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.]