From Russia With Alpha

Verno invests to mitigate Russian market risk

BILL McINTOSH

Dimitri Kryukov, founder and the chief investment officer of Verno Investment Management, is known for jumping into a helicopter to perform due diligence on investment opportunities that crop up in the far flung corners of Russia and the former Soviet Union. A hands on approach is often needed to assess opportunities across the region and gauge the prospects of both emerging and established companies for Verno’s flagship equity long/short fund.

It is a role that Kryukov is well qualified for, having been involved in Russian capital markets for two decades, including a stint in 1992 on the World Bank team that advised the Russian government on privatisation. Subsequently, he co-founded Kazimir Partners and managed its Russia fund before leaving with several colleagues to launch Verno in January 2010 with $15 million in start-up capital. Verno has a double meaning that is apt for a hedge fund: in Latin, it means to blossom; in Russian, to do correctly. In a nutshell, Kryukov is aiming to deliver much of the Russian market’s upside – it currently stands on a P/E of eight, 30% below the long run average – while side-stepping its notorious volatility.

In an interview, Kryukov discussed opportunities in Russia and the challenges of running one of the country’s first equity long/short funds. “The opportunity is that the Russian market has performed very well historically, but as an investor you have always had to take the risk of a very deep pull back,” he says. “I went through three such sharp pull backs in 1995, 1998 and 2008 when the market in each instance was off more than 75% peak to trough1. The main challenge for me as a hedge fund manager is to identify these kinds of risks and try to smooth these sharp bouts of volatility.”

Typically, traders in Russia have had difficulty generating short exposure. That’s changing and now shares in about a dozen of the country’s biggest capitalised companies – mainly energy, metals and financial companies such as Gazprom, Lukoil, Rusal and VTB – are available to borrow. There is also an increasingly well developed derivatives market with futures and options on big cap stocks and on the RTS Index.

Going into the summer of 2010 Verno responded to the volatility filtering into Russia from global markets with defensive positioning. Directional positions were avoided and net exposure was trimmed to just 5% with long and short books of 40% and 35% respectively. In sum, Verno played a waiting game.

“The underlying data on the macro front and on the corporate side is very supportive,” says Kryukov. “Valuations in Russia are looking pretty attractive in the cross border context and in the historical Russian average. The entry point is looking obvious now. What I’m concerned about is the uncertainty (on economic data) coming primarily out of Europe and the United States. I don’t think it is time to be chasing the market on the long side but to go for the names we like fundamentally but protect the stock picks with a short at the index level.”

One strand of the long book is mining and metals companies. Kryukov notes this is a bit of a contrarian call, but believes stock valuations reflect output prices which fell after a first quarter rally. He is also a fan of integrated Russian steel makers – Evraz and Mechel – whose self sufficiency in iron ore and coking coal inputs insulates them from raw materials price increases. In addition, their specialisation in construction steel caters to the one market – domestic construction – where consumer demand bucked up by lower borrowing costs and better access to credit should fire a recovery. In the banking sector, the fund is long Sberbank, Russia’s biggest bank. Bad loans have stabilised and substantial provisions, already taken, may give some unexpected upside, Kryukov says, if an upswing brings balancesheet write-backs. What’s more, the Russian Central Bank injected liquidity to the sector leaving banks well capitalised and able to boost net interest margins as interest rates have contracted. Verno is also long Bank St Petersburg for its strong niche in SME lending.

The short side is mainly expressed through selling emerging market index futures and the RTS Index future. But generating short exposure using the RTS Index future can be tricky given its 50% weighting to oil and gas companies. The fund is currently short a couple of stocks but Kryukov declines to be specific. The focus of the fund is to identify Russia specific news and gauge how that may affect volatility, while also capturing the significance of events that may only affect one company.

On a macro economic level, Russia was hit hard in 2009 with a GDP contraction of nearly 8%. Verno estimates the rebound will be around 4-5% in 2010 with inflation in mid-single digits, well below the double digit average over the past two decades despite the central bank running a very accommodative monetary policy. Kryukov expresses some concern about the Russian fiscal deficit. Not about the size – 5.7% of GDP in 2009, 5.4% this year – but about the structure of the deficit, pushing more resources to social spending when investment in infrastructure would help boost future economy growth. But the point Kryukov underlines is that with accumulated reserves of over nearly $200 billion and a 12% sovereign debt to GDP ratio, there is substantial capacity to finance growth.

As stock pickers, Verno’s approach to risk management combines extensive financial research with meeting senior company managers. At Kazimir, the team did 200 company meetings annually. “Doing research upfront removes a lot of the Russia specific risk in terms of corporate governance – you get a sense of where the business is going and you also get a sense of management’s attitude to capital markets and minority investors,” Kryukov says.

There is a formal 20% NAV limit on any position in the portfolio. Stop losses are set at 15% from entry or when a loss equals 1% of the portfolio’s NAV. Overall long exposure is limited to 200% with options used to get long exposure over 100%. Gross short exposure is limited to 100%. Kryukov says that throughout his investing career there have been only a few instances when portfolios he’s run have approached these levels.

Verno is marketing to institutional investors in the Europe and US, including pension funds and endowments. It has also met an Asian sovereign wealth fund and is in talks with a seeder looking to take a strategic stake. Kryukov says the liquidity of the Russian market can support a fund with capacity of up to $1 billion.

Allocating to Verno lets investors draw on a bottom up approach to the Russian market rather than take a more macro orientation. “A lot of large institutional investors are looking to construct their exposure to emerging markets through local country managers,” says Kryukov. “The reason is pretty obvious. The advantage of a single country manager is the local presence and the experience in that specific market. Previously we were pretty good identifying Russia specific risk early. As I have explained to investors overseas, in Russia things very rarely happen overnight. There is a long lead time before things actually happen. If you pay attention and do proper analysis you can indentify these trends long before they happen. That is the main advantage of going to a local country manager.”

Footnote

1. ROS Index fell from a high of 1,706.40 on September 15 1994 to a low of 426.10 on April 1995, a decline of 75%
ROS Index fell from a high of 4,095 on October 3 1997 to a low of 273.10 on October 2 1998, a 93% decline
ROS Index fell from a high of 16,292 on May 19 2008 to a low of 3237.10 on February 5 2009, a decline of 80%