Market insider: From Russia with love

Michael Wilson considers whether investors should risk Russian volatility in the hunt for stellar returns.

I’ve no idea who first said ‘what goes around comes around’, but I bet they weren’t thinking of Vladimir Putin at the time.

The former Russian president stepped down in May 2008, after serving his maximum two terms in office, and swapped places with his prime minister, Dmitry Medvedev, while he waited for his next move.

And now, the old KGB chief says he’s thinking of going back on the presidential trail in 2012 and that he plans to stand for office against anyone except Mr Medvedev. If Medvedev’s name is on the presidential ballot in 2012, Putin won’t stand.

Obviously there’s still time for a change of plan – the election is two years away – but the world has changed a heck of a lot since Putin and Medvedev swapped roles in 2008.

For a start, we’ve had a credit crunch and a global banking crisis, the intensification of the war in Afghanistan and an escalation of Iran’s nuclear programme. The latter has even got the Kremlin worried about its former ally’s ambitions.
We have had a new president elected to the White House and a resurgent China, which has been putting its rivals in the BRIC investment group (Brazil, Russia and India) in the shade. So what kind of outlook for Russia can reasonably
be expected?

A single-product economy
If you haven’t been tempted by a Russian car, a Russian TV set or a Russian suit recently, there’s a reason. Elements of Russian industry remain disorganised and uncompetitive, largely because its innovation culture is non-existent, its marketing is bad and its products are worse.

Nothing there to interest an investor, then. And especially not in an age when China does all those consumer things so well.

However, if you’ve turned up the gas or ordered more heating oil during the winter, then you’ve made the bosses of Gazprom, Lukoil, Transneft and Rosneft very happy. These are the companies that help to keep us Europeans supplied with our critical energy needs.

So how do you get in on that wealth?
It certainly isn’t too late to join the party. Russia’s energy fields might be old, underfunded and underdeveloped, but the Russians keep on finding more of the stuff under Siberia.

In 2009 alone, Russia’s declared oil reserves grew by nearly 4 billion barrels, or about 6 per cent, and its gas reserves went up by over half a trillion cubic metres. That’s not bad at a time when other countries are looking at shrinking national hydrocarbon reserves.

There is an issue, though, in that Russian industry lacks diversification. Oil and gas accounts for as much as 90 per cent of all the foreign investment now moving into the country.

There was a time when Russian banks looked like a good bet, or when government bonds were all the rage but, when inflation is nudging 8 per cent and the government’s bailout is driving the official overspend above 9 per cent of gross domestic product, finance suddenly doesn’t seem like such a great idea any more.

Improving the public image
It is a shockingly imbalanced economy, judged from an investor’s point of view. But the awkward fact is that the Moscow stock exchange made a stunning 123 per cent growth in the 13 months to the end of January, or 128 per cent in dollar terms. (Yes, the rouble was still gaining against the greenback, while also holding steady against the wobbly pound.)

The RTS stock exchange index soared from around 540 at the start of February 2009 to nearly 1,600 in mid-January 2010. Marvellous, except that it then crashed by almost 15 per cent in the space of three short weeks – more than twice as fast as the Footsie and the American S&P 500.

So what’s all that about? Risk aversion, say the analysts. The growing fear of a double-dip recession in some Western countries is encouraging professional fund managers to pull in their horns and desert the BRIC markets. That, and the fact that Russia’s economy contracted by an estimated 8 per cent last year. Oh, and that Moscow is running out of money for its bank bailout.

One thing we can say for sure is that this year’s downturn in Moscow isn’t due to the oil market. Crude prices might have dropped a bit during the early months of the year, but nobody really believes that they’ll stay down.

A short and rather warm winter in most countries has temporarily reduced fuel demand, and worries about sustainable economic growth have also hurt prices temporarily. But so what? Surely, in the long term, oil and gas are the nearest thing you’ll get to a one-way bet.

The wobbles have probably got more to do with Russia’s shaky record on corporate governance. Shareholder protection is poor, and government behaviour has frequently been downright shabby. Too many companies have had their assets seized, their contracts torn up or their capital diluted by absurd fundraising exercises. This is the reason that Western fund managers rarely feel safe investing in them.

This is certainly the case in the oil sector. In 2005 and 2006, Russia snatched exploration assets away from Shell and BP on allegations relating to environmental controls. Earlier, Putin’s people seized oil company Yukos on a tax evasion charge and sent founder Mikhail Khodorkovsky to the labour camps, while its other assets were redistributed. The prospect of corruption and bribery is still a major concern for foreign companies operating in Russia.

Moscow is acutely aware of its image problem. At the start of February, first deputy premier Igor Shuvalov told a business conference in Moscow that the investment climate would be ‘significantly improved’ by next spring to meet foreign concerns.

Red tape would be reduced, he said, and the court system would be cleaned up. By 2020, he insisted, the country would be ‘transformed’ and a radical culture of innovation would be introduced.

2020? That’s a very long time to wait. And besides, in two years’ time we may have President Putin back at the big desk. Perhaps it would be better to focus on what’s good about Russia right now. And, without a doubt, that’s its mining sector.

What to buy
So what sort of prices do you pay for Russian stocks? Well, according to Reuters you will currently pay about 12 times earnings for a typical portfolio – which is about the same as you would in London.

You’ll receive an average dividend of 1.7 per cent, which sounds OK until you hear that Russia’s inflation is running at 9 per cent and that its government bonds are paying about the same. However, the investment story is still startling if you have the nerve.

You could buy Gazprom, the biggest gas provider on the London Stock Exchange (LSE), for about 12 times earnings, and yes, it has doubled and sometimes tripled its share price in the last year. Or if you’re a bit more adventurous there’s the oil giant Lukoil, in Frankfurt, for about the same price and a similar performance.

Finally, if you want something more diversified, you might like to look at the JPMorgan Russian Securities investment trust, which is also big on nickel, steel, banking and telecommunications. It produced an astonishing 160 per cent in the year to February. Just as long as you don’t mind the fact that its three-year performance was minus 3 per cent