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Russia Needs a Re-Fi, and Is Willing to Pay Up: Research Affiliates

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Smart beta proponents like Rob Arnott oppose dumb beta — that is, unguided market-cap-based indexes — because they believe such indexes overweight the most popular stocks and thus fail to capture the value of unloved stocks whose value has yet to be unlocked.

As Arnott once put it in an interview: “Relative to the economy, it is the market that is making … constant big active bets in the direction of growth, popularity and comfort….It’s called a ‘risk premium,’ but none of those feel risky.” 

In contrast, the Research Affiliates founder says of his brand of smart beta — indexes constructed according to value-based, or fundamental, criteria:

“If the market hates a company, fundamental indexing will say: Its value is not showing up in prices yet; we’re going to top up.”

In that spirit, two of Arnott’s lieutenants — Research Affiliates chief investment officer Chris Brightman and head of equity research Vitali Kalesnik — have found an investment opportunity on a potentially grand scale: not a company that the “market hates” but a country whose popularity has been on the wane.

In the firm’s January newsletter, Brightman and Kalesnik devote nearly all of their analytical attention to the risks Russia currently represents before getting to the flip side — the opportunity commensurate with that risk.

Sure, the ruble is cheap, interest rates are high and dividend yields are currently the world’s highest. But investors are steering clear of Russia because of its immense perceived political, economic and default risks, which the country’s actions in neighboring countries have magnified over the past nine months.

The catalogue of woe intensified last month when the ruble fell by 32% and the stock market by 22%, losses that have been largely recovered. Or perhaps the slump in oil prices for more than half a year is the source of worry.

Brightman and Kalesnik organize their risk assessment by looking at three sources of risk, beginning in the political sphere.

Russia’s foreign policy, they say, derives from its constant sense of threat.

“Reflecting the fear that other powers plan to dismember the country, Russian foreign policy is oriented toward promoting puppet regimes in bordering countries,” they write, adding that some of the country’s friendly bordering dictators have strong criminal tendencies. Because the populations of these border dictators eventually get fed up with their Moscow-imposed kleptocrat rulers, the broader region is characterized by general instability.

The Research Affiliates duo note that Russia itself is effectively a one-party state with a subservient media and legal system as well as a state-dominated corporate sector where political considerations might outweigh shareholder concerns.

Ready to write off Russia? Wait, it gets worse.

Economically, the country’s income rests heavily on its natural resources, and within that 70% of the country’s exports are in energy, a sector battered by oil prices that have halved in part as the result of technological advances in the U.S. and slowing growth in China and Europe.

Worse, the country’s high inflation, currency upheaval and stock market volatility have intensified Russia’s woes vis-à-vis other oil-exporting nations.

Running away yet? What about the possibility of default.

From a broader historical perspective, Russia may feel risky to investors because of two previous defaults, 1990s hyperinflation, Putin’s crony capitalism or perhaps memories of the Bolsheviks’ confiscation of all private property.

But Brightman and Kalesnik look at the numbers, and argue that the perception of default risk may be exaggerated. The country’s foreign debt is 34% of GDP, compared to U.S. debt approaching 100%. Even adding the debt of its state banks results in a total that is less than the country’s currency reserves.

And while Russia’s annexation of Crimea and sponsorship of militant separatism in eastern Ukraine have triggered international sanctions, Brightman and Kalesnik point out that those sanctions are quite tepid, prompted by Europe’s reliance on Russian energy imports and its banks’ fears of defaults on its Russian debt portfolio.

The Research Affiliates team conclude that Russia’s financial risk is not default — as the country has the means to service its debt — but solvency. The problem, essentially, is that Russia needs a refinancing, which sanctions disallow.

The authors cite the example of the country’s biggest oil company, Rosneft, which has $19.5 billion in debt due next year but whose expected revenue at today’s low price of oil will be insufficient to pay the debt. The company’s extraordinary, and costly, efforts to re-fi by issuing a ruble-denominated bond and converting the proceeds into dollars is reportedly the source of last month’s ruble crisis.

While the market fears bankruptcies, Russia’s central bank has responded to the needs of its corporate sector by steeply raising interest rates so as to attract needed investment in the ruble.

Brightman and Kalesnik conclude that Russia can weather its crisis. Its European oil customers don’t have any good alternatives, and Russia needs Western capital and has proven it is willing to pay a premium for it.

If Russia merely ceases to further escalate tensions in the region, let alone relax them, investors may have an attractive buying opportunity. But  the Research Affiliates duo go further, noting that if Russia toughens its stance, engendering tougher sanctions, Russians have many times their capacity to endure hardship — subsisting  on homegrown vegetables as recently as the 1990s hyperinflation crisis.

“In investing, what is comfortable is rarely profitable,” Brightman and Kalesnik conclude. “Investing in Russia now is definitely discomfiting, but it might pay off in the long run.”

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