There’s no exaggerating the risks – corruption, bad corporate governance, and an economy vulnerable to the oil price. But there are bargains to be had in Russia, says James McKeigue.
When the recent WikiLeaks cables described Russia as a “virtual mafia state”, most observers just shrugged their shoulders. It was, after all, what many business people had been saying for years. As one fund manager told Citywire: “What can you say about Russia that hasn’t been said already?”
This gangster state image is the main reason why Russia remains relatively unloved by investors. Despite seeing a bullish end to 2010, Russian equities are still among the cheapest in the world.
On both p/e and price-to-book ratios, it ranks below other large emerging markets, such as China, Brazil and India. What’s more, while those countries attract huge inflows of capital, more than $21bn left Russia in the first ten months of this year. But are investors right to shun Russia?
Before we give the impression that there are no reasons to be concerned about investing in Russia, let’s make this plain: there are. One major fear is corruption. Transparency International, a corruption monitoring group, ranks Russia at 154 out of around 200 countries in terms of transparency – only a few places above the Democratic Republic of Congo. The group reckons that Russians spend $300bn a year on bribes – roughly a quarter of 2009’s GDP.
Corruption is nothing new, of course. Graft was a staple of the Soviet era and the post-Soviet privatisation boom of the 1990s. The problem is that since Vladimir Putin became president in 1999 – protégé Dmitry Medvedev replaced him in 2008 and Putin became the prime minister – corruption has not gone away. If anything, it has got worse. Elections are due in 2012, but most commentators expect that it will boil down to a choice between the two. Former Soviet PM Mikhail Gorbachev last week said that: “In the eyes of the people, the government’s authority has increasingly become a tool for dividing spoils and putting pressure on people.”
The main victims are the Russian people. But foreign investors can also lose out. Poor levels of corporate governance mean that shareholder value is quite far down in the boardroom’s list of priorities. And in many cases over the last decade the Russian government has bullied successful businesses while the country’s weak institutions stood back and watched. The most striking case was the destruction of Yukos. In 2003 it was the largest oil company in Russia, but by 2007 it had been liquidated. Most of its assets ended up in government hands, while its boss, Mikhail Khodorkovsky, ended up in jail – where he remains.
Many Russians supported Putin in reclaiming the country’s resources. And it is clear that Khodorkovsky was no angel. Yet the destruction of one of Russia’s biggest companies created an unsettling environment for investors. In 2008, Putin’s threat of a similar attack on Mechel – a Russian steel and commodities giant listed in New York and Moscow – wiped about two-thirds off its market capitalisation of $15bn.
Foreign firms have been targeted too. Shell was forced to sell fields to Gazprom, while BP’s top representative in Russia was denied a visa to work in the country. Even Swedish retailer Ikea and Norwegian telecoms group Telenor have found that Russian courts normally side with Kremlin-friendly, local businesses.
Fear of state interference has kept a lid on the prices of some of Russia’s most profitable firms. Oil and gas major Gazprom, for example, trades at a huge discount to international peers such as Exxon Mobil. That’s not surprising when key decisions – such as a contract to supply cheap gas to Ukraine – are made for political, rather than economic, reasons. Again, shareholder value is a long way down the list of priorities.
So investors are right to be wary. But is this all in the price? UBS’s Jonathan Anderson happily admits that “corporate governance is clearly a very serious issue”. But he feels the market has over-reacted. “Russia is still trading at levels well below other markets that have similar, or even worse, governance rankings.”
He points out that Russia is cheaper than Argentina, even though the latter is a frontier market. And careful stock-picking can help to guard against the problem. “Corporate governance can explain up to 40% of the differentials in valuation and performance between stocks,” Anderson says. He is also hopeful that joining the World Trade Organisation – which seems likely to happen in 2011 – will improve corporate governance.
Eric Kraus, a former Société Générale banker and writer of the respected Truth and Beauty (and Russian Finance) newsletter, blames Russia’s bad reputation on the Western press for “manipulating naïve Westerners as regards the political situation in Russia”. Kingsmill Bond at Troika is rather more diplomatic, but notes that the more popular Bric countries also have challenges. “Russia may have a number of fragilities… but so do the other major emerging markets… China has much higher debt levels, a more autocratic government, less transparency, and excess amounts of capital. India has a dangerously bad relationship with its nuclear neighbour Pakistan, an enormous and impoverished rural population, a large youth bulge, vulnerability to global warming, and high levels of government debt. Brazil has huge income inequality, a history of failed potential, and an expensive currency.”
So what does Russia have to offer investors? For starters, huge amounts of what the rest of the world wants. Russia overtook Saudi Arabia two years ago to become the world’s leading oil producer and its production continues to rise.
BP estimates that Russia has almost 25% of the world’s reserves of gas, 20% of its coal and around 3% of its oil. The Chinese economy may be growing more quickly, but as a recent gas deal showed, it will need Russian energy to do it.
Asia’s rising middle class is also demanding more food. Russia stands to benefit as it has the potential to become a global agricultural powerhouse. The World Bank estimates it could double its grain production if it employed modern farming techniques. Putin and Medvedev have already begun to reform the sector and have changed ownership laws to attract foreign investment. In the last ten years Russia has gone from being an importer to a major exporter of wheat. A recent drought and wildfire was a serious setback, but Medvedev aims to double grain exports by 2020. Indeed, Russia is one of the best ways to play the commodities supercycle, reckons Bond. “Russia has more raw materials, especially energy assets, than the rest of the Bric countries, and by a wide margin.” In the last decade Russian exports to China have risen more than ten-fold.
Of course, the downside to having so many commodities is that they dominate your economy. Energy makes up 18% of Russian GDP and around two-thirds of its exports. Commodity stocks, meanwhile, dominate the Russian equity market. The heavy reliance on energy meant that Russian stocks pretty much tracked the oil price in 2010. As we saw in late 2008, if oil tanks, the Russian market gets hit pretty hard. But this year has demonstrated that Russian equities perform well at prices above $70 per barrel. Black gold is notoriously volatile, but oil’s recent rise to $90 in the face of a weak US recovery suggests that emerging-market demand is giving support to prices.
Russia also has a better educated and larger middle-class than its Bric peers. The Russian middle class – defined as a post-tax monthly income per person greater than $500 – more than doubled between 2004 and 2009. Between now and 2019 Russian GDP per capita is expected to outpace that of the other Brics. This has fuelled demand for consumer goods as most Russians can get their hands on what were once viewed as Western luxuries. “Russia’s consumer market is benefiting from changing tastes and lifestyles, not simply rising disposable incomes,” says Jason Bush in The New York Times.
Pepsi recently paid $3.8bn to buy a 66% stake in Russian soft drink and yoghurt manufacturer Wimm-Bill-Dann. In the 1990s, most Russians didn’t know what yoghurt was. It’s big business now, but they still consume far less than in western Europe. “We are very enthused by this deal. It completely vindicates our argument that the Russian consumer sector remains an interesting high-growth destination for foreign capital,” says Bond. Pepsi’s move came hot on the heels of US rival Coca-Cola’s acquisition of Russian juice-maker Nidan earlier in the year. Russia’s fifth-largest retailer, O’Key, raised $420m with a recent initial public offering. Areas such as financial services and housing also have massive room for growth, says Bond.
Infrastructure is another opportunity, with investors waiting for the $40bn privatisation programme starting in 2011. Since Soviet times Russia has spent little on upgrading infrastructure. Not a single new refinery has been added in 20 years while the rail and road networks have barely been touched.
The best investments to buy now
The Russian financial sector performed strongly in 2010. Analysts expect it to enjoy another good year in 2011. For high-street banks, the main driver will be increasing their surprisingly low penetration among Russia’s growing middle class. Another positive factor will come from the government. Its attempt earlier this month to release a rouble-denominated bond failed to draw much market interest. That means it will be seeking finance from within Russia. As a result, companies will be competing for money with the government, which should allow banks to raise the rates they charge for loans, boosting profits.
One bank that should benefit is Sberbank (Frankfurt: SBNA). It has around 60% of the growing retail market and is strong in corporate lending. The bank is planning a global depositary listing – giving it more access to international capital – while the government is expected to sell a 7% stake. That would still leave the Kremlin with a 53% share. UBS rates the bank as “the best way to play the domestic recovery story”. On a forward p/e for 2011 of eight, it is cheaper than most of its peers in Russia or other emerging markets.
Another way to play the consumer story is the JP Morgan Russian Securities Investment Trust (LSE: JRS). The fund is tilted towards consumer-related sectors, such as telecoms and financials, but it also has 30% in materials energy and industrials. Simon Caufield, editor of the True Value newsletter, tipped this trust in July when it was trading at 560p, and on a 6% discount to its net asset value (NAV). It’s now trading at 660p, but with the discount remaining at 5.8%, it’s still not too late to buy in.
A key beneficiary of economic expansion is normally the transport sector. More business activity means that more people and goods need to travel around the country. Russia’s road system is notoriously bad, but its rail system is far more efficient. Despite receiving little government investment in the 20 years of democracy, Russia’s trains still carry 85% of the country’s freight (excluding pipelines).
Globaltrans (LSE: GLTR) is the largest private player in a fragmented market, carrying around 5% of all rail freight. The stock performed well in 2010 and possible upsides in 2011 could come from a pick up in construction activity or clarity on locomotive liberalisation. Some of its rates are determined by the state rail company, and analysts feel that Globaltrans will be able to increase profitability when the sector is liberalised.
It has been upgraded to ‘outperform’ by Credit Suisse. Around half of the firm’s cargo is coal or oil, meaning that it is also a play on demand for Russia’s energy. Despite a 68% rise in the last year, the stock is on a reasonable forward p/e of 9.5 for 2012.
No summary of Russian companies would be complete without a representative from the oil and gas sector. Oil companies have seen their margins hit by taxes. That is likely to continue next year, with the Russian government eager to find any way to fund its deficit. Gas producers have also been affected by tighter margins, but some have managed to retain profitability.
The daddy of all gas companies is Gazprom (Frankfurt: GAZ). Gazprom is very cheap on a p/e for 2012 of 4.1. That is nothing new, as government interference has made investors sceptical about the gas giant’s ability to deliver shareholder value. However, with several large capital expenditure projects due to be completed in 2012, free cash flow is set to swell. This could be returned to shareholders through improved dividends – especially as the Russian government, a major shareholder, wants cash.
Russia’s drink problem
One thing worries Russians more than corruption, national security, or even crime. It’s alcohol. That’s no surprise when you realise that alcohol is directly responsible for 100,000 deaths a year. For the US, which has twice the population, the figure is just 35,000.
President Medvedev has been trying to combat the problem since 2007 with a series of taxes and restrictions on alcohol sales. They were probably needed – between 1990 and 2005 food-price inflation outpaced alcohol by around 400%. But so far the taxes have had little success in a country where around 17 million people – more than 10% of the population – are alcoholics. On average, each Russian adult drinks 18 litres of vodka per year, more than twice the recommended maximum.
They are also partial to cigarettes, with 40% of the population smoking. This is one reason why Russia has Europe’s lowest average life expectancy. Men can expect to die at 60, compared to 77 in western Europe. Aids is also a major problem. The World Health Organisation estimates that there are more than a million HIV sufferers in the country. Most are heroin users and many are ex-soldiers, but there are signs the virus is spreading into the wider community. In most of the world, including sub-Saharan Africa, the virus is being contained. In Russia, however, infection rates continue to rise.
Money has been made available for medicine, but there has been very little emphasis on prevention. So far the Health Ministry has refused to sanction ‘progressive’ techniques, such as using replacement drugs to wean addicts off needles. The health problems, coupled with a low fertility rate and skewed demographics, are causing the population to drop by around 700,000 every year. In Russia’s far eastern provinces the population is about 1.1 people per square kilometre compared to 140 across the border in China. The lack of manpower has led to ten million labourers from neighbouring countries, such as Tajikistan and China, coming in. But as recent skinhead demonstrations showed, not all Russians welcome the extra hands.
• This article was originally published in MoneyWeek magazine issue number 517 on 17 December 2010, and was available exclusively to magazine subscribers. To read all our subscriber-only articles right away, subscribe to MoneyWeek magazine.