Russian Roulette

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 [email protected].