Why Russia could be a gusher for daring investors

 When oil prices collapsed in the wake of the 2008 economic crisis, Russia, the world’s top oil-producer, was hit hard and investors fled. More than three years later, foreign money appears to be returning. But as presidential elections approach and political uncertainty grips the nation, nerves are once again setting in.

According to analysis by Russian investment bank Troika Dialog, $475 million cascaded into Russian retail funds in the 12 months through Feb 15. Russia was the second-most popular investment destination after China among the so-called BRIC countries (Brazil, Russia, India, China), despite its comparatively slow economic growth and its greater exposure to the troubled European region.

The growing interest in Russia comes at a time when oil prices are rising and the country is recovering strongly from the global economic crisis. State statistics agency Rosstat in January reported that the economy grew by 4.3% in 2011, surpassing forecasts. Continued growth is expected in 2012, though at a more subdued rate, as Europe, a major customer of Russian oil, continues to struggle with its sovereign debt crisis.

Russia-focused analysts also point to falling inflation, strong exports and increasing retail sales as reasons to be bullish on the country. Increased demand from the Russian middle class, which is growing in both number and influence, is also bolstering sentiment.

Bank of America Merrill Lynch analysts have even suggested that Russia could be “the next Brazil,” if it considers wooing foreign investors to help develop offshore oil and gas resources, as the South American nation has done in recent years.

A campaign billboard  in the Siberian city of Yakutsk

Political and economic risks

Investor confidence in Russia has recently been knocked by a series of mass anti-government protests that erupted in response to an allegedly rigged parliamentary election in December. Troika Dialog data revealed that at the end of January all other emerging market country funds attracted new money, but Russian funds reported outflows.

To be sure, the presidential election slated for March 4 is heightening the political risk for investors in Russia. And though the main target of the rallies, Prime Minister Vladimir Putin, is widely expected to win the presidency, analysts are not convinced his victory will quash the unrest.

This uncertainty could certainly continue beyond the elections, as market participants wait to see what kind of regime Putin will lead in his third term as president.

Even beyond the Kremlin, Russia’s political landscape is risky. Vladimir Putin said it himself... the business environment is difficult because although the corporate legislation is there, the tax code is there, it seems that everything is perfect on paper, [but] the implementation remains problematic...

Investors also see risk in Russia’s dependence on its energy sector. Unlike other emerging market economies, including India and China, its economy is extremely vulnerable to commodity price changes.

Alternatively this heightened risk represents a significant opportunity to make timely investments.

Russia’s track record of economic and political volatility has pushed asset prices below those of its emerging market peers, and this discount has widened since political unrest broke out in the country in December. At the end of 2011, Russia’s main equities index had a price to earnings ratio of 5.13, versus a ratio of 10.75 for the MSCI Emerging Markets index (reflecting 21 emerging economies).

Taking stock

There are several ways for investors to tap into Russian equities.

First, some Russian companies are listed in the U.S. as American Depository Receipts (ADRs). Bought and traded like any other security, ADRs allow investors to sidestep Russia’s tricky trading environment, while gaining exposure to the economy.

A substantial number of Russian companies are listed in ADR format, including major players in the pharmaceutical, transport, utilities and finance sectors. Some of the country’s big telecommunications firms are also available, including one top pick VimpelCom Ltd. (NYSE:VIP)  .

VimpelCom has been operating under the radar while it consolidated a series of acquisitions. The company now has a presence across Europe, in Africa and in several Asian states.

Buying ADRs in Russia’s dominant energy sector is a worthwhile move. If China continues to grow, it will be phenomenally good for Russia. China does not have natural resources, so Russia is in an unbelievably good position to feed China’s growth.

Shares in firms like Gazprom OAO,  the world’s top natural gas producer, or Rosneft , Russia’s leading oil company, are available as ADRs, for example. Both entities are partly state-owned, which gives them extra stability.

Alternatively, investing in Russia’s largest conglomerate, Sistema JSFC (OTN:JSFCF)  , which trades in London as a global depositary receipt (GDR). The company is highly diversified, with telecom, technology, tourism, energy and construction divisions. This one stock gives you exposure across Russia, not only in oil, gas and telecoms, but also in the next most promising [sectors], including retail.

But according to Chris Weafer, chief strategist at Troika Dialog, “the more attractive domestic stories are not listed [internationally], including some of the fastest growing.”

Weafer calls upon the example of M.Video, “Russia’s Best Buy,” to illustrate his point. While counterparts in Western Europe floundered, M.Video sales rose 30% in the first nine months of 2011. It’s a fast-growing company that is plugging into rising affluence — that’s exactly the sort of story people should be buying in Russia as the economy grows.

Open access

International investors will soon be able to purchase local shares in companies like M.Video as easily as they can purchase ADRs in Russia’s corporate giants.

As part of a series of efforts to ease outside access to Russia’s financial markets, President Dmitri Medvedev signed a law in December to create a central depository. The facility is expected to be operational in April, when investors will be able to instruct their broker or bank to open an account in the depository. There they can hold local shares.

Still, putting money into a country as complicated as Russia can be daunting, and some investors prefer to engage in Russia through mutual funds, managed by analysts familiar with the market.

“Russia is a difficult, idiosyncratic equity market,” said Roland Nash, chief investment strategist at Russian investment specialist Verno Capital. Fund managers understand the equity market and if you’re not comfortable with the risk, the volatility and corporate governance issues, they allow you to have exposure whilst mitigating those risks.

Mutual funds also offer diversification. Innes’ fund, of which 70% is invested in Russia, comprises a range of sectors including financials, energy, information technology, consumer goods and health care. Russian giants Gazprom, Rosneft and Sberbank Rossia (OTN:SBRCY)  are among the recent holdings.

In addition, mutual funds that represent a pure play on Russia include Third Millennium Russia Fund (MFD:TMRFX) , ING Russia Fund (MFD:LETRX) , and JPMorgan Russia Fund (MFD:JRUAX) .

Mutual funds are not the only way to get diversification. Exchange-traded funds (ETFs) are increasingly popular among investors wanting a piece of Russia’s growth story. Analysis by Troika Dialog shows that in the 12 months to Feb. 15, ETFs accounted for 72% of the total investment received into Russian retail funds.

The range of Russia-focused ETFs trading in the U.S. includes SPDR S&P Russia ETF (NAR:RBL) . This fund tracks an index that measures the investable universe of Russia’s public companies. It includes holdings in firms in the energy, communications, financial and real estate sectors.

Other options include Market Vectors Russia ETF (NAR:RSX) , Market Vectors Russia Small-Cap, and iShares MSCI Russia Capped Index Fund (NAR:ERUS)

Alternatively, investors can buy ETFs that track all the BRIC countries. The SPDR S&P BRIC 40 (NAR:BIK)   has more than one-quarter of its holdings in Russia and returned 18.4% in the 12 months to Feb. 16.

Troika Dialog’s Weafer says ETFs are a good way to manage interests in an environment as prone to volatility as Russia.

Investors are attracted to Russia, but there’s always lingering suspicion, That’s what makes an ETF attractive, because you can get in and get out very quickly.