU Commercial banks3.44.6NITT
Telekomunikacja Polska PL3.43.63.1
KGHM Polska2.9NITTNITT

*NITT – Not in Top 10.

The big change over the two years is the shift away from oil and gas. (Surgutneftegaz, which had accounted for 11% allocation in 2006, is no longer in the top 10 holdings). The realized funds were channeled into investments in the banking sector. There was also a minor geographical shift in allocation during this period, which was the shifting of about 5% of assets from Turkey to Poland. The shift away from oil and gas into the financial sector is very much in accordance with the fund manager’s stated goal to diversify into consumer sectors. All in all, given the allocation shifts and the current investments, CEE is a good proxy for growth in the consumer sector and general economies of Russia and Central Europe.

Compared to the benchmark (CECE-45%, RTX – 45%, ICE-30 – 10%), the Turkish allocation (8%) is somewhat inline. There is roughly a 10% divergence in the CECE and the Russian allocations – Russia accounts for 56% of the assets while the benchmark allocation is only 45% and CECE accounts for 30% while the benchmark allocation is 45%. It is evident from the last two years that the fund has been following a different benchmark blend (CECE – 35%, RTX – 55%, ICE-30 – 10%) than what is indicated in their investor reports. While such divergence is reasonable, given that it has continued for two years, it is misleading that the fund is not following the published benchmark index.

Similar Fund Comparison:
The following table is a comparison of funds that have exposure to Central Europe:
















Fund NameRegional Details*Expense RatioCapitalizationPremium/Discount to NAV**
Morgan Stanley Eastern Europe Fund (RNE)Russia – 72.4%, Poland – 14.2%.1.9992M(5.79)
Central Europe & Russia Fund (CEE)Russia - 56, Poland - 22, Turkey - 81.01655.27M(14.73)
Templeton Russia & East Europe Fund (TRF)Russia – 911.73235.88M(4.34)

* Regional Details as of 3/31/2008.
** Premium/Discount data as of 9/19/2008.

The expense ratios of the funds are roughly proportional to the capitalization with CEE being lowest at 1% and RNE highest at 1.99%. CEE is trading at a discount of about 15% while TRF and RNE are trading at a discount hovering around 5%. Given the size of the fund, low expense ratio, and the sizeable discount compared to the NAV, CEE is a good choice among CEFs focused on Central Europe & Russia.

Projected Distribution:

Historically the fund announces distributions in December. The mid-year realized gain (as per the investor update) stands at over $100M making the distribution on that portion to be in the $7.5/share range, conditional to no further trading in the last 4 months. Last year, the payout was $10.26/share and the payout for this year is expected to be similar. The distribution is taxable to shareholders. As indicated in the mid-year investor update, last year's distribution was as follows: Ordinary Income: 0.84, Short-Term gain: 0.47, Long-Term gain: 8.84. Of these, the long-term gain is the most desirable type of distribution for shareholders because it is taxed at the relatively low long-term capital gains rates. For this year, the distribution ratio among the three classes should follow last year’s and looks favorable given most of the gains are long-term.

Risks:
Many of the risks mentioned in our previous update still remain, and added to it are the following additional risk factors:
  • Banking exposure: In the consumer slow-down spreading over Eastern Europe, banks are especially vulnerable and the fund’s increased exposure in the financial sector can backfire as the slow-down spreads to Central Europe.
  • The gradual re-nationalization of the Russian energy sector has the risk of Russia getting isolated. They are also very vulnerable to a global energy-demand slowdown as they are dependent on energy exports. Investors are already choosing to move away from holding Russian assets
  • Rising tensions with the US and to a lesser extend the European Union has resulted in the possibility of Russia getting isolated diplomatically. This has far-reaching consequences.
  • Devaluation of the Ruble against both the Euro and the US dollar as evidenced by the biggest drop in Ruble against the Dollar-Euro basket since 1995. The sizeable Russian foreign currency reserves of about $600B mitigates this risk somewhat as the central bank tries to keep the currency pegged based on the policy of a “managed float”.
  • Ageing demography’s in the region is a long-term risk that needs to be managed.
Summary:

A new investor should pay attention to the Distribution effect and the Geopolitical factors. As the shareholders are inline for a large distribution in December, it makes sense to consider purchasing the fund after the distribution date to avoid taxes. Such an event will be especially painful for new investors: They did not get to participate in the funds gain in market value in the years prior to their purchase. But, since the fund is realizing sizeable gains this year by trading out of many of their holdings, current investors have to pay taxes on the gains the fund realizes.

For an investor who purchased the fund earlier this year, the unrealized return should roughly be in the range from –15% to -35% depending on the timing of the purchase. Sitting tight is indeed the best option as the short-term risks and the distribution effect are not sizeable enough to justify exiting the position.

Lastly, for a long-term investor, the guiding criterion is the likelihood for out-performance in the future. Central European and Russian markets are undervalued by most measures although significant risks still remain.

The fund has relatively low expense ratios, is one of the largest funds specializing in Central Europe & Russia, and maintains a low turnover ratio while also being aggressive about shifting allocations to growth areas as such opportunities arise. The stocks listed in the Central European & Russian markets are generally not available to US investors as they are not listed in the NYSE or Nasdaq markets. For this reason, funds that specialize in those markets are the best bet to participate in the growth in those areas and Central Europe & Russian Fund (CEE) is a good choice.

12/09/2008 update:

The fund announced a distribution of just $0.07 for the year on 12/05/2008 payable 12/15/2008 - the ex-dividend date is 12/11/2008. They had significant capital gains in the first eight months of the year and so such a small distribution indicates one or more of the following happened in the last four months: a) The fund realized significant capital losses, and b) The fund experienced redemption pressure which resulted in them having to sell portfolio company investments at a loss. The Net Asset Value (NAV) as of yesterday is close to $20 - the fund is trading at a significant discount of close to 18% and as such represents good value.

Related Posts:

1. Central Europe And Russia Fund (CEE) - Analysis - 09/07.
2. Added to Central Europe And Russia Fund (CEE) holdings - 01/08.
3. Added more to Central Europe And Russia Fund (CEE) holdings - 09/08.

2 comments :

George said...

Nice review of CEE. I see the potential that this fund has. I especially like that it has a 14% discount to NAV. Thanks for submitting it to the Festival of Stocks.

ks said...

A reader asked why we say one should wait until after the distributions for the year w.r.t. investing in CEE. Here was our response:

In the US, for most people, dividends are taxed at 15%. That means, if you buy just before a large distribution is due, you get hit with a tax of 15% on the amount you received as dividends. So, it usually makes more sense to buy after the dividend is paid out. This is true whenever there is a large expected distribution due within a short period as is the case with CEE.

In a majority of publicly traded companies, the distribution is below 4% and that is paid out on a quarterly basis and so the tax consideration is not as relevant. But, CEE pays out yearly dividends and for this year the expected percentage is sizable...

Regards,

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