Investment Adventures in Emerging Markets

The Russian Evolution

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It might be tempting to say “everything old is new again” in Russia, given the return of Vladimir Putin to the presidency after a four-year hiatus, an interesting development in the country’s political evolution. I think Russia has also evolved a great deal as an investment destination in the past two decades and holds great potential, although there is still more work to be done to open the markets and instill investor confidence.

Russia is the largest country in the world in terms of land mass (17 million sq. km),1 covers nine time zones and boasts a rich and ancient history, abundant natural resources and a resilient and well-educated population. The literacy rate is near 100% and there are more than 1,000 institutions of secondary education attended by more than 8 million students.2 Russia has often been characterized by its harsh climate, and its economy has weathered equally harsh challenges throughout its history. I’ll save the history lessons for the books, but from an economic standpoint the past two decades have been characterized by periods of growth and crisis leading to progressive steps forward—then back.

While it’s easy to criticize political missteps, I believe there are reasons to be positive about Russia’s economy and finances. In the first quarter of 2012, Russia was the only BRIC nation (the emerging economies of Brazil, Russia, India and China) to experience acceleration in GDP growth from the prior quarter (to 4.9% from 4.8%)3. Russia also boasts enviably low amounts of leverage in its economy; its debt-to-GDP ratio was 8.7%3 in 2011 and domestic credit as a percentage of GDP was 45.9%.4  It also has coffers of $500 billion in foreign reserves and is a major global producer of many commodities, including energy and precious metals.

Russia’s economy could be moving into another evolutionary stage as it just became the 156th member of the World Trade Organization (WTO). There will likely be some short-term adjustments (for example, the removal of tariffs and subsidies could hit certain industries), but this may bring potential long-term support in expanding trade, foreign investment and economic growth. According to World Bank estimates, joining the WTO could boost Russia’s GDP through 2020 to 11% above what it would be without membership, and its people could benefit from increased wages and an improved standard of living as a result.

Oil’s Handcuffs on Russia’s Economy

Energy is, of course, extremely important to Russia, representing about three-quarters of its exports. Russia is the world’s largest producer of crude oil, churning out some 10 million barrels per day, representing about 12% of the world’s oil.5  It also holds the world’s largest natural gas reserves and second-largest coal reserves.  As such, energy companies account for a big part of the country’s market. Major export destinations include the European Union (taking in nearly half its oil exports), China and Turkey. While Putin has pledged to diversify Russia’s economy and draft budgets that are less reliant on oil tax revenues, Russia’s future is still largely dependent on oil prices. Volatility in the price of oil, therefore, also contributes to volatility in the Russian stock market.

Higher prices don’t necessarily help oil companies, and at the same time, low prices don’t necessarily hurt them. With higher oil prices, Russian oil companies often bear the burden of more taxes. Companies prefer steady or perhaps slightly rising prices, rather than drastic fluctuations that are more difficult to plan for and react to. We like to look for opportunities across the energy sector, including companies that engage in exploration, production, refining and marketing.

Turmoil in Europe (and the prospect of slower growth elsewhere this year) contributed to oil price declines this spring and summer, but our team doesn’t anticipate a dramatic fall in oil prices. Many individual companies in Russia have been able to prosper regardless of the dips, because the cost of commodity production there is so low that each company can still continue to capture profits. We believe a worst-case oil price scenario could already be priced into the valuations of Russian oil companies. Of course, if there is a severe depression in Europe or the U.S., it would likely have a negative price impact, not just on oil but also on other commodities—but we don’t think that’s likely to happen in the near-term.

Longer term, we think the greater possibility is an uptick in commodity inflation, as central banks around the world have been engaging in easy monetary policies to stimulate growth and provide liquidity. This could be very supportive to the Russian market, as long as inflation doesn’t spiral out of control.

Russia’s Stock Market and Investment Climate

In the early 1990s, Russia’s stock market was primitive. Trading began around three o’clock in the afternoon, give or take, when a vehicle would pull up to the stock exchange building carrying loads of cash. Brokers would sit at long tables waiting for workers and ordinary citizens who had been given share vouchers—which could be exchanged for shares in newly privatized Russian companies—to sell them on the exchange. Around six o’clock in the evening, the vehicle would return to collect the vouchers the brokers had bought on the cheap.

As investors there, we faced an extremely unstable environment and were often told “trust us!” with little basis to go on. And, the vast majority of Russian stocks were so thinly traded we had to wait days, or even weeks, to execute a trade. How things have changed!  The newly merged Moscow Interbank Currency Exchange (MICEX) and Russian Trading System (RTS) Exchange offers trading in a full range of equities, options and commodity futures products—on an electronic platform, day and night. The MICEX-RTS reported yearly trading volume of more than US$10 trillion in 2011.

In the first half of this year Russia’s market suffered from negative investor sentiment. Much Western capital took flight, and local investors lost confidence, too. The problem is there is a lot of uncertainty about what a new Putin presidential term means for the country. Some believe the Putin government is discouraging private sector growth and the economy will move even more toward a state-controlled economy than it already is. On the other hand, there are those who say foreign investment is being encouraged through various government mechanisms. The jury is still out.

As value investors, this has meant we could pick up shares at bargain prices. In our view, Russia appears to be one of the most attractive markets in emerging Europe from a valuation standpoint, with an average market price-earnings (P/E) ratio of about 5 in the first half of the year.6  To attract more foreign capital and instill confidence, the MICEX-RTS announced planned reforms that would affect new listings, including English-language reporting of quarterly reports and efforts to move toward a more traditional security and cash settlement trade transaction process.

From an investment standpoint, we are looking for opportunities not only in the energy sector, but also in areas including consumer goods and services, and shipping. Rail-container shipping is an area which we believe should see growth aided by increasing consumer demand, a potential improvement in the global macro-economy, and development of the country’s Europe-Asia transit potential. Increased privatization efforts in this area and others in Russia should help further stimulate investment. Russia’s effort to build a planned high-tech center outside Moscow (akin to the “Silicon Valley” in the U.S.) is also an interesting enterprise that bears watching.

No matter what the future holds, Russia—and its people—have proven resilient time and again. I look forward to the next stage of Russia’s economic evolution.

1. Source: U.S. State Department, March 2012.

2. Source: U.S. State Department, 2008 estimate.

3. Source: CIA World FactBook, 2011.

4. Source: The World Bank,“Domestic Credit to Private Sector – % of GDP,” 2011.

5. Source: U.S. Energy Information Administration.

6. Source: Bloomberg L.P.

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