Russia Offers Growing Range of Investable Stocks

Macro trends, valuations underline attractions

MICHAEL KART, MANAGER OF THE SPECTRUM FUNDS AND MANAGING PARTNER AT MARSHALL SPECTRUM

Despite the fundamental attractiveness, Russia and CIS remain difficult markets to operate in for a business without strong local presence and in-depth knowledge of the region as well as efficient access to information. The region still has one of the highest betas within the global universe; market infrastructure remains quite weak while liquidity may dry up in a very short period of time in the case of increased market volatility.

The Russian and CIS equity markets now offer a much broader array of opportunities compared to 10 years ago. Numerous IPOs, restructuring and consolidation processes have led to the emergence of a wide spectrum of investable stocks with a different underlying investment story and different levels of liquidity. Easy money has been made in Russia and nowadays it is virtually impossible to reach solid performance over the longer term through a simple “buy-and-hold strategy” by building exposure to a portfolio of five blue chip Russian stocks traded on the LSE. Alpha can be generated either through distinctive stock picking abilities and/or an active portfolio management approach that involves directional trading, sector rotation and various hedging strategies in an attempt to exploit the high volatility that is attached to the regional market place.

Spectrum Funds aim to embrace the whole range of investment opportunities in the region’s equity market. From our point of view there are two ways to approach investing in Russia and CIS:

Our first approach is represented by Spectrum CIS Value Fund where we apply a bottom-up stock selection process to build a diversified portfolio of small- and mid-cap securities spread throughout the whole CIS region. We invest in stocks that are currently “off–the–radar” of bigger institutional investors and represent a strong investment case with an identifiable catalyst, preferably a liquidity event (e.g. IPO). The fund’s portfolio is strongly diversified throughout the region with its main focus on bigger markets like Russia, Ukraine and Kazakhstan but also covering more exotic markets like Georgia, Turkmenistan, Belarus and Uzbekistan as well as other truly “emerging” markets in the former Soviet Union space. An important objective of this strategy is to maintain a balance between the fundamental attractiveness of under-owned and under-researched CIS stocks and the relative liquidity of the portfolio. Focusing on this objective allowed the fund to survive the crisis of 2008 without ever applying gates or suspending NAV. In 2009 the fund was one of the best performers in Russia and CIS generating a 135% net annual return. The strategy enables the investor to get exposure to otherwise inaccessible investment opportunities managed by an experienced operator with a strong local presence on the ground, sound research, due diligence capacity and a broad execution network.

Our second approach is through a long bias long/short equity strategy available through the Spectrum Russian Phoenix Fund. The fund applies a top-down investment approach with the aim of building concentrated positions in selected industries and/or single stocks focusing primarily on large and liquid mid-caps across the CIS region. The objective of the fund is to achieve strong risk-adjusted performance aiming to outperform the broader market with reduced volatility. This objective is reached through active rotation between sectors, single stock shorts, relative value trades as well as periodically increasing the cash position of the fund. Hedging and leveraging are exercised mainly through the active use of derivatives (options and futures on single stocks and index). Strong execution capacity and market timing skills have become the basis for the successful implementation of this strategy. The fund was launched in April 2009 and in the first 10 months of trading delivered 62% net return to investors with 55% of market volatility as measured by MSCI Russia index. Taking into account the long-term growth profile of the Russian equity market the fund maintains a net long bias most of the time, varying its net exposure in a range between 50 and 150%.

These days Russia can be viewed as one of the most interesting markets globally for two key reasons: (1) positive macroeconomic trends in an environment of financial easing conditions – the market expects 100-150 bp in rates cuts in Russia by the end of the year on the back of declining inflation; and (2) undemanding valuations – we believe that the market still looks cheap relative to its growth profile and to its historical relative valuations. Let’s look at the above arguments in detail.

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There are quite a few positive developments taking place in Russia right now that provide the necessary support to the regional investment case. First of all, inflation, which used to be around 13% back in 2008, is on a downward trend since mid 2009. According to the street’s estimates, the annualised inflation rate stood at around 6% by late-February. Those dynamics allowed the Central Bank of Russia (CBR) to proceed with cutting the refinancing rate, which currently stands at 8.5%. By doing so the CBR will continue to stimulate lending and at the same time reduce the interest rate differential with other major economies so as to avoid undesirable short-term capital inflows that would effectively lead to further ruble appreciation. Secondly, economic activity is showing positive signs of improvement while the consensus view for this year’s real GDP growth stands at around 4%; which might be a bit too conservative. After having fallen by 7.9% in 2009, this year Russia’s economy will resume growth driven primarily by rising household consumption, stabilising inventories and growing oil and gas output. In addition, we would anticipate a revival of the debt markets, both external and domestic, with the government seeking to finance the budget deficit while continuing efforts to reduce financing costs by CBR will result in accelerating domestic loan growth closer to the second half of 2010. All of the above should help fuel growth and improve the general investment sentiment in Russia. The ruble stabilised in the second half of 2009 and strengthened in excess of 12% over the last six months. Going forward we expect the ruble to remain firm on supportive commodities’ markets and loose fiscal and monetary policies.

Russia has lagged the recovery in other BRICS (see Fig.1) and is still relatively early in its economic recovery cycle. As a result, whereas the economic momentum in other emerging markets may be slowing, the near-term macro data in Russia should continue to accelerate.

At the same time valuations remain undemanding. Since 1998, the MSCI Russia index has traded on average on a 30% discount to the MSCI EM, but this discount has varied over time. Following the 1998 crisis until 2003, the discount was closer to 45%. From 2004-2008 the discount was closer to 20%. According to our estimates, Russia is trading now closer to a 40% discount. Therefore, we think the market looks quite inexpensive. Russia is also the cheapest country in the MSCI EM relative to ROE (see Fig.2).

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In Russia, we currently favour four major investment themes: continuing restructuring of the domestic fixed-line telecom sector, growing reform and earnings momentum in the power utilities sector, low cost production and strong market fundamentals in the bulk commodities space and finally strong earnings momentum and consolidation potential of the infrastructure sector.

We think one of the best ways to play the Russian recovery story is through building exposure to power utilities. Clearly with the colder weather, power demand in Russia is seasonally strong but we are also expecting growth later this year from a rebounding economy. With Russia moving ahead with power liberalisation (100% free electricity market by 1st January 2011) power generating companies will be able to generate higher prices and margins from electricity sales. For instance, Rushydro, as the lowest cost producer, benefits most from this with margins expanding by nearly 65% to reach astonishing 58% at the EBITDA level. The company will also be adding new capacity at the end of the year, making it a growth story as well as a restructuring one. Of course, not only generating assets are of interest in Russia but also power distribution companies represent an interesting investment case that benefit from the continuing reform in the sector. We view the transition to Regulated asset based (RAB)-based tariff regulation as a source of long-term value for Russian power distribution companies. Global RAB-regulated utilities generally trade on a par with RAB while the average Russian 2010 EV/RAB is around 0,45.

Outside of pure domestic demand-driven investment themes, where we are currently overweight, we also focus on investment themes that are benefiting from global demand recovery and where regional companies can successfully compete with global players. A good example is bulk commodities that are rising on the recovery of ex-China industrial production, including steel with supply-side remaining constrained on well-known infrastructure issues and advancement of some projects being stalled by the global financial crisis. In that particular area we like companies such as Kazakh miner Eurasian Natural Resources, Ukrainian iron ore producer Ferrexpo and Russian coking coal company, Raspadskaya. All of the above companies build on their competitive advantages such high quality assets with strong growth potential, low cost production and proximity to key markets.

We would not be positioned directionally to the regional oil & gas producers, preferring to “play the industry” through relative value trades focusing on the entire CIS region. If we look at the Russian energy sector it appears to be now more than ever a pure play on energy prices.We would expect these to be capped in terms of fundamental upside potential going into 2010 as more than 18% of OPEC capacity still remains offline and with overall Russian energy production growth remaining modest through 2010 (2% growth for oil and 3% growth in natural gas production over the next 12 months). Valuations remain undemanding but value catalysts are scarce.

We are cautious on the banking sector in Russia. From our point of view the sector is facing an extended period of inferior profitability following the decade 1999-2008 when Russian banks averaged a return on equity of 21%. We are concerned that net interest margins will start to suffer under pressure from CBR to cut the cost of borrowing to the real economy. The Russian banking sector overall loan to deposit ratio remains far too high, and we believe the sector’s historical reliance on foreign funding is being overlooked while the risk of default has not yet evaporated—as non performing loans (NPLS) have not peaked yet. Going forward we continue to be particularly concerned about the impact of low corporate cash flows on debt repayment schedules. And finally, we do not think that Russian banks deserve a valuation premium to CEEMEA peers at which they are currently trading – relative forward valuation multiples for the sector do not appear attractive.

The risks of investing into Russian and CIS markets appear exaggerated. Often risk perception is formed as a result of too academic an approach to investing which disregards the specifics of a particular region and the characteristics of the local financial market that sometimes leads to serious losses and general disappointment. On the other hand, Russia and CIS is too big a region to ignore when constructing a global equity portfolio – the potential rewards are much bigger than the risks. The best way to capture extremely attractive investment opportunities in the region is to partner with a strong local specialist that can help investors navigate the periodic storms emerging in the market and reach consistent and satisfactory results over the longer term. Russia should feature as aconstant element of an equity portfolio rather than periodically opening and closing exposure to the region.