From the April 2005 issue of Investment Advisor • Subscribe!

Russian Roulette

Investing in emerging markets is always a gamble, but John Connor's Third Millennium Russia Fund has continued to beat the odds

Russia is a vast and complicated land. It's where Europe and Asia meet, but it's also a symbolic nexus of old and new, of communism and capitalism, and the contradictory impulses toward authoritarianism and democracy. Like many emerging markets, Russia can also be a land of opportunity.

That's certainly been the case for John Connor, manager of the Third Millennium Russia Fund (TMRFX). Although the fund is less than seven years old, Connor has more than 30 years of Russian experience, dating back to the Nixon Administration and the early days of d?tente, when he was deputy director of the Commerce Department's Bureau of East-West Trade. In the private sector, Connor ran both an insurance company and a hedge fund in Russia. Initially, his investments there were limited to government treasury bills, because that was the only vehicle available.

"When the equity windows opened up in 1996 and a Russian stock market was established, we began to buy stocks," Connor recalls. "Then I started this open-end mutual fund on October 1, 1998. In the beginning I thought, what am I doing? There's nothing to invest in at this point, but you go through the process with the SEC and within two weeks I was buying the big electric company, UES. It's been pretty much all up from there. Five out of six years have been gainers. We had one down year, and it's turned out to be one of the best performing funds around."

Objective sources echo Connor's assessment of the fund's performance. Standard & Poor's gives it five stars and ranks it fourth out of 1,560 global equity funds for the three-year period, and fourth out of 1,139 funds for the five-year period. Like many emerging market funds, Third Millennium Russia's risk level has been high, but so have the rewards. According to S&P, return since inception is 36.32%. For the first two months of this year the fund has returned 20.43%, compared to the 8.64% of its style peers and 8.66% for the S&P/IFCI Composite Index.

Although for all practical purposes the fund is an independent, it's affiliated with World Funds in Richmond, Virginia, which handles most of the back-office functions.

How does the Third Millennium Russia Fund work? I start with a general perception about the economy and where it fits in the world. The Russian economy is in the sixth year of a secular expansion. In 1998 [when the Russian economy collapsed] the young men who ran it were obviously humiliated and they decided they were never going to let that happen again. I think they've been pretty sure-footed since then. They've reduced the tax rates and people are paying their taxes. They have a budget surplus of about 2.5% of GNP, and they have this stabilization fund of another 2.5% to 3% of GNP. So they have a total budgetary surplus of about 6% of GNP. They built up the reserves of the central bank very smartly. As compared to the dollar, the ruble is one of the places you wanted to be over the last few years. The macroeconomic picture has been and remains very, very positive.

Within that context, I've been picking industries. I've downplayed oil for the past few years because of the policy problems there. I've been heavily into steel and telecom. Telecom is a quarter of the fund and is led by the two wireless companies--Vimpelcom and Mobile Telecom. They're both private startups. One is sponsored by the Norwegian phone company, the other by DeutscheTelecom. That's been a classic case of market penetration of underserved markets. I figure there are about two more years to go in that play. Then on the wireline end of it, the [Russians] had a very successful reorganization. They set up seven super-regional wireline companies and we're into four of those.

I figured out a couple of years ago that the Russians had not overinvested [in telecommunications] the way we had in the States and in western Europe, but their telecom companies were still hit by the worldwide depression of telecom stocks. I began to buy telecom two and a half or three years ago. That's been my big move.

What are some of the other industries and companies you've invested in? Steel is kind of self-evident, although everyone has his own judgment as to where the commodity cycle on that is. Personally, I think we have another couple of years to go because there's continuing demand not only in China, but also in India and Latin America, and now the U.S. is consuming steel again.

Our titanium company (Verkhnaya Salda Metallurgical Products, or VSMO) has done really well. It is the largest manufacturer of titanium in the world and makes the landing gear for the Airbus.

Fertilizers have also been going great for us. Uralcoly has been one of my best performers and I just bought a fertilizer company in Ukraine, Stirol, which makes 3% of the potash in the world, all for export.

The Russian economy has basic industries that have been performing well. During the last couple of years for me, oil has been 15% or 20% of the portfolio.

My biggest winner there has been Sibneft, which means "Siberian oil." Russian is like German. They stick all these words together. Anytime you see "neftegaz" in a larger word it means oil and gas.

What are the risks of investment in an economy like Russia? The oil stocks are a good example. The average [P/E] multiples of my three biggest [oil] holdings--Lukoil, Surgutneftegaz, and Sibneft--are about seven. That's about half of the global majors because of the so-called Russia risk. To my mind, and I've very recently begun to heavy up in oil, which represents a tremendous upside, the risk is what they perceive as being fallout from the Yukos affair. [Ed. Note: The Yukos affair started with the October 2003 arrest and imprisonment of the company's chief executive Mikhail Khodorokovsky on charges of fraud, forgery, tax evasion, and embezzlement. The Russian government claimed that Yukos was $28 billion in arrears on its tax payments, but Khodorokovsky's popularity and bankrolling of opposition political parties was considered by many international observers to be as much a factor in the move as anything else. In December 2004, the government held a limited bidder auction at which the Baikal Finance Group, a reputed front company, bought Yuganskneftegaz, Yukos's oil production unit, for $9.4 billion. Before year's end Rosneft, the Russian state oil company, had acquired Baikal Finance Group.]

My perception of that whole thing is very different than what you read about. I see it as a two-stage affair. There was an electoral strategy executed by the Kremlin brilliantly. The second stage has been a rethink on the relationship between the state and business. The bottom line is that they have done their worst in taking back Yuganskneftegaz, which was 50% of the company. Even after that, the state still only owns 7% of the refining capacity of Russia and 19% of the production of oil in the ground, which worldwide is very modest. Generally speaking, governments around the world own 100% [of the oil]. If you want to deal with oil in a given country, you deal with the government. Russia gets all this bad press, but frankly, the people who run Yukos have spent an enormous amount of money in the West on PR.

Anyway, that's Russia risk, which is first of all political risk, but it really doesn't matter what I think; it matters what the market thinks. That's why the market for the Russian oil stocks is so depressed, but I believe that perception will moderate. That's one of the reasons I've been heavying up in the oil stocks in the last couple of months. I just bought 150,000 shares of Yukos. I got out of Yukos when I listened to [Mikhail] Khodorokovsky's last quarterly phone call in November 2003; I was not listening to the CEO of a public company, I was listening to a political speech. I thought to myself, this guy is not acting the way I want my CEO to act. I got out of the stock entirely then so we suffered very little with Yukos but we suffered in general with the oil stocks.

Do you do all the research and analysis for the fund yourself? There's a lot of material on Russia from brokerage houses that is first rate. I have some friends who are reporters and they're always quoting some turkey who's in a think tank in Moscow, some academic type, and I tell them, "This guy is totally out to lunch," but their editors don't want them to use commercial people, they want them to use "objective" people. To me, Russian academics are at the bottom of the barrel. They have no idea what's going on anywhere, including in their own country. They have very limited backgrounds.

My research means reading a lot. In the case of steel, Aton, a Russia-based brokerage house, came out with a report, "Russia Is the Saudi Arabia of Steel," about two and a half years ago that really caught my eye. So I placed orders with them [for steel equities]. Severstal, which simply means "Northern Steel," right now is about my biggest holding. The king of the hill for research is Brunswick UBS, and Renaissance Capital is first rate. MDM Bank is very good. So I get materials from about five or six firms that I read, but I almost never take anyone's recommendation. The analyst's job is to make a recommendation, but I almost never take the actual bottom-line judgment at that time. I make up my own mind, but I get a lot of good information from these firms and then I obviously have my own perceptions of life in Russia and big business--tax rates and GNP growth and all that good stuff. I do my own research, but am I capable of doing this without help from a lot of good people? Absolutely not.

How often do you visit Russia? I go four times a year. When I had the insurance company I went every month, but now it's four times a year, more or less. Last year, I had a very heavy travel schedule in Russia and I met with about 20 CEOs, meeting every company in the portfolio. It was a very big year for me.

How often do you readjust your holdings? The turnover ranges from 60% to 120%. Some years it's fairly modest. A lot of this is forced on you by panic. One of the reasons I keep a huge chunk of Lukoil is that I can sell it all in a minute. Last year the fund was up 34% at the end of the first quarter and then we had a triple whammy in April: the Fed signaled higher interest rates so there was a sucking sound out of emerging markets worldwide. There was a commodities scare that steel had peaked, among others, and then this Yukos thing took a turn. So Russia just collapsed in April. Then it went up again. I still have the chart from last year up on the wall. It went up until mid-April, then almost to ground by August, and by November/December it went up and then down again by the end of the year. Still, the fund managed to be up over 20% for the year, which is about three times the market.

The assets in the fund have climbed over the last couple of years. Do you see that continuing? We're up to $60 million. At its height at the beginning of April it was at $64 million and it's coming back. The problem with a retail fund is that people tend to buy high and sell low. They read something in the newspaper about how Russia is going to hell in a handbasket and they just get very, very nervous. But every year, every peak has been higher. I do think it will be a $200 million fund in the next few years.

Where does this fund fit into an investor's portfolio? First of all, with Russia there's this macro perception. It's almost like having kids. If you don't have kids, you have no window into what's coming on in the next generation. I think a lot of what's happening in the world you can view in a place like Russia. That's helpful to investors. So it's one way of keeping up on what's coming down in the future. But given the risk profile, I say to people, I want 1% or 2% of your life savings. I don't want 20% of your life savings. It's an opportunity to participate a little bit in outsized gains.

Is a lot of the capital fueling Russia's economy still coming from overseas? Definitely. You had a 39% increase in foreign direct investment in Russia last year.

What should that indicate to somebody looking to get into the Russian market? A lot of [investors] are sector oriented. The consumer disposable income there is skyrocketing. So there are people who buy [shopping] malls. There's timber and pulp concerns, which I can't really get into because there are no public companies, but there are people who make direct investments in timber and paper companies. I think [investors] look at various sectors of an economy, not just steel and fertilizer and petroleum and the stuff that's available in terms of listed securities, but also areas where you have to make direct investments. They find a way to participate. I think that it's a macro play. The Russians want what you and I want: homes and cars, cars and homes. Their economy is being well managed, but it's a poor European country. So they have a long way to go.

There was a good article in Foreign Affairs about a year ago written jointly by a Harvard and a UCLA professor, and they judged Russia to be a normal country in its peer group, with about a $6,000 per capita GDP and behaving in a normal fashion for a country at that level. I think your more sophisticated investors make the judgment that there's a lot of upside in a place like that.

What else should our audience be aware of about your fund and investing in Russia? There are certain areas where they have to make their own judgments, like the commodities cycle. There are a lot of speculators in these markets and a lot of short sellers. A lot of false information circulates. In that area they should feel confident that they're capable of making their own judgments because otherwise they're going to panic and run at the wrong moment.

They can say "John Connor really knows Russia and I can rely on him," but in reality, they're going to read something in the newspaper one day and say, "Uh oh! Time to get out."

Obviously there's going to be a time to get out. There is for everything and I don't see this going forever, but they have to make the judgment that they want to participate in the secular expansion of the Russian economy.

Staff editor Robert F. Keane can be reached at bkeane@investmentadvisor.com.

Reprints Discuss this story
This is where the comments go.