Investing In The World’s Most Overlooked Economy – VanEck Vectors Poland ETF (NYSEARCA:PLND)

Investment Summary

Recent geopolitical instability in Poland has withdrawn investor attention away from the burgeoning growth of the Polish economy. This article has two key aims. The first objective is to evaluate Poland’s transformation from a distressed communist nation to a leading emerging market. Determining the reasons for the success of Poland’s early institutional reforms serves to enlighten essential areas for continued development. The second objective is to evaluate Poland’s current economic prospects amidst recently strained relations with Brussels. Recent pessimism over Poland’s ability to maintain fiscal discipline are argued to be in contrast to prevailing economic data.

Poland’s Transformation

In June of 1989, Poland was peering into the chasm of complete economic collapse. Widespread food shortages choked off labor productivity, while the inflation rate peaked at 639.6%. Even a tumbling zloty failed to promote export competitiveness, as state-owned monopolies lacked efficiency and relied on nearly obsolete technology. With 20% of Poles unemployed, the monthly pay of remaining laborers declined to as low as $20 USD. A regime change was inexorable.

Fortunately, Finance Minister of Poland Leszek Balcerowicz moved quickly to restore stability. The aptly named “Balcerowicz Plan” established the independence of the national central bank, abolished preferential treatment for state-owned companies, removed price controls, and opened Poland to private investment. Initially, the gutting of state-owned monopolies resulted in the loss of 1.1 million jobs. A widespread drop in industrial output and gross domestic product earned the Balcerowicz Plan the identifier of “shock therapy.”

However, the drastic limitation of state influence over price-fixing and removal of subsidies to industries such as coal and petroleum quickly brought internal debt to 3% of GDP. By 1992, earlier job losses were completely extinguished as more than 600,000 private companies provided jobs for approximately 1.5 million people. Hyperinflation too was tamed, as inflation fell from 250% in 1990 to 10% by 2000.

A Closer Look at Privatization

Since the economic liberalization of 1990, Poland has joined a small group of countries which have managed to avoid crises in 25 years. In fact, Poland was the only European Union Nation to avoid a recession through the 2008-2009 financial crisis. Taking into account purchasing power parity, Poland has averaged a GDP per capita growth rate of 6% over the last 20 years, the highest in Eastern Europe. How did Poland achieve the capacity to expand industrial output so rapidly? The extant literature provides only preliminary clues.

Blanchard, 1997 and Gomulka, 1998 highlight the creation of Poland’s thriving private sector. By early 1990, more than half of Poland’s economy and over three-fourths of the country’s farmland was privately owned. By 2001, over 6,800 state-owned enterprises had been involved in the privatization process, and the private sector grew to account for more than 70 percent of GDP.

Improved transparency, corporate governance, and productivity in these firms was crucial in unlocking the potential of Poland’s working population. Weisberg and Socha demonstrate that not only did privatization circumvent the deficiencies of unprofitable state-monopolies, it also promoted earnings 9.8% higher than those in the public sector. In short, from both a physical and human capital perspective, higher returns are stimulated by greater private sector activity.

Nevertheless, the privatization of large industries was far slower than anticipated. Gomulka 2016 notes that state ownership receded not due to bankruptcy and privatization, but due to a fall in state-owned production and employment. After rapid small-scale privatization of retail shops by 1992, it took until 1994 for the Mass Privatization Program (MPP) to begin to the transform just 500 large and medium-sized firms. The MPP created 15 national investment funds, or NIFs. Each NIF contained a broad range of enterprises and was listed on the Warsaw Stock Exchange. By 2011, more than 300 sizable conglomerates still remained under state ownership. Three major Polish conglomerates including PGE Polska Grupa (Poland’s largest power supplier), PZU (Poland’s top insurer), and Tauron (Poland’s second largest energy utility) only saw initial public offerings in 2010.

Investment in Poland

Liberalization of prices improved allocation of resources in smaller private sector businesses. However, it was the attraction of foreign direct investment to remaining large-scale public operations that created sustainable macroeconomic growth. From 1995 to 2010, various European neighbors were drawn to Poland’s low-cost, high-skilled labor and geographic advantages. Overall, Poland received more foreign direct investment than any other previously socialist European country, increasing from $89 million in 1990 to $178 billion by 2012.

In Lodz, foreign investment transformed the area into the largest white goods production center in Europe. Meanwhile, Germany invested nearly $113 billion in Poland as recently as 2013, or 17% of total FDI. At the same time, German investment of $113 billion in 2013 alone grew Poland’s automotive manufacturing sector to 10% of total output. Only around 37% of Poland’s banking sector is domestically owned, with various European multinationals controlling the flow of credit in and out of the country.

Moden et al.’s landmark 2007 study found that foreign privatized firms realized larger productivity gains than all types of domestic firms. From 1995 to 2000, foreign privatized firms across all industries averaged 46% higher labor productivity than state-owned firms.

Meanwhile, lower foreign investment into Polish agriculture over the same period has drastically reduced competitiveness in food production. The Heritage Foundation notes that while the agriculture sector employs 15% of working Poles, it contributes only 4% to the country’s GDP.

Evidently, while the rise of Poland’s dynamic private sector was instrumental in enhancing output, foreign direct investment played an equally important role. With Poland’s level of R&D expenditure to GDP ranking among the worst in all of Europe, reliance on foreign innovation and credit is crucial to sustaining current economic growth.

Poland Today: A Contrarian Investment Prospect

An analysis of the key structural underpinnings of Poland’s continued economic renaissance reveals that, despite EU concern, Poland remains a glowing economic prospect.

Geopolitical Concerns: Risk

Poland experienced a major shift in the political sphere in October 2015, when the right-leaning PiS party swept the government in favor of the Civic Platform. Since their victory, the PiS government initially instigated conflict with the EU for expanding state-control over the media. Within months of establishing party majority, the PiS passed a law that gives it the right to name heads of radio stations and public TV.

PiS efforts to impose conservative, Roman Catholic principles on Polish society have also incited protests involving thousands of Poles. The primary cause of public outcry was legislation aimed at restricting abortion privileges. Street protests again stirred the nation when the PiS pushed through three bills aiming to:

Force all sitting judges on the Supreme Court to step down and given the minister of justice the power to replace them. Dissolve the National Council of the Judiciary–the body that nominates judges–and give parliament the power to determine the makeup of its successor. Transfer the power to appoint the heads of local courts to the Minister of Justice.

The EU threatened instituting sanctions against the Polish state in response to such judicial reform, viewing the bills as a threat to judicial independence and the core tenets of democracy. Consolidation of judicial authority risks bringing back regulatory favoritism to a select elite.

Ignoring the foundations of Poland’s economic past, the PiS has also signaled a desire to wind down privatization activity. While previous administrations declared objectives to whittle down the number of state-controlled companies to 250, the PiS party will likely leave state-ownership at the existing 1000 small, medium, and large enterprises.

Aiming to reduce reliance on foreign companies, the party has also levied additional taxes on large foreign-owned retail and banking. Consequently, fixed capital formation shrunk by as much as 7.2% in the third quarter of 2016 as Poland experienced a material drop in foreign direct investment. The material lapse in GDP growth in late 2016 and early 2017 can be directly attributed to the deterioration of Poland as a hotbed for FDI and privatization, the very policies that led to its economic prominence post communism.

Geopolitical Concerns: Mitigant

A recovery in geopolitical stability in the latter half of 2017 has restored confidence in Poland’s economic engine. In October of 2017, the Sejm resoundingly voted 352-58 to cast down legislation that would have constrained legal abortion to cases where the mother’s life was threatened. President Duda defied Prime Minister Kaczyński and vetoed the bills which would have reshuffled the supreme court and dissolved the National Council. The bill allocating the power to appoint heads of local court remains, with President Duda citing a goal of removing judges which have been unaccountable and slow to render judgements.

Simultaneously, investment rebounded by 3-4% in the first quarter, as revivified confidence also buoyed private consumption by 1.6%. Although public relations continue to remain strained, the marked inflow of EU funds back into public investment projects and infrastructure revised GDP growth upward to a healthy 3.4%. Meanwhile, changes Poland introduced in 2015 and 2016 aimed at improving bankruptcy and restructuring frameworks, deregulating over 70 barriers to foreign business operation, and cutting the number of hours necessary to report taxes kicked in to mitigate remaining inefficiencies of state-owned operators.

Building off of the momentum Poland has established in the first quarter of 2017 will prove crucial in restoring economic sentiment. The PiS government’s acknowledgement of the economic rationale behind Poland’s shock therapy, namely privatization and FDI, will ultimately define the future as well as the past.

Demographic Themes: Risk

Poland’s population of 38 million has not proven immune to an aging demographic currently plaguing a variety of developed countries. As in most transition economies shedding a communist government, Poland experienced a rapid drop in birth rates in the early 1990s. Further aggravating the shrinking labor force, Poland’s accession into the European Union in 2004 opened the doors to substantial emigration to Ireland and the UK.

While the Civic Platform responded by increasing the pension age and lowering pension payments, the PiS party has reversed on sensical labor reforms. In December of 2016, legislation was adopted to reduce the retirement age from 67 to 65 for men and 60 for women. Furthermore, the PiS party has reneged on its agreement with the EU to absorb 6,200 Muslim refugees from Greece and Italy. Poland also records one of the lowest labor participation rates in the OECD. The lower labor supply artificially decreases Poland’s unemployment rate and has obscured structural deficiencies.

Poland’s ethnically homogenous population and the PiS’s imposition of Roman Catholic patriotism naturally resist the relocation package signed with the EU in 2015. Brussels has since launched infringement proceedings, further weakening bilateral relations between the two countries.

Demographic Themes: Mitigant

While an aging population continues to hamper labor supply, half of Poland’s population falls below the age of 35. Consequently, Poland’s labor force is actually younger than the majority of EU nations. What’s more, Poland has pioneered improvements on hits young labor force through emphasis on education. The average number of years of schooling stands at 11.8, one of the highest in the world. While corporate R&D is reliant on foreign innovation, 500 academic centers across the country foster a vibrant scholarly community.

By emerging as the dominant European center of modern Business Process Offshoring services, Poland finds employment for millions of young poles in service sectors from banking to retail. While exports continue to be dominated by automobile manufacturing and chemical processing, the services sector still contributes about 64% of Poland’s GDP. Wage bargaining in the service sector especially remains largely decentralized, with agreements over collective pay and conditions covering only 5% of employees in small companies.

Moreover, though Poland has remained defiant against accepting Middle Eastern refugees, the country has absorbed over 1 million migrants from Ukraine and the East in 2016 alone. Given a labor shortage of 75,000 employees in the retail sector, the influx of foreign workers is crucial in avoiding the need to excessively raise wages to attract laborers. Compared to the designated 6,200 refused refugees highlighted by media, Poland’s adoption of eastern migrants has flown under the radar.

Overall, Poland’s young, educated populace remains resilient to the structural difficulties hindering growth in developed markets. While recent PiS actions undermine the advantage Poland has maintained in Eastern Europe, continued emigration from Baltic States and a receding brain drain will sustain current labor force advantages. Recent resistance to the Posting of Workers Directive aimed at preventing companies from hiring workers in poorer European states by posting them for temporary work in Western areas will stem the flow of labor away from Poland.

Manufacturing and Industry

Even in the midst of one of the most enduring economic expansions in recent history, Poland has been reprimanded for lackluster infrastructure spending and inefficient tax regulation.

Infrastructure Risk: Ranking a mediocre 53rd (out of 138 countries) in the World Economic Forum’s Global Competitiveness Report 2016-2017, Poland physical capital lags many of its Western EU peers. Poor reviews are substantiated by the World Bank’s 2016 Logistics Performance Index (LPI). The LPI cites outdated road infrastructure and railway connections as Poland’s most immediate impediment to labor and capital mobility. Poland is currently ranked 72nd for the quality of its roads, with international companies often suffering long distances to airports, rail stations, and ports.

Mitigant: Despite its shortcomings, the PiS party recognizes the obstacles to further stimulating trade. The PLN 6.5 billion Polskie Inwestycje Rozwojowe (PIR) fund aimed at modernizing Polish infrastructure is now fully funded. Maria Wasiak, the Minister of Infrastructure and Development, has further pledged PLN 5 billion for road and railway development by 2023.

Meanwhile, restored foreign direct investment into public projects in Poland will continue to spur productivity improvements. Thomas White estimates that EU funds instrumental in developing Poland’s infrastructure propelled nearly 100% growth in GDP per capita in the last decade, and will continue to renovate rural areas. Since 2004, EU accession has severely limited trade restrictions to Poland from member countries. The World Bank’s Doing Business 2017 survey ranked Poland 1st in the trading across borders sub-category even despite infrastructure inhibitions.

With latest official statistics showing that Poland has successfully reduced its fiscal deficit by 10% to PLN 900m, the combination of strategic fiscal policy and foreign equity injections create an opportune environment for developing infrastructure.

Tax Risk: Meanwhile, Poland’s corporate tax regime is a sizable regulatory burden. For instance, companies spend an average of 271 hours per year declaring taxes, required to service 7 different payments before tax completion. Despite Poland’s low corporate tax rate of 14.5%, the country was ranked 47th out of 190 countries in the World Bank’s Doing Business 2017 report in tax matters.

Mitigant: Despite historical inaction against tax complications, a crucial component of recent fiscal discipline has been a crackdown on tax avoidance by tax authorities. Strengthened IT systems and an improved tax administrative system have improved budget deficit projections by 30% to 0.7% of GDP for 2017. While the domestic tax system consumes an abhorrent amount of company resources, it takes just one hour to comply with Polish import regulations. Comparatively, the OECD averages 13 hours to deal with import customs.

Inherent Advantages

Despite concentration on Poland’s geopolitical machinations, the country has championed a half-trillion-dollar economy that is now the world’s 24th largest. Poland’s exports account for 33 percent of GDP, 50% above the emerging market average of 22 percent.With wages at one-third of those in Germany, Poland has cultivated a manufacturing engine that rivals the Asian tiger economies of the 1990s.

Poland’s geographical location in the center of Europe has expedited its robust economic growth. Poland has been targeted by imperialistic powers as recently as WWII for its prevalence as the link between Eastern and Western Europe, connected with cities like London, Paris, Vienna, and Berlin. Poland’s large fertile area in Lower Silesia, the Little Poland Lowlands, the Kujawy, the Vistula delta, and the Lublin area have forged the world’s leading producer in rye, sugar beets, and wheat. Meanwhile, natural endowments in bituminous coal, sulfur, barite, and salt have crafted a mining sector active since the 13th century.

While other emerging nations are reliant on exporting raw materials like oil or soybeans, Poland has avoided the inherent volatility in commodity-oriented economies. Out of the 13 middle-income countries with average incomes of $10,000 to $15,000, Poland is among the 4 not dependent on materials such as oil and coal (which define Brazil, Russia, and Argentina). While 90 percent of leading oil exporters no richer relative to the US than they were two decades ago, Poland has gradually been eroding its development gap.

Most importantly, Poland has achieved continued economic exceptionalism without overindulgence in credit markets. While China has run up debts to nearly 300 percent of GDP, Poland’s credit exposure has remained stable since 2013. Again, Poland was the only European Union member to escape recession. As Poland had not yet joined the euro in 2008, the zloty’s ability to strongly depreciate against the euro bolstered exports, while Poland’s minimal fiscal deficit avoided rapidly augmenting debt payments. The Heritage Foundation cites Poland’s flexible exchange rate, central bank with an IMF credit line, and economic ties with Germany as the reasoning behind its escape from recession.

Investment in Poland

In 2016, retail investors closed 22,000 unused client accounts and continuously drew money out of Polish equities. Nevertheless, Poland has seen a resurgence in 2017, as continued economic resilience has finally begun to register on investment radars. The most popular Polish investment options include the iShares MSCI Poland Capped ETF EPOL and the VanEck Vectors Poland ETF PLND. PLND is the older of the two Poland ETFs, and has appreciated 11.5% over the MSCI Emerging Markets Index this year. U.S. investors’ enthusiasm for EPOL has also become evident, as the the ETF added $27.4 million in new assets, an additional 10% over its $260.3 million in assets under management.

While the U.S. stock market has reached frothy valuations and the Western European stock market has exceeded pre-crisis highs, the Polish market is still 20% below its previous peak. Again, Poland was the only EU nation to avoid a recession, and has averaged growth nearly double that of the U.S. economy. The best opportunities in Poland lay in the energy sector, where replacement of outdated energy plants and exploration of shale gas reserves create appealing investment options. Continued PiS favoritism of national Polish banks and retail options serve to solidify the attractiveness of the domestic financial sector. Finally, concerns over Brexit, Greece’s debt gradually mitigated debt crisis, and a cooled China have yet to materialize into a slowdown in the Polish economy; if anything, such developments have obscured the charm of the Eastern Europe region and nurtured a value investment opportunity.

The Market Vectors Poland ETF (PLND) currently presents an enticing pure-play Polish investment. With a forecasted PE Ratio of 12.84 due to healthy earnings growth of 8%, the ETF offers a risk-tolerant, value-add investment with low correlation to the S&P 500. The ETF’s concentration in key sectors including Financials (41%), Energy (16%), and Basic Materials (11%) target the most opportunistic components of the Polish market. Finally, a minimal expense ratio of 0.60% reduces risk of flowing returns to fund managers rather than fund owners. Given a dividend yield of 1.49% and an earnings growth rate of approximately 8%, investors can anticipate a 9.50% return before accounting for expansion in multiples. As a result, a conservative price target of $21.40 is expected for FY 2018, with a bullish price target of $22.90 (17.2% return) when accounting for increases in PE ratios to MSCI averages of 15.54.

Despite present political concerns, Poland remains one of the most overlooked, expansion-oriented value investments in the entire European region. Polish expatriates have returned to their country given rising economic opportunity, reducing the brain drain and inducing greater nationalism. No longer is the Polish plumber the poster child of emigration away from the nation. The Pole has returned to Poland, and soon foreign investors will flood in as well: the golden knob to the door is PLND.

Disclosure: I am/we are long PLND.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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