From the May 2012 issue of Investment Advisor • Subscribe!

April 24, 2012

Cold Comfort: Russia and Your Investments

Despite political risk and tales of corruption, investors remain interested in—or at least curious about—investment opportunities in Russia. What do they need to know before investing?

When a tearful Vladimir Putin accepted the Russian presidency in early March, his political opponents, who had endorsed the view that his victory was fraudulently won, were confident that the protests that began after a disputed parliamentary election in December were not a flash in the pan.

Russia and Russians were angry, they said, fed up of the allegedly undemocratic ways in which their politics have been run. They wanted change, they would fight for change, and they would continue to protest until they got the changes they sought.

Today, the anti-Putin protests are still raging. As in other countries—Tunisia and Egypt, to name a couple—the Internet is playing a keen role in spurring an angry population (or parts of it, anyway) to participate in protests across the country.

Is Russia another Arab Spring in the making? Despite the serious political awakening that the Russian population is experiencing, most pundits and analysts have said no. But there’s no denying that political risk has become the No. 1 concern for anyone investing in Russia, undoubtedly leading some to cut back on their exposure to one of the largest emerging markets in the world.

At the same time, though, the allure of Russia is undeniable. This is a huge, vast nation with boundless growth prospects. Most importantly, it has a wealth of natural resources: That alone is enough to keep many investors committed and going back for more.

How do investors view Russia from here on? Politics aside, what do they consider the greatest challenges to investing in Russia? What are the greatest investment opportunities, and where do they lie? What sort of reforms would they want to see enacted to ensure stability in the long term?

Investment Advisor interviewed several Russia experts to get a sense of how they’re answering these questions and how they’re navigating the rough waters between politics, corruption, oil and other opportunities.

Tom Wilson, head of EMEA equities, SchrodersTom Wilson, head of EMEA equities, Schroders:

“Compared to other emerging markets, particularly Asia and Latin America, Russia is starkly cheap.”

Tom Wilson, head of EMEA equities at Schroders in London, is overweight Russia for the company’s $500 million Emerging Europe fund (SEMVX).

Granted, Russia makes up 60% of the Emerging European index, but that aside, what’s driving the overweight at Schroders is simply valuation: the fact that Russia appears cheap compared to the rest of emerging Europe.

“The current market multiple is 5.2 times price to earnings—notably cheap compared to other emerging markets, particularly Asia and Latin America,” Wilson says.

That’s too good to be true, but difficult to pass up for investors like Wilson. To boot, he believes that “Russia is also attractive from an economic perspective. The economy is well-supported by current crude prices, which have positively surprised investors in 2012. The demand picture in the United States has been somewhat weak, but limited spare capacity at [the Organization of Petroleum Exporting Countries] and geopolitical events in Iran, Nigeria and Sudan have been supportive.”

Easing geopolitical tension and higher Saudi Arabian oil supply might reduce crude prices somewhat, but Wilson is nevertheless comfortable where things stand.

“My expectation is that we see oil prices average $110 per barrel in 2012,” he says.

At the beginning of this year, Wilson and his team had counted on 3.5% GDP growth for Russia. But if crude oil prices remain at their current level of $125 per barrel, “there is a clear upside to that figure,” he says. “If crude prices are sustained at current levels, then it is positive for Russia both fiscally and in terms of the current account. It is therefore positive for both the currency and domestic liquidity, and supportive of both corporate and consumer confidence. It is also positive for the government debt metrics, already notably low compared to other countries, with gross public debt to GDP at only 10%.”

As a region, emerging Europe is currently out of favor from an allocation perspective given its links to the eurozone. Valuations are attractive across the region, but for Wilson, Russia stands out compared to both the emerging European region and particularly compared to global emerging market peers, as it is relatively cheap in almost all industrial sectors, except consumer staples.

Wilson likes a large number of Russian equities, particularly consumption-driven stocks. Media and food retail are two areas he likes, and he has a positive outlook on financials as well, while he finds oil and gas notably cheap. Contrary to other investors, though, Wilson is cautious on metals and mining, mainly because of the slowdown in demand from China.

When it comes to Russian politics, Wilson is less bearish than other investors. After the December parliamentary election and the questions about its legitimacy, there was a material sell-off in Russian equities (which made the market even more attractively valued), and protests in the streets of Moscow and St. Petersburg dominated the headlines.

“The big question before Christmas was whether the protests would gain momentum and whether we’d have another Arab-Spring-type situation, but we took the view that we wouldn’t and that the protests would not run out of control,” he says. “The government addressed them in a pragmatic fashion. Furthermore, even though Putin’s poll performance has been falling, he retains a high degree of popular support. The key question now is how the government responds to the concerns of the protestors. We have seen positive reform rhetoric on this front, but implementation will be key during the next presidential term.”

The protests—which came mainly from the middle class—can be viewed as a testament to Russia’s increasing political maturity, whereby the middle class has achieved relative prosperity and is increasingly concerned with issues like rule of law, civil liberties and freedom of expression. Nevertheless, the protests did and will continue to highlight corruption in Russia—a concern for Russians as well as for foreign investors.

Richard Segal, Emerging Markets Credit Strategist, JefferiesRichard Segal, Emerging Markets Credit Strategist, Jefferies:

“Russia’s oil and natural gas reserves are its greatest asset, but could be the country’s undoing.”

It goes without saying that investors will be attracted to any large market, no matter the challenges and risks it presents, if it is rich in natural resources.

This has been and continues to be the case for Russia, says Richard Segal, an emerging markets credit strategist at Jefferies International in London. Russia’s oil and natural gas reserves are its greatest asset, but Segal—who has been covering Russia for many years—believes that this same wealth could also turn out to be the country’s undoing. Russia, in his opinion, is far too oil- and gas-dependent, and that dependence seems only to be increasing. If ever the oil price trend were to reverse itself and head downward, things would become tough for Russia.

“Unfortunately, even if the country diversifies away from oil, it tends to be toward metals or other natural resources in general,” Segal says. “It’s been hard also in Russia to build industries that can compete with oil and natural gas for a number of reasons. Geographically, it’s a huge country to manage, which makes diversification even tougher. Really, there’s little incentive to diversify because whenever oil prices have been low, the government has gone into an effective crisis management mode and manages to keep things stable.”

Diversification efforts—or lack thereof—aside, Russia doesn’t have what the other BRICs have in terms of being able to produce consumer goods. It hasn’t proven to be much of a service industry nation either, and it is affected by several inherent challenges, namely a falling population, a difficult geography and high levels of governance risk.

That said, there is no need to panic in the near term about the potential negative impact too much dependence on oil could have on the Russian economy. The price of oil appears to be constant and oil reserves will last a long time, Segal says. Besides oil, Russia is extremely rich in many other natural resources.

Russia is also close to Europe and China, which means it benefits from a strong demand for both oil and other natural resources from several quarters.

“Although demand from China could slow down if they have a hard landing, the Chinese will still need oil and copper, aluminum and other metals,” Segal says.

The Russian growth dynamic also has a long way to go in playing itself out. The country is vast, and besides Moscow and St. Petersburg, there are several other large cities that are linked to gold, oil, petrochemicals and so on. Some scientific cities have also opened up, and cities along the Silk Route have good growth potential, too.

“As oil and natural resource revenue pour into the country, they do create a lot of inflation, but they result in increases in wages that help create a consumer boom across the country,” Segal says. “It may not be real wage growth that stems from good economic policy, but on the other hand, if oil revenues are strong, I think things are all right, and the nation isn’t going to fall apart.”

Daniel Broby, CIO, Silk InvestDaniel Broby, CIO, Silk Invest:

“The trick is to avoid the banks and anything in which the state is involved—and that includes much of the large-cap and the oil and gas sector.”

The best advice that Daniel Broby, CIO at investment firm Silk Invest in London, can give foreign investors putting money into Russia is to have all documents “double-signed in triplicate and drafted by competent lawyers.”

In a country where corruption is rampant, Western investors often find that they’re ripped off. While there is a legal framework designed to address corruption by due process, and the Russian authorities occasionally put their foot down against corruption, investors who want to be in Russia have to take upon themselves the onus of self-protection. Knowing what you’re investing in and having first-hand knowledge of the companies to the greatest extent possible is key, Broby says, which is why he believes the best way to get the most out of investing in Russia is to do on-the-ground due diligence.

Of course, this isn’t always possible for many foreign investors. Still, Broby urges investors not to go by their perceptions of Russia as a wild and crazy place where corruption rules and creates an impasse that’s impossible to get around.

“Russia is a very dynamic and big place,” he says, “and there are a handful of entrepreneurs who are carving out a niche and [offering] many investment opportunities in an inefficiently priced environment.”

In the Russian equity space, many of the mid caps are now trading on extremely low valuations, Broby says, because they are priced “off the main market, which suffers from a state and commodity discount.”

The best examples he has are Synergy, a distiller that’s currently trading on seven times earnings; Acron, a mineral fertilizer company, trading on a price-to-earnings ratio of 5.6; and Irkutskenego, a hydroelectric company, which is trading at valuations of 6.7 times earnings.

Unlike other investors who believe that corruption and governance are perhaps less of an issue in the large, state-sponsored companies, Broby prefers to invest in the mid-cap space and is particularly bullish on pharmaceuticals, media and service companies.

“Many of the mid caps have had to tap the capital markets, so they are better governed and more transparent than the large-cap companies that have enjoyed state patronage,” he says.

In fact, he’s of the opinion that the greatest opportunities are to be found outside the realm of the state. “The trick is to avoid the banks and anything in which the state is involved—and that includes much of the large-cap and the oil and gas sector,” Broby says.

Traditionally, Russia has always priced and continues to price at the bottom end of the BRICs because of all the risks they present, namely overdependence on oil, acute corruption, and, of course, political risk—the greatest concern for foreign investors in Broby’s book. Yet these risks are also what attract the more adventurous investors who do allocate there, he says, because they result in low prices for potentially great investments.

But while he’s definitely got Russia high on his list, Broby would nevertheless choose to err on the side of caution, and he would rather favor a basket of frontier market exposure over a strong overweight in Russia.

Vlad Milev, Emerging Market Strategist, Payden & RygelVlad Milev, Emerging Market Strategist, Payden & Rygel:

“For the medium- to long-term, I am watching Putin’s first steps. I want to see if the new government has a reformer bent or whether it’s just going to be more of the same.”

In a tense environment fraught with geopolitical challenges, where the uncertainties in countries like Egypt, Syria and Iran remain unresolved, it’s a wonder that the price of oil has not been more deeply affected.

Oil prices may not experience any significant upside, but it’s probably safe to wager that they’re not likely to plunge dramatically in the other direction either. And in a range-bound oil price environment, Russia does just fine, says Vladimir Milev, emerging market strategist for Payden & Rygel.

“Here is a country with a debt-to-GDP ratio of 10%,” Milev says. “Russia’s foreign exchange reserves are far higher than its indebtedness, and its metrics, from a fixed income side, look great.”

So long as oil prices remain range-bound, then the Russian picture is still favorable, if not extremely attractive, especially when it’s stacked up against the rest of Europe.

But what happens to that picture in the medium- to long-term? That’s what concerns Milev. Russia has built this dependency on oil revenues that is central to its economy and growth, he says, but should its ability to do that change in any way, then the colors of the Russian picture could tarnish quite quickly.

“If you have built this dependency and then it’s gone, you will have a deficit, and you will no longer have a current account surplus,” he says.

Of course, this isn’t something that’s going to happen any time soon, and Milev is still overweight Russia for the global emerging market fixed income strategy that he manages for all the same reasons that investors are generally attracted to the country.

As a fixed income investor, corruption is not such an issue for Milev, and even on the political risk side, he does not have any major concerns.

But Milev is focusing on the need for reform aimed at reducing Russia’s oil dependency and has put it high on his list of expectations going forward.

“There’s been a lot of talk about reforms and what seem to be a lot of good intentions, but I would really want to see serious moves by the government to reduce the dependence on oil revenues and encourage other industries,” Milev says. “Russia has enormous potential—it has commodities, a very well-educated population and much more. It would be good to see the government encouraging other industries by, say, offering them preferential tax treatment or inviting [foreign direct] investment into different sectors.”

The problem is that Russia has never had any incentive to do real reform. With oil prices at $120 a barrel, there’s been no sense of urgency and even now, there really isn’t.

“For the medium- to long-term, I am watching Putin’s first steps. I want to see if the new government has a reformer bent or whether it’s just going to be more of the same,” Milev says. “Putin has made some promises along the way, but over the years, I’ve seen other leaders make promises along the way. So what’s important to me now is to see whether Putin will really deliver and what the deliverables will be.”          

 

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