A Russian Rebound
Our Russia-based investment correspondent shares some of his personal insights on the country.
Moscow is finally seeing the sort of multiplication of small service businesses seen in Eastern Europe two decades ago (there are a good 30 lower/mid-market Sushi places within walking distance of our Kurskaya apartment – as opposed to zero a decade ago).
After more than a decade of trying, the merged RTS/MICEX will finally allow the direct participation of those foreign investors not yet scared off by the abuse of minority shareholders.
Russia is the world’s biggest exporter of natural gas and the second-biggest exporter of oil. It is also the third-largest exporter of steel and primary aluminum. However, it was one of the hardest-hit countries during the recent global economic crisis, largely due to its huge dependence on commodity prices. Oil prices plummeted and rating agencies lowered their credit ratings on several Russian banks, while the country’s GDP shrunk by 7.9% in 2009 and stock prices plunged significantly from their peak. The government had to recapitalize the banking system and bail out several large state companies, thus putting further pressure on its own finances.
Many companies are still reeling from the aftermath. During the thriving years of economic growth, we saw many start-up companies emerge, flourishing in a very favorable environment. However, tested in challenging times, some companies’ business models turned out not to be viable and failed to see them through.
However, we have already seen a sharp recovery for Russia’s GDP growth recently when commodity prices stabilized. Russian oil supply experienced significant growth in past years.
Skolkovo, a high-tech hub
Russia’s avenue for growth is plentiful. A key government priority is to diversify into technology. The Russian government earmarked 170 billion rubles (5.5 billion U.S. dollars) for the establishment of Skolkovo, a high-tech hub outside Moscow and Russia’s answer to Silicon Valley. Several US, EU and Asian technology companies will be taking part in the Skolkovo project, with one American multinational pumping in US$1 billion worth of investment. This project is enjoying strong governmental support, which could create a strong platform, take the budding tech industry to a new level, and bring in fresh state, institutional and private investments in a sector that seems immensely promising.
We have also seen the government take a number of initiatives to attract investors such as abolishing capital gains tax on long-term direct investments. However, significant comfort for foreign investors can only be achieved by reducing state involvement in businesses. Corruption is still prevalent and we believe the government should create clear rules to help protect private businesses.
While Russia diversifies and integrates with manufacturing and services, it is imperative to bear in mind that with more global industrialization, natural resources demands are increasing dramatically. It is challenging for a country so abundant and reliant on oil and natural gas for revenue to reduce this dependency. For oil and gas companies to weather economic storms and stay ahead of its competitors, they should have a strong exploration base, professional operations and low production costs. For instance, one such company is one of the world’s largest and lowest-cost producers of nickel and palladium as well as a leading producer of platinum and copper. It also produces various by-products such as cobalt, rhodium, silver, gold and many others. Its resource base is well over fifty years ahead, and it enjoys great demand for its products. Such companies that have outstanding business models could garner a lot of credibility for Russian investments.
Doing business in Russia is getting easier
International investors still have little interest in Russia. Many seem to have failed to notice that the country is currently implementing an ambitious reform agenda, which is to make doing business much easier.
We have received lots of feedback after having had the privilege of talking to many of our correspondents and clients. All are often at least just as passionate about and interested in investments as we are. It was clear that many of them are interested in lowering their exposure to bonds and increasing their proportion of share investments. Except for Russia, which is constantly front and centre in the majority of the questions we are asked, the number of questions concerning the recovery in China has increased significantly. Many clients are interested in China, but have been waiting to see a turnaround in GDP figures, which we recently saw quarter-on-quarter.
One big reason for the success of the Turkish stock market is the country's effective inflation control policy and its focus on bringing down the country's interest rates to more manageable levels. The effect this has on the economy, which previously had been living under hyperinflation, is enormous.
Russia is in a similar situation with regard to interest rates and inflation control, and can also boast of record-low unemployment. In spite of that, interest from international investors is scant. The questions that come up repeatedly concern corruption and political instability. What many people failed to notice is that President Putin campaigned on an ambitious reform agenda. One of the most measurable goals was that he wanted to move Russia from no. 120 to no. 20 on the World Bank's ease of doing business index. Russia already took a small step up to no. 112 in the first year. We are convinced that Russia, similarly to other former Soviet republics, has the ability to move far up on the list. For example, the former Soviet republic of Georgia is ranked no. 9.
Speaking of the success of former Soviet republics, it's hard to overlook the Baltic States. We still think there’s a special feeling when paying with euros in Estonia, and soon people will be able to use the euro in the rest of the Baltic states too, with Latvia aiming to convert to the Euro in January 2014 and Lithuania in January 2015. We'll already know how things look for Latvia this summer, which is when it will be decided whether the Latvians fulfil the criteria. If they do, it would mark an incredible recovery from the 2008–2009 crisis!
Russian equity and bond investors – worlds apart
The equity market is putting an almost historically large discount on the Russian market, whereas bond investors are valuing Russia at an all-time high. This discrepancy does not only hold for comparison with other emerging markets, but also with Russia’s own history.
It is difficult to see how both groups of investors can be right, as the most commonly cited problem in Russia is related to governance in a broad sense, which should have an impact on valuations of equities as well as sovereign bonds.
Let’s begin by taking a look at the valuation discrepancies, starting with the spread between Russian bonds and equities over time. The spread between the implied 10-year bond yield and the equity earnings yield used to be around 5%, and stayed well below 10% before the global financial crisis. But it has widened to almost 20% today.
Russian bonds vs. Russian equities
Source: Bloomberg
The trend is the same when studying equities alone. The Russian discount on the global emerging markets (GEM) average has risen to an all-time high of 64%, which is almost twice as high as the 10-year average. Although this long-term data may not be fully robust (due to a sharp revision in the trailing P/E estimates), the trend is clear. Russian equities are also roughly 50% cheaper today than their own 10-year average.
Russian equities vs. global emerging markets equities (trailing P/E)
Source: Bloomberg, East Capital
The equity market has been volatile over the years, but was nevertheless one of the best markets in the world during the 2000s. Whereas it was the bond market that failed back in 1998. So before answering who’s right and who’s wrong, it is relevant to discuss if bond investors are too naive and equity investors too sceptical of Russia.
There is a prevailing view among equity investors that there is a deep governance deficit in Russia, in the public (politics) as well as in the private (corporate governance) sector. Anecdotal evidence – based on discussions with a large number of investors – suggests that equity investors have a problem with corruption, corporate governance and the cost of doing business in Russia. Put differently, they have the same view of the Russian market as the Economist magazine, where next to nothing in Putin’s Russia is good. The resilient economy and excellent public finances are only a function of high oil prices – the transformed monetary policy and strong consumption trend are conveniently overlooked – whereas any attempts to fight corruption and improve governance are either ignored or dismissed as dead on arrival or destabilising. It is rarely mentioned that Russia already scores better than both Brazil and India in the World Bank’s Doing Business Survey, and that Putin has made it a goal of his third term to move from place 120 in 2012 to 20 by 2018. Instead, equity investors focus on Pussy Riot and dismiss Russia as a prefix democracy, while happily investing in China, which is not a democracy by any standards.
Equity investors also seem to have missed the fact that Russia joined the WTO last year and has pushed through a series of financial market reforms over the past year. More surprisingly, they seem to have ignored how dividend payments have increased substantially and that all listed companies now must use Western accounting standards. These used to be discount factors in Russia, and suggest that the discount on its own historical average should have decreased rather than increased. And equity investors do not seem willing to give Russia the benefit of the doubt when it comes to the fight against corruption. Or they could be simply unaware, as most of the Western press has failed to report on the anti-corruption drive that started last autumn with the firing of Defence Minister Serdyokov. The news outlets that were very quick to report on the legislative changes that made life difficult for the opposition last summer seem more hesitant to report the new legislation that is limiting the reach for corrupt officials.
A certain dose of scepticism is not necessarily a bad thing, but it sometimes seems that equity investors are overly emotional when it comes to Russia. It is probably fair to say that much of the Western establishment has a problem with Putin’s Russia, and this is increasingly reflected in public opinion as well.
The latest survey from Pew Global suggests a dramatic shift in opinion towards Russia over the past year. The percentage of respondents with favourable views of Russia dropped by almost 14 percentage points on average in the UK, US, France and Germany, while those with unfavourable views increased by almost 13 points. The result is that majorities in all four of these countries now have unfavourable views against Russia, and the negative bias is very pronounced in France and Germany. In 2011, it was only Germany that had an unfavourable majority, and the negative bias was rather small. There is reason to believe that this has had an impact on the equity market, as Russia has a small domestic investor base and a lot of the external capital comes from financial centres like London, Frankfurt and New York. But if this is the case, why has it only affected the equity market and not the bond market? This leads us to the second question.
Opinion of Russia
Source: Pew Global
Few people would characterise the sovereign bond market as naive, as it is normally very sensitive to macroeconomic and political issues. So why aren’t bond investors more concerned about the situation in Russia? It is tempting to argue that they are more short-term, as the economy is on solid ground as long as the oil prices are high, which most analyst believe will remain the case in the short to medium term, and no political change is better than an uncertain change in the short term. A related explanation could be that bond investors are more cynical than their peers in the equity space; they do not care about host market governance or home market public opinion, as long as the risk-reward is appealing.
Moreover, the Russian bond market has benefitted from the general interest in emerging market bonds during the past year. There has been a virtual flood of capital moving into EM bonds in search of yield, and a certain amount of that also reached Russia. It has also become easier for foreign investors to buy Russian bonds through the introduction of Euroclear. The same process will be introduced for equities in 2014, so the bond market is in many ways an earlier mover compared to the equity market.
All of this only gives a partial explanation of the valuation discrepancy. I actually believe that both groups of investors are wrong. Russian bonds should perhaps not trade at a premium on other bond markets, or at an all-time high. And the equity discount is just too large right now. The prices should meet, as these kinds of discrepancies are difficult to maintain over time. There comes a time when equities simply become too cheap to ignore (even for the sceptical equity investors), and the global rotation from bonds to equities, which has only just started, should have an impact on Russia as well. Moreover, Russia should be able to surprise on the upside in terms of governance, as the expectations in Western Europe and the US are close to zero. It is extremely difficult if not impossible to say where the new equilibrium will be, as it will not necessarily move back to the historical average. But the trend should be one of convergence rather than continued divergence.
Stock Market Recovery
Russian stocks have been in a slump this past year, and deservedly so. But the Russian market usually recovers nicely after a bad year, and the government is even helping it along this time.
The MSCI Russia Index has gained just 6.9% this year, a little more than half of the MSCI Emerging Markets Index's 12.3% rise. And predictions of Russia's rally have proved premature in recent years, causing some investors to lose patience. Investors have pulled $48 million out of actively managed Russia funds this year, even as emerging-market stock funds generally have attracted $8 billion.
But Russia could surprise many investors in 2013. The two biggest reasons: Russia's stocks are cheap, and its government is finally embarking on some much-needed reform.
Let's start with valuation. Russia's market is among the world's cheapest. The Market Vector Russia exchange-traded fund (ticker: RSX), for instance, has a price/earnings ratio of 5.5 times 2013 earnings, according to Morningstar. The Shares MSCI Emerging ETF (EEM) has a P/E ratio of 11.3 times.
That isn't to say that the low valuations aren't deserved. Russia is notorious for treating investors as an afterthought, and it isn't so easy on local business, either. The bribes required to get electricity or building permits have placed Russia at 112th of 185 countries in the World Bank's Ease of Doing Business rankings. "Reforms need to happen," says Simon Mandel, head of emerging Europe equities at Auerbach Grayson, a New York brokerage firm that deals predominantly with international stocks. "But given the course of Russian history, they won't happen quickly."
Still, Russia has made investing notably easier for foreigners, says Bruce Bower, a portfolio manager at Verno Capital. It recently agreed to set up a central depository, making the trading of Russian securities far easier. At the same time, the nation's central bank has been doing more to boost its credibility by targeting inflation and letting the ruble float more freely. Both should make Russia a more attractive locale for investor cash.
As "the perception of risk will diminish," Harris says, and oil will find a floor. "Even if the market is not flying, Russia will work against this global backdrop."
Russian stocks have generally outperformed following disappointing years, Harris says. Still, it wouldn't hurt to get exposure to Russian companies outside the oil and gas sector. Analyst favorites include Sberbank of Russia (SBER.Russia), one of the country's largest banks, and mobile-phone operators OJSC MegaFon (MFON.Russia) and Mobile Telesystems OJSC (MTSS.Russia).
The Market Vectors Russia ETF has returned 10% so far in 2012 and has an annual fee of 0.62%. The downside: It has 42% of its portfolio invested in the energy sector. But if investors do unleash their "animal spirits," it may not matter, says Société Générale's Benoit Anne. "As we start 2013 with a strong rally, I can see the Russian market taking off nicely."
