Nicholas Watson in Prague -

Pity the small-cap stock in Central and Eastern Europe: mostly ignored during the good times and then dumped at the first sign of trouble. And the fallout from the present financial crisis could make investing in such assets even harder.

Given there's no CEE equivalent of the US' small-cap index, the Russell 2000, it's hard to put a precise figure on how small-cap stocks have fared over the past year. But the performance of the Avaron Emerging Europe Small Cap Fund, which invests in listed small and mid-cap companies in new and prospective EU member states, gives a pretty good idea of the depth of their problems: in the past year, the fund is down 43%.

Small-cap stocks in the region have, like their cousins elsewhere in the world, suffered badly from the so-called "flight to liquidity," when in times of trouble investors switch out of small-cap firms, which have higher levels of perceived risk and lower levels of stock liquidity, into the larger, more liquid caps, so that should the investor need to raise cash to meet margin calls or redemptions, they can do so relatively easily and quickly. Given that virtually all stocks in emerging Europe are small and mid-cap stocks by international standards - "Some 54% of our current coverage has a capitalization of below €500m," says Fritz Mostboeck, head of research at Erste - the "micro" caps in the region have suffered particularly badly.

Weighing further on the price of these shares is that the companies are based in countries that are, rightly or wrongly, perceived to be riskier. Therefore, the trillions of dollars of wealth that have been destroyed since the collapse of the US sub-prime mortgage market sucked out money from these developing countries like a black hole, leaving stock markets across the region nursing huge losses. In the second week of September, another $2.2bn was pulled out of emerging market funds to the benefit of US funds, which were, ironically enough, reckoned to be a comparative "safe haven" after the US government began putting together its massive bailout package. Falling commodity prices were another of the main factors pushing money out of diversified global emerging market funds, which are supposed to have seen some $11bn flee since beginning of the year. In total, Erste calculates that all emerging market funds have so far suffered outflows of $28.6bn since the beginning of 2008, which works out as 5% of assets that were being managed at the beginning of 2008. For the same period last year, these funds enjoyed inflows of $10.7bn.

With the markets currently being driven purely by that hard-to-pin-down quality called sentiment, growth - such as that associated with emerging markets and small-cap stocks - is now synonymous with risk. "We are in a place where panic and chaos exists. That means stocks are sold worldwide and at the moment nobody is interested in fundamental data or valuations," says Erste's Mostboeck.

Diamonds in the rough

In the short term, with volatility set to continue for some time to come, at least until the first quarter of next year, few would recommend a precipitous return to small caps. However, tumultuous periods such as these typically represent a good entry point into small-cap stocks for the medium- to long-term investor.

Why? Analysts point out that the equity market tends to precede the economic cycle and small caps can start to outperform in the middle of a recession. In the medium to longer term, there is the prospect that small caps will outperform large caps as the valuation discount narrows.

"I agree with the idea that small caps could perform in the middle of a recession. Their size alone means the time lag it takes from a switch in strategy to the implementation is shorter than for mid to large companies, thus the small caps could - or theoretically should - respond and adjust faster in times of recession, by switching production," says Adrian Ciocoi, head of research Emerging Europe at Riedel Research Group, which provides independent research on companies in emerging markets.

Ciocoi adds, however, that on the flip side, due to the wide range in their performance, be it in revenues or income, the small caps are the ones to go bankrupt faster in a recession. "Of the entire small-cap universe, there are definitely some sectors that perform better than others - as is the case with the mid or large caps as well. Therefore, I would not generalize for the entire small-cap spectrum," he says.

Fund managers stress that an investor's focus should be on small-cap stocks that have a clean balance sheet, solid revenue and profits, and the ability to sustain the operations internally without the need for external funds, which are increasingly hard to come by in the present credit crunch. However, here the investor runs up against another perennial problem for small-cap stocks in the region, and one that will arguably become worse after the current shake-up of the world's financial architecture.

A recent study by AQ Research, which analyses data put out by the investment banks and brokerages, unveiled that small-cap companies have long suffered from a lack of research coverage in the market. The unfortunate effect is a lack of liquidity in the company's shares and a market value that can often be wildly out of sync with fundamentals, it says.

Ciocoi lists two main reasons why the micro-to-small caps in CEE are generally "neglected" by the research departments of the brokerages. First, there is simply no financial incentive for the brokers to direct their analysts to cover the companies and, second, the underwriter of the company's IPO will almost always have a slight competitive advantage in terms of research over others. By way of example, he cites Polish Energy Partners, which has a market cap of about $230m. Although the free float of Polish Energy Partners is 100%, the average daily turnover is just $290,000. That means the potential commission for any broker is approximately $290 per trading day in net fees, assuming an average 0.1% commission after tax and expenses. "This amount of $290 per day is not an amount that would bring in intense competition over who would want to intermediate/broker the shares of PEP on the Warsaw Stock Exchange," he says. "As a result, there will not be available research on this company - or on such companies as PEP - as the sales personnel of the brokerage houses usually decide on which companies their analysts in the research department will cover."

Such a problem promises to get worse as the standalone investment-banking model disappears and the number of banks offering such research is reduced either through bankruptcy or merger. "Of course, from this crisis there will be an impact in that the research capacities will be reduced overall because all the larger investment banks will not exist in the form they had for decades," says Mostboeck.

This will inevitably open up space for independent niche players like Riedel Research, as well as the existing "local" regional banks such as Raiffeisen and Erste. "Our on-the-ground analysts are willing and able to provide the investors with research on companies categorized as micro-or small caps as well. Why? Because Riedel Research is not involved in any trading or investment banking but does only equity research," says Ciocoi.

The continued availability of such research will be crucial for investors if, as Mostboeck and others say, small-caps in CEE are set to outperform their peers in other emerging markets once investors start looking again at the fundamentals, perhaps from the first or second quarter of next year. "Fundamentals are key for identifying the gems among small caps," says Mostboeck.

Given the region encompasses countries as diverse as the Czech Republic, Romania, Russia and Serbia, many experts say it's hard to really class the entire region as "emerging."

"The CEE region overall is regarded as an emerging market asset class, but in my opinion that's not true," says Mostboeck. "Of course there are some emerging markets like Serbia, Romania or Ukraine, but from my perspective most of the equity markets in Central Europe like Poland, Austria, Hungary or the Czech republic are developed."

As well the fact that membership of the EU means these countries can't be thought of as a risky emerging asset class, Erste is predicting an average of 5% GDP growth for the new members in 2008 and 2009 - quite the opposite of what's expected in the US and western Europe.

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