Lowered oil prices and political fear have rocked the balance of Russia’s economy, but there is still some cause for optimism.
The intensification of the global credit crunch in autumn put emerging markets under serious pressure – as Western money sought safe havens during a concerted ‘rush from risk’. The MSCI Emerging Markets index was down by 60% during the year up to mid-December. But the RTS index of leading Russian shares fell even more dramatically – by 70% during the same period.
Until June, and almost uniquely in the world, the RTS was up for the year-to-date – despite the credit crunch. As the Western world suffered, the Kremlin boasted that Russia was an “island of stability”. But then lower oil prices and political fears undermined Russian shares. That sparked a wave of margin calls – turning leveraged investors into forced sellers and causing the market to spiral, wiping out $1000bn of value between August and October.
Ultra-low valuations
As a result, the RTS became detached from any notion of fundamental value. Having flatlined since then, the index trades at an average price-to-earnings ratio of 2.6x – the lowest of any stock market in the world. Many leading companies, with good management and multi-billion dollar turnovers, are priced below the cash they have in the bank.
These ultra-low valuations belie the fact that Russia is the world’s eighth largest economy, boasting a highly skilled workforce, Europe’s largest retail market and awash with tangible commodity wealth.
Some of the country’s leading oil producers have price-to-earnings ratios of less than 2.0x, despite paying high dividends. One can argue that such firms have uncertain earnings, given the doubt about commodity prices. But more basic, asset-based valuations look less rational. Russia’s second largest oil producer – Lukoil – has an Enterprise Value/Reserve ratio of 1.9x. The same measures at Conoco, Petrobras and Exxon are well into double figures.
Such rock-bottom valuations extend across Russia’s oil industry, even though lifting costs are low and the country accounts for 11% of global crude oil output – second only to Saudi Arabia.
The same holds in Russia’s power sector – now privatised and restructured. Generating companies are priced at $80/kW capacity – less than one-tenth of replacement cost. Yet Russia is the world’s fourth largest power market, capacity constraints are biting and tariffs, already partially liberalised, will be completely market-driven by 2011.
Russia’s retail sector is also seriously undervalued – despite expanding strongly in 2008. The food retailer Magnit, less than 10 years old, has just opened its 2500th store – in addition to 12 hypermarkets.
During the first 11 months of 2008, Magnit posted sales of $4.8bn – an annual rise of 48%. This seems to be a great investment. Yet Magnit is valued at only a fraction of its Western peers – even though Russian food retailing remains entirely unconsolidated, pointing to huge upside potential for market leaders such as Magnit.
Systemically strong
After months of forced selling, current RTS valuations can only be justified by assuming a systemic economic meltdown. But that looks unlikely.
Some Western analysts predict a repeat of Russia’s 1998 default. At that time, external sovereign debt was 80% of gross domestic product (GDP). After a decade of careful repayment, it is just 3.6% – less than $40bn.
So Russia’s foreign exchange reserves – at $450bn, the third largest in the world – are 10 times larger than its sovereign debt. Together with the fact the state reaps hundreds of millions of dollars a day from hydrocarbon taxation, even with oil at $40 a barrel, a sovereign default seems almost impossible.
Russia’s fragile banking sector has also surprised people abroad. But the government’s $230bn stability package – financed with no extra borrowing – minimises any danger of systemic collapse.
While portfolio investors were leveraged, across the Russian economy as a whole, debts are very low. Total bank lending amounts to just 40% of GDP – compared to more than 200% in the US and UK.
As the credit crunch has spread, some Russian firms are having repayment problems in sectors such as steel and real estate. But in general, loans have accounted for only one-third of investment finance in recent years, with the bulk coming from retained earnings. The government’s robust stability should prevent the failure of any big, strategic company.
This applies, above all, to the financial sector. Russia has more than 900 banks – far too many. Consolidation is long overdue. But while liquidity shortages are already causing welcome closures among weaker banks, the state has the means to prevent any large bank from failing, therefore preventing systemic problems.
The governance question
There is one big question. Why are Russian valuations so low? One reason is that outside pundits are so negative. Major economic advances – such as the power sector privatisation, or the introduction of a 13% basic rate of income tax – receive little overseas coverage. So the vast majority of foreign portfolio investors – clinging to the media’s Cold War clichés – remain unjustifiably gloomy.
Yet as Russia’s transition continues, the ongoing industrial restructuring and sector consolidation will continue generating the large productivity gains that have driven shareholder returns.
Even after the recent asset-price lurch, the Russian Prosperity Fund – which was launched in 1996 – has returned 15% a year in dollar terms. During the same period, the S&P 500 posted just 1.3% annually.
Prosperity Quest Fund – the ‘event-driven’ special situations vehicle – has grown at an annual average of 38% since 1999. So Russia has already generated excellent long-term gains – and will do so again due to the energy and drive of its people and its wealth of real, unimpaired assets.
Yet amid all of this promise, a big question mark now looms. During the time I have been investing in Russia, corporate governance has advanced considerably. There has been more transparency, the tax code has been streamlined and the commercial courts, while nascent, have improved. And Prosperity Capital Management (PCM), despite only representing overseas investors, sits on numerous Russian boards.
But it is the company’s view that some of the progress that has been made in recent years is in jeopardy. The credit squeeze and related payment problems have led to some firms claiming that they ‘cannot afford’ to comply.
Along with other domestic and foreign minority shareholders, PCM has suffered recently as high-profile Russian industrialists have flouted their legal obligations in Russia’s flagship power generation sector. Government ministers have so far just let this happen – despite the potential impact on Russia’s reputation as a place in which to do business.
During his inauguration speech back in May, Russian president Dmitry Medvedev stressed the dangers of “legal nihilism”, placing “particular emphasis on the fundamental role of law”. It would be a great shame if these words were said in vain – and Russia was set back, failing to fulfil its immense commercial potential.
Mattias Westman is CEO and co-founder of Prosperity Capital Management, the largest foreign portfolio investor in the Russian Federation.
