February 2009

RUSSIAN EQUITIES: The bear truth

The investment situation in Russia is far from rosy, so Fiona Rintoul asks fund managers why they are still there... There have been some wild ups and downs in global markets in recent months, but few markets have been able to provide quite as spectacular a roller-coaster ride as Russia. Not that long ago, Russia was one of the best performing markets in the world. In 2008, however, the falls on the Russian stock market were precipitous and unrelenting, as the chart overleaf demonstrates.

“It’s been a dramatic few months in Russia,” says Peter Elam Håkansson, founding partner and head of portfolio management at Stockholm-based Eastern European specialists East Capital. “The falls were much more concentrated than in the West. Falls that took place over one and a half years in the West took place in a couple of months starting on 19 May last year.”

Never was the old adage ‘the higher you climb, the harder you fall’ more appropriate.

“Only a few months ago, before July 2008, the Russian market was considered one of the most promising, thanks to vigorous growth in consumer spending at home and high commodity prices abroad,” says BNP Paribas Asset Management in its start-of-the-year Russia Flash. “However, since July, the Russian market has fallen abruptly, following a series of negative surprises that buffeted investor confidence.”

These included “the Mechel case in July, the conflict with Georgia over South Ossetia in August, the impact of the financial crisis in September, the pressure on the rouble in October and the drop in Russia’s growth and industrial production in November and December”.

“The MSCI Russia lost 74.2% in 2008 bringing the value of the index back to levels last seen in 2003,” says BNP Paribas Asset Management. “Comparing Russia to other constituents of the MSCI GEM Index, only MSCI Pakistan did worse in 2008 – it lost 75.4% of its value. The closest Bric country in terms of performance compared to Russia was India – it has dropped 65.1%.”

What does this mean for the future of investment in Russia? Is it time to get seriously bearish about the Bear, or is there still a chance for a comeback?

Håkansson’s firm East Capital has been in Russia from the off and its funds did exceptionally well in the good times. In 2005, the East Capital Russia fund returned 109.3% in euro terms. Today, it is down -4.1% year-to-date and in 2008 it lost -73.5%, slightly more than the RTS index.

You might think that a fund manager in this situation would head straight for the nearest vodka bar in search of oblivion through fermented potatoes. But not a bit of it for Håkansson and his partners at East Capital, who remain upbeat.

“We still very much like Russia, it is a large economy and has more potential domestic growth than other countries,” says Karine Hirn, another founding partner at East Capital. “Russia is less leveraged than many other countries, with political stability and low valuations making it one of the cheapest markets in the world.”

In fact, East Capital currently has 50% of its Eastern European funds invested in Russia, the highest allocation to Russia since the fund’s inception. An important reason for this is the attractive valuations the firm believes exist further to the stock
market correction.

Another key plank in East Capital’s ongoing optimism about Russia is the fact that the country is no longer new to this game. It has weathered crises before.

“This is not the first crisis,” says Håkansson. “There is much more flexibility in the system than there is in the West. The managers are better. They’ve gone through a crisis before. And the population is much more used to crisis this time. That will help.”

Others, however, are less optimistic. For a start, it’s a moot point whether the kind of ‘political stability’ that Russia is currently experiencing is desirable.

“What we have seen recently doesn’t look very promising,” says Claude Tiramani, manager of BNP Paribas Asset Management’s Parvest Russia Fund.

Tiramani includes among his concerns anxiety over whether the government will use the need to refinance at the likes of gas producers Gazprom and Novatek to bring them directly under Kremlin control.

“It’s a big corporate governance issue, which directly impacts the risk premium,” he says. “Concerns over corporate governance intensified throughout 2008 following situations involving Norilsk Nickel, Sibir Energy and several other companies. Any new conflict involving state interests would be detrimental for the stock market.”

When it comes to gas there is, of course, also the gas dispute between Russia and the Ukraine over payment for gas supplies from Gazprom. Many EU customers were left without heat this winter after Gazprom cut supplies to the Ukraine. Supplies have since been restored, but the damage to relationships between the affected Central and Eastern Europe countries, and both Russia and the Ukraine is likely to be longer lasting. Plans are now afoot for a pipeline project that would bring Central Asian gas to Europe, bypassing Russia.

“Gas is supposed to be very stable,” says Tiramani. “But we’ve seen what has happened in the Ukraine.”

In January this year, Gazprom was also negatively affected by news that the Swedish firm Vostok Nafta was planning to wind up the investment vehicle in which Gazprom shares are held, according to Barings’ Neues aus Osteuropa newsletter. Barings feared this would lead to a flood of Gazprom shares on the market.

Bank transparency
Then there’s the banking sector to worry about. “We are underweight on the banking side,” says Tiramani. “It’s very difficult to get inside transparency on the banks. The main two will benefit from consolidation, but will they be forced by the Kremlin to lend to bad companies? Who knows.”

Even the eternal optimists at East Capital have concerns about Russia’s financial system.

“We were big investors in Russian banks and we were always pointing out how small the financial system was,” says Håkansson. “This was an advantage because it meant there was a lot of potential for growth, but it also meant the big oligarchs had to go abroad and finance themselves in dollars rather than roubles.”

This makes the depreciating rouble more of a problem than it might otherwise be. The rouble has lost over a fifth of its value
against a euro-dollar basket since August as the government pursues a step-by-step devaluation policy.

The falling rouble has prompted savers to dollarise their savings and has depressed consumer spending, already undermined by job cuts and rises in salary arrears. This, in turn, has put a dampener on the consumer stocks that were the touchstone of non oil-related optimism about the Russian market.

Other problems include corporate debt, which is a much bigger problem than in 1998. The government has stepped in to guarantee refinancing for strategically important companies through the state-owned bank VEB, but other companies may face refinancing problems, says BNP Paribas Asset Management.

And, of course, there’s the low oil price, from which, to some extent, all other problems stem. Largely as a result of the collapse in commodity prices, economic growth in Russia may fall below 2% this year, having averaged around 7% over the past five years.
Hiding places
Where, then, are the hiding places for companies running portfolios of exclusively Russian stocks who must engage with
the market?

Raiffeisen Capital Management says it is focusing on companies that either have a low level of foreign currency debt or would not be affected too severely by more rouble depreciation. East Capital was mainly liquid in the autumn, but started to invest again in January and December, targetting companies such as food retailers and power utilities. BNP Paribas Asset Management favours exporters and big blue chips (forget about mid-cap, says Tiramani), as well as consumer stocks, particularly in the telecoms field.

Parvest Russia is overweight in energy stocks and underweight in banks. On the energy side, Tiramani prefers stocks that have a high exposure to refining, such as West Siberian. Refining benefits from a better taxation scheme than crude and companies with a strong emphasis on refining therefore outperform others. West Siberian also has the advantage of not being Kremlin owned, plus it is listed in Sweden, not Moscow.

“Most of the fund is invested in stocks listed in London,” says Tiramani. “There is no liquidity in stocks listed in Moscow.”
And what of the longer-term picture for Russia?

The only way is up

Despite all the manifest difficulties that the country is facing, professional investors in the region are surprisingly upbeat. The oil price must rise, runs the thinking, and the government will at some point signal that the devaluation of the rouble is over.

Things are far from rosy, but the likes of BNP Paribas Asset Management believe the Russian market is now pricing in an overly negative outlook. On a two-year view, the oil price will be higher, says Tiramani. In the meantime, the government has learnt from 1998 and is buying time by raising pensions and civil-service wages, thereby stabilising the population.

There are many factors that are hard to predict, however. One is how the global economic situation will pan out, and in particular the situation in the US. If there’s one thing that the crisis has highlighted it’s that Russia is not insulated from global economic movements. In other words, the decoupling theory is dead.

“The long-term picture is still there,” says Håkansson, “but it’s hard to know when there will be a turnaround.” ©2009 Funds Europe

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