Political uncertainty is a big red flag, but if you’re still bullish, avoid individual Russian equities and plump for a passive fund instead, says David C Stevenson.
One stock market in the world today represents either the single greatest opportunity within emerging markets – or the single biggest value trap. If you hadn’t guessed it already, I’m talking about Russia.
By various measures, Russian stocks look fantastically cheap. But are they set to soar? Or could they get even cheaper?
The key lies in whether or not you believe that politics should matter to investors. When I was a young business hack at the BBC, one of my earliest TV editors proudly informed me that “politics and investing don’t mix – markets care about numbers, check your politics in at the door!”.
But I always thought it was dreadful advice. I’m no great fan of social and ethical investing, but I do believe investors need to think about macroeconomics – the ‘big picture’ – and that inevitably has a political dimension.
I’m also a great believer in investing in societies where the rule of law is recognised, and corporate governance (looking after the interests of outside investors) is at least regarded as important.
Sure, corporate governance isn’t the be all and end all – history is littered with examples of individual businesses that have been pretty poorly managed, with little regard for shareholders, but which have eventually turned out to be brilliant investments – but it’s certainly a key consideration for investors.
But if you need convincing of why politics matters, you just need to turn to William Bernstein, a seminal investment thinker and author. He reminds investors that the greatest threats to our long-term wealth come from the four horsemen of the economic apocalypse: war, deflation, inflation and confiscation.
Anyone who’s ever looked at long-term data from the research work of Paul Marsh and Elroy Dimson at the London Business School will see exactly what Bernstein means – countless markets have seen near-total capital destruction caused by one, or all, of Bernstein’s economic catastrophes, not least post-revolutionary Russia after 1917.
So we need to take the threat of political confiscation seriously. Indirect confiscation could take place via tit-for-tat sanctions, followed by steady currency depreciation and then economic deflation within Russia – perhaps followed by an orgy of inflation, then outright confiscation.
I think Russian stocks are a bad bet…
I’ll be up front about my own views here: I believe the Russian government has crossed the thin red line of acceptable state behaviour, and that Russia is now a criminal state with blood on its hands. I also accept that many might disagree with my somewhat neo-con views.
However, whatever your view, I think it’s fair to say that the odds on Russia pursuing brazenly exceptionalist foreign and economic policies are increasing.
I think it is perfectly sensible to suggest that Russia might choose not to abide by many respected global rules, and that as its economy continues to weaken, and oil prices decline, its increasingly authoritarian government might be tempted to cut corners.
It might spend money it doesn’t have on handouts to its people – or it might raid government wealth funds. Perhaps more objectively we should also expect the rouble to remain under pressure as US-based investors withdraw their capital.
Add it all up and I think Russian equities are a dreadful bet – as indeed they have been for the last few months. Investors have been abandoning Russian stocks at a fast clip.
Research firm Markit reveals that investors have been selling out of exchange-traded funds (ETFs) tracking Russia for ten straight weeks now. “Outflows from Russian assets over the last two months topped $400m” in July, according to ETF.com. If you think that money and ETF flows matter – as I do – this is as big a red flag as you can imagine.
…but I could be wrong
But maybe I will be proved wrong in the next 12 months. Perhaps my old editor was right and politics really doesn’t matter. Markets may ignore these issues and view Russian equities as a ‘steal’. Certainly, more than a few respected investors rate Russian equities.
For example, I was struck by the number of presentations at the Value Investing Congress in Las Vegas a while back that highlighted Russian businesses, such as Gazprom. And there’s no doubt that the majority of Russian large caps are cheap.
While consumer-facing stocks trade at over 15 times earnings, they’re pretty much the exception. On average, Russian stocks now yield 5.6% and trade at 4.2 times estimates for 2015 profits, according to Andrew Lapthorne and the cross-asset research team at Société Générale.
Of course, I believe there are good reasons for Russian stocks to stay cheap – but let’s ignore my rampant scepticism for the moment. The thing is, great value investments are only worth the bother if there is a catalyst for change.
History teaches us that incredibly cheap stuff can become even cheaper – just before it becomes entirely worthless! But there’s no doubt that catalysts could emerge.
Maybe Putin and his gang will tack back to a moderate course, or oil prices could rise, or both. And if this does happen, and the outlook for the big picture brightens, we could well see a surge in prices.
For example, research by Philip Lawton and Noah Beck of US-based fundamental indexing firm RAFI suggests that investors who’ve been spooked into selling Russian equities by the Ukrainian crisis may be underestimating the potential for a rebound in prices over the next six months. Lawton and Beck’s key finding is that “when regionally contained wars break out, the negative impact is sharp but relatively short lived”.
This RAFI analysis looked at six modern-day military conflicts and the stockmarket reactions. The samples included the US market’s response to the start of the Gulf War in 1990, the US reaction to Nato’s involvement in the Bosnian War in 1994, and the Russian market’s movements after the start of the Russo-Georgian war in 2008.
Their conclusion? “On average, the markets we studied rose in the six months of sabre-rattling that preceded the start of the military campaigns. The markets fell sharply in the first two or three months after the beginning of the conflict. On average, stock prices remained depressed for up to six months, but fully recovered eight months after the wars began.”
So maybe Russian equities are cheap and they’ll bounce back.
For the bulls
If you do buy the bullish case (despite my warnings), then what should you do? I’d avoid all but a few individual stocks – I have always liked the London-listed Russian retail logistics property specialist Raven Russia (LSE: RUS), but virtually every other Russian-based equity strikes me as just too risky – that includes the idea of investing in Western-listed Russian businesses with ADRs and GDRs (which are secondary listings on UK and US markets).
A better bet – assuming you’re bullish – would be a fund. Your decision then boils down to whether to go for a more expensive, actively managed fund, or a cheaper, passive ETF.
Looking at the data (see the table below), most actively managed funds – including the popular Neptune Russian funds – have not really outperformed their passive peers in the recent market rout.
| Actively managed unit trusts | 1 year | 5 year | YTD |
|---|---|---|---|
| Baring Russia (A Inc USD) | -9.6% | 11.9% | -17.7% |
| HSBC GIF Russia Equity | -5.7% | 10.9% | -12.1% |
| JPM Russia (A Dis USD) | -7.4% | 10.6% | -15.4% |
| Neptune Russia & Greater Russia (A Acc GBP) | -14.1% | 16.2% | -17.6% |
| Neptune Russia Special Situations (A Acc GBP) | -14.2% | N/A | -18.9% |
| Pictet Russian Equities (P dy GBP) | -14.3% | 23.6% | -15.9% |
| ETFs | 1 year | 5 year | YTD |
| db x-trackers MSCI Russia Capped Index UCITS ETF 1C | -13.37% | 12.96% | -15.2% |
| db x-trackers MSCI Russia Capped Index UCITS ETF 1C GBP | -13.34% | 3.59% | -15.42% |
| HSBC MSCI Russia Capped UCITS ETF | -13.15% | N/A | -15.12% |
| HSBC MSCI Russia Capped UCITS ETF GBP | -13.94% | N/A | -16.07% |
| iShares MSCI Russia ADR/GDR UCITS ETF GBP | -12.41% | N/A | -14.85% |
| iShares MSCI Russia ADR/GDR UCITS ETF USD | -12.44% | N/A | -14.7% |
| Lyxor UCITS ETF Russia (Dow Jones Russia GDR) D-GBP | -12.92% | N/A | -15.82% |
| Lyxor UCITS ETF Russia (Dow Jones Russia GDR) D-GBP USD | -15.06% | N/A | -16.29% |
| RBS Market Access Daxglobal Russia Index Fund GBP | -10.96% | N/A | -14.15% |
| Source RDX UCITS ETF | -13.71% | N/A | -15.81% |
At a push, I’d say that the HSBC GIF and JP Morgan Russia funds have added some value in the last year, and both are highly respected.
But make sure you’re aware of exactly what you are investing in. The table below shows that even in the more successful HSBC fund, you are taking a big bet on big energy stocks (Lukoil and Gazprom) as well as Russian banks (Sberbank).
| HSBC GIF Russia Equity fund holdings | |
|---|---|
| Sectors | % of fund |
| Energy | 35.30% |
| Consumer and telecoms | 22% |
| Mining | 17.3% |
| Financials | 16% |
| Industrials | 3% |
| Top individual stocks | % of fund |
| Lukoil | 9.9% |
| Magnit | 9% |
| Gazprom | 8.6% |
| Sberbank | 8.35% |
| Severstal | 5.3% |