Noughties But Nice

Russia leads emerging market performance

Liam Halligan, Chief Economist, Prosperity Capital Management
Originally published in the March 2010 issue

Few mainstream equity investors will miss the “noughties”. Western stock markets have just emerged from their worst decade in almost 200 years of recorded share price history. The two bear markets of the last ten years –the “dot-com” crash and “sub-prime” – mean that 2000-2009 registered the most dismal equity performance of any previous calendar decade.

Despite an end-of-decade rally, or government-sponsored sugar rush, America’s most important stock index, the S&P 500, ended the “noughties” down 24.9% in dollar terms – an average loss of 2.7% a year. London’s FTSE-100 also finished the decade in negative territory – registering a 2.4% annual dollar-terms loss.

Despite all that, investors can only view the “noughties” as disastrous if they’ve spent the last ten years looking through a narrow lens. While leading Western markets fell, the MSCI EM index of the main emerging markets (EM) rose no less than 102% in dollar terms over the last decade, a 7.2% annual gain.

As Western asset markets have suffered over the last ten years, the “emerging giants” have powered ahead. China’s manufacturing miracle has driven the Shanghai Composite up 191% over the last decade – or 11.2% a year. India’s Sensex 30 rose 226% during the “noughties” – a 12.4% annual return – reflecting the country’s industrial, IT and out-sourcing progress. Brazil’s Bovespa Index also excelled, up 314% in dollar terms since 1999, a 15.1% average annual gain. President Lula, dismissed as a “Marxist”, has pursued pro-stability policies that have put most Western nations to shame.

Yet the stand-out equity market success of the “noughties” has been Russia. Much maligned, the Russian stock market is given a wide berth by most international investors. Back in 1999, an unnamed trader told The Financial Times he “would rather eat nuclear waste than invest in Russia”. Yet, over the last decade, Russia has been, by a long way, the best-performing major stock market in the world – with the RTS Index of leading shares yielding a dollar terms return of 724% since December 1999, an annual gain of 23.3% including the sizeable 2008 dip.

Prosperity Capital Management’s (PCM) three main funds – all open-ended and unleveraged – have returned 3,604%, 1,828% and 1,605% respectively since December 1999. This reflects well on the Russian market. All three PCM funds are invested entirely in Russia/CIS and predominantly in listed equity. Over the last ten years, in fact, five of the world’s top ten performing funds have been focused on Russia. So much for “nuclear waste”.

PCM was founded in 1996. Operating only in Russia/CIS and controlling investments worth $3.5bn, it’s the largest stand-alone asset manager in the region. While the firm has a big on-the-ground team in Moscow, its client-base is wholly international – and includes leading institutions, private banks and family offices, as well as sovereign wealth funds.

PCM’s flagship Russian Prosperity Fund – focused on blue-chips and mid-caps, and pursuing a fundamental value strategy – has yielded 32.5% per annum over the last decade, while maintaining weekly liquidity. Prosperity Cub Fund, which includes small-cap plays as well, has done even better, returning 34.1% a year.

These returns have been outstripped by PCM’s “special situations” Prosperity Quest Fund. Focusing on second-tier stocks and tapping into “special situation” restructuring and consolidation plays, this unleveraged fund returned 43.1% a year while offering monthly liquidity terms. For all the talk of a new cold war and a relentlessly negative Western press, don’t let anyone tell you only fools invest in Russia.

While Russia’s well-known oil and gas names posted big gains over the last decade, driving the RTS higher, such stocks have generally been out-performed by the best companies in domestic sectors such as retail, consumer goods and infrastructure. As Russia continues its long march from state planning, many Soviet-era assets are in the midst of root-and-branch restructuring. And while the shop-by-shop, factory-by-factory privatisation program left the economy highly-fragmented, various sectors are rapidly consolidating.

These related features of Russia’s corporate landscape – company restructuring and sector and sub-sector consolidation – have generated enormous productivity growth, as firms have begun to compete and millions of skilled and increasingly motivated workers have turned their energies towards meeting commercial needs, rather than state diktat.

Since it began investing in Russia 14 years ago, PCM has specialised in “buy-and-hold” investments with the aim of helping to catalyse, then benefit from, the value-generating restructuring and consolidation processes at the heart of Russia’s on-going transition to a fully-fledged market economy. Running concentrated portfolios, building significant stakes and sitting on the board of many core holdings has allowed PCM to address the corporate governance issues that remain a hazard of investing in Russia, and to push for efficiency gains.

Prosperity Quest Fund holds long-standing core positions in Russia’s power sector. Quest also has a track-record of building significant stakes in companies, using board membership to add value.

The PCM team has also developed a knack for finding and backing lesser-known second-tier stocks. Back in December 2008, PCM’s monthly Prosperity Newsletter singled-out an unfashionable oil outfit called Bashneft as “Company of the Month”. A year later, Bashneft’s share price is up five-fold, reflecting its status as Russia’s fastest-growing oil producer.

West to East
While the EMs have easily out-performed the West over the last decade, they’ve also been more volatile. Having said that, Russia and the other BRICs, along with many smaller such markets, have oscillated around a trend that’s been unequivocally up. There are many reasons to assume this trend will continue. Developed world economies grew 2.1% a year on average over the last decade, while the EMs averaged 4.2%. In 2010, those numbers will be 1.3% and 5.1% the International Monetary Fund predicts. This “West-to-East” trend will continue during 2011-14, says the IMF, with the developed economies forecast to grow by 2.5% a year and the EMs by 6.4%.

That’s unsurprising. The eastern giants boast low economy-wide leverage, hefty reserves and have dynamic, ambitious workforces. Western growth, meanwhile, will be weighed down for years by heavy debt-service, systemic risk and worsening demography. For some time now, the share of global portfolio investments in EMs has been steadily climbing. The sub-prime fiasco – and the related loss of faith in Western markets and institutions – will accelerate and accentuate that trend. As the EMs come more into favour, Russia will significantly benefit. In 2009, all of the world’s top-ten performing equity indices were EMs, with Russia taking top-spot. But although the RTS rose 129% last year, it still trades at an average valuation of only 8.8x 2010 earnings – the lowest P/E of any major market.

Russia is now the world’s eighth largest economy. Having risen from the post-Soviet ashes, this vast country is full of firms with strong fundamentals and low debts, providing non-complex goods and services for which there is demonstrable demand. While foreign direct investors have piled-in, portfolio money remains coy. A combination of the post-Lehman sell-off and continued international scepticism means Russian equity remains extremely cheap – even after the recent rally.

There’s something else. As Western governments print money, debase their currencies and rack up more debt, mainstream global investors are seeking “tangible” assets – not least as an inflation hedge. Russia will benefit from this trend. Along with massive hydrocarbon reserves, the country has an abundance of metals/minerals and unmatched resources in timber, water and agricultural land. And the economy itself has been transformed.

When the Quest Fund launched in 1999, annual inflation was 84%. Russia had no reserves and had just defaulted on its Soviet-era debts. Today, Russia has the world’s third-biggest forex reserves, almost no foreign debt and single-digit inflation. Real average wages are 13-times higher than in 1999. Corporate governance, while far from perfect, is unrecognizably better. And while Russia’s communist party was resurgent 10 years ago, it’s now a political irrelevance.

In fact, just about the only thing that’s similar to 1999 is the average valuation of the RTS. That’s why PCM will soon be launching a new special situations recovery vehicle. Not only are Russian blue-chips still close to 1999 valuations, less liquid second-tier stocks are much lower still. Many fundamentally sound businesses are available at significantly depressed valuations, or in need of debt/equity swaps.

Russia’s corporate restructuring and consolidation has a long way to go. Valuations are low. This combination offers an interesting investment opportunity over the next three to five years.

Restructuring/consolidation is well underway in energy, telecoms and retail – but still far from complete. In the power utilities sector, and many parts of Russian manufacturing, such processes have only just begun. Meanwhile, as the big EM economies keep growing, and the West-to-East shift continues, demand for Russia’s commodity exports should remain buoyant.

True shareholder value
While a strong commodity outlook helps Russia, PCM’s experience is that true shareholder value derives from improvements within portfolio companies themselves. The trick is to focus on companies that are restructuring, cutting costs, improving client offerings and consolidating the various sectors and sub-sectors. We favour companies that play to their own and Russia’s competitive advantages, rather than any fickle political advantages. Companies generating cash from their assets, rather than simply those merely with the lowest asset multiples. Companies where the management team has a strong track-record, is of proven good character and has taken on little leverage. Many such companies exist in Russia and most still trade at low multiples.

This investment approach goes to the heart of the on-going development of corporate Russia, providing exposure to some very interesting opportunities, often pre-IPO. All that said, corporate governance is still the main hazard of investing in Russia. PCM helped establish and currently chairs the Investor Protection Association – Russia’s main corporate governance lobby group.

Over the last decade, Russia’s business environment has improved significantly. The tax code has been streamlined, accounting standards have been transformed, the courts are improving and peer pressure is exerting a positive influence. Yet Russia’s institutions, in many cases, remain a work in progress.

Russia remains a tough place to invest. It is, after all, a nascent market economy. Corporate governance is highly imperfect and, despite genuine improvements, real dangers remain. Yet, despite last year’s strong rally, RTS valuations remain extremely low.

And, on top of that, the best Russian companies are set to benefit very significantly from on-going restructuring and consolidation gains.

In this context – one of considerable opportunities, but genuine risks – even the most careful and knowledgeable “bottom-up” stock-pickers can’t always be right. What’s important is being right more often than wrong.


Liam Halligan is Chief Economist at Prosperity Capital Management, an asset-management firm that focuses on Russia and the former Soviet Union. Its international client base includes sovereign wealth funds, international pension funds, insurers, endowments, family offices and private banks. All the money it manages originates from outside Russia.