Russian equity is rerating. The leading RTS (Russian Trading System) index passed its all-time high of 782 on August 1 and then powered through technical resistance at 800 to put on 100 points in less than a month. Russia is once again a top-performing global market and analysts, caught unaware, were left scrambling to upgrade their end-of-year targets.
The rally seemed to come out of the blue and, oddly, it happened in August, which is traditionally the quietest month of the year. Russia has been enjoying a fairly uninterrupted flow of good news since the Yukos affair came to an end with the jailing of Mikhail Khodorkovsky in May. Oil prices are high and rising. The Kremlin’s public finances are strong and getting stronger. And a raft of economic indicators continues to tick upwards.
“This is last year’s rally happening this year,” says Eric Kraus, head of strategy at Sovlink, a boutique brokerage in Moscow. “Yukos was a one-off but now everyone believes it.”
The rally was an outflow of demand that has been building up for more than a year and another big step up for an erratic market that has grown nine-fold since 1996. The Yukos affair meant that Russia missed out on the strong rally that swept central Europe last year and stymied a response to the steadily improving economic numbers.
“The emerging markets have outperformed for several months and Russia is in that category. Russia’s high economic growth has led to extremely high liquidity given the global oil prices environment and some of this inevitably trickles down to stock prices,” says Ian Hague, principal at Firebird Management, which has invested in Russia since the early 1990s and has $510m under management.
President Vladimir Putin has always banked on the belief that foreign investors suffer from chronically short memories and the bet seems to have paid off. Foreign investors are buoyed by Russia’s improving risk ratings and were the biggest buyers, continuing to buy after the locals started to take profits when the index passed 850.
Rating upgrades
In January, the country scored a hat trick of investment grade ratings and Fitch was the first agency to mark Russia up again in August to one notch above investment grade. Not only has Russia’s improved rating opened the market to a whole new class of institutional investors, such as US pension funds, but it has also coaxed Asian investors into the market. At the same time, a round of interest rate hikes around the world has failed to boost long-term bond yields, leaving investors still hungry for the sort of big returns that the Russian market can provide.
“There are two groups investing in Russian stocks and when they start buying together that leads to a big impact on prices. At the moment, we have both Russian domestic investors and foreign institutional investors in buy mode,” says Mr Hague.
The fears of a pogrom against the oligarchs that have dogged sentiment since the destruction of oil company Yukos seem to have finally evaporated. Mr Putin has been on a charm offensive in recent months and seems to have convinced both domestic and foreign investors that Yukos was a one-off.
“The Yukos affair was very damaging for perceptions of equity risk but, given the overall positive trend and improved profitability, sooner or later people’s concerns were going to be outweighed by the positive results,” says Mr Hague.
Best performance
At the end of August, the RTS was hovering at around 875, a 41% rise since the start of the year, and slugging it out with Hungary and Ukraine – both of which have put on about 40% since the start of the year – for the title of best performing market.
The best performers in the two months to end-August were energy and banking stocks. Russia’s biggest independent gas producer, Novatek, was the big winner: its shares rose by 35% since June in anticipation of an initial public offering (IPO) in July. Retail banking giant Sberbank continued its meteoric gains, up 29% in the two months to end-August to $850 a share (shares were a mere $50 about three years ago). And energy companies LUKoil and Gazprom, both of which are quoted on foreign exchanges in addition to Russia’s, continued their strong appreciation, beating the index’s 21% gain in the two months to end-August with rises of 27% and 25% respectively.
The laggards were from the telecoms and steel sectors but analysts say that is a reflection of their worsening fundamentals and increasing investor sophistication. In the past, investing in Russia was all about timing and had little to do with stock picking. Mr Kraus dubbed the entire second tier the “great unpronounceables” as traders from New York rang Moscow to buy shares the names of which they could not even say just because the market was rallying. The days of shopping for plain vanilla equities are gone.
Interest from Asia
Traditionally cautious Asian investors are now entering the Russian game. At the end of August, Japanese investment company Daiwa Securities and US bank JPMorgan teamed up to launch a large-scale campaign to sell Russian and eastern European securities to Asian investors. They join Société Générale, which is already selling these equities to the Asians.
Japanese investors have already been attracted to the Russian market as their companies do increasing volumes of business with Russia and already have more than $1bn committed to the Russian equity market.
For a long time, Russia has been at worst a basket case and at best a very risky investment but since its rating upgrade, it has been slowly joining polite society. A slew of IPOs this spring are acting as ambassadors: Russian companies accounted for $3.8bn of the $31.2bn of IPOs on international markets in the first half of the year, compared with the $1.6bn raised in the previous 10 years.
Novatek’s July IPO highlighted the vogue for Russian stocks. The issue was 10 times oversubscribed, implying a demand of up to $8.8bn for the $879m that was raised on the London Stock Exchange and sold at the maximum offer price.
Russian stocks are becoming a mainstream commodity and, once the Gazprom ring fence comes down sometime over the next 12 months (special regulations that preclude foreigners from buying domestically traded shares in Russia’s biggest company), Russian equity will be ratcheted up another notch in international investors’ portfolios.
With half a dozen IPOs under its belt and at least another dozen on the slate for the second half of this year, Russia is well on the way to beating Poland as the hottest issuance market in the world in 2005.
Domestic development
The Kremlin has woken up to the need to develop the domestic stock market as a source of investment capital for domestic enterprises. There are plans to float 10%-20% of state-owned bank Vneshtorgbank, and the government intends to pay for its $10bn purchase of Gazprom shares this year by floating part of its new oil and gas holding company Rosneftgas sometime in the next year.
Oleg Vyugin, chairman of stock market watchdog the Federal Service of Financial Markets (FSFM), has spearheaded the first real market-orientated reforms to the equity capital markets with a draft reform package, sent to the Duma on July 10, that could be in place by the end of the year. Mooted for years, the draft includes the first concrete proposals to create a super-regulator for the financial markets, a single national depository and a controversial change to rules of issuance that would force essentially Russian companies – those that have more than half their business and assets on Russian territory – to list on the domestic market before going overseas to the London or New York exchanges. Currently, many such companies are domiciled in places like Cyprus and Holland, and so are exempt from Russian regulation.
In 2004, foreign exchanges accounted for 75% of turnover of trade in Russian securities but the FSFM promises to return 70% of this turnover to Russian marketplaces within the next three years.
Mr Vyugin was in London in July to warn his counterparts in London, who are aggressively marketing to Russian companies, of the coming changes. He said: “We would like to follow a standard practice: obtaining listing in Russia and then placing both on Russian and foreign exchanges. We will not yield to the use of schemes and I think we will come to an agreement with the London Stock Exchange.”
Russia’s IPOs
Russia’s stock market has been heavily geared to oil but a number of IPOs in the past year have been snapped up by investors who are keen to diversify and acquire exposure to the roaring retail sector. The first ground-breaking IPOs capitalised on their pioneer status and were sold with very high valuations, based on astronomical growth rates. Now that the main body of IPOs has arrived, valuations have gone down.
Renaissance Capital launched an index earlier this year to track the IPOs; it highlights the changing nature of the Russian economy. The market capitalisation of all the companies that have floated grew from zero a decade ago to $56.5bn by July and the free float of their traded shares was worth $12.7bn, more than double the $5.1bn they were worth at IPO.
The vanguard companies overestimated their growth potential and have posted disappointing returns as they failed to live up to expectations. However, among the main train of companies now arriving on the market are several with triple-digit returns. The RenCap IPO index as a whole has consistently beaten the RTS index.
More than half the weighting of the traditional RTS index is made up of oil companies but telecom companies account for more than half of the RenCap IPO index. Retail and consumer goods companies make up a few percent on the RTS, but are up a healthy 12% on the IPO index, while the oil sector’s weight was boosted from a mere 3% to 14% by the inclusion of Novatek’s IPO in July.
