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Pop Goes Russia's Hot Air Balloon (Int'l Edition)

Where to Invest in 1998 -- Strategies for Stocks: RUSSIA


The crash has refocused attention on the gaping structural woes Russia must address

Has Russia's long-awaited economic recovery been nipped in the bud? Just when gross domestic product and industrial production were inching up after six years of decline, foreign money is leaving amid jitters sparked by the Asian crisis. Higher interest rates are smothering the expansion plans of managers in heavy industry and the budding service sector. Inflation, which Russia had managed to get down to a respectable 11% in 1997 (from 131% two years ago) is again on the rise. Says Anatoly B. Chubais, Russia's First Deputy Prime Minister: "In the best scenario, [economic recovery] has been set back three to six months."

Whether they like it or not, Russians are now members of the global economy. Decisions made by traders in Hong Kong, London, or New York affect Russians' lives almost as much as decrees issued by President Boris N. Yeltsin in the Kremlin. When investors fled all emerging markets, including Russia, after the Oct. 28 global market crash, the Russian stock market lost more than 40% of its value. Yields on Russian government debt jumped from 17% to more than 50% during November. As investors took money home, the ruble came under pressure. Russian banks, which had large portfolios of stocks and bonds, were hit hard. Many banks had only started investing in stocks in the spring and bought shares at peak prices. "We will be more cautious after this crisis," says Vitaly B. Malkin, president of Bank Rossiyskiy Kredit, Russia's sixth-largest lender.

For most of 1997, foreign investors were infatuated with Russia. They were impressed with the level of economic stability the government had achieved and were counting on economic growth in 1998. And on an asset basis, Russian stocks were among the cheapest in the world. Primarily because of foreign money, the stock market rose 180% from Jan. 1 to Oct. 23. Russian debt was also hot. Foreigners snapped up $16 billion of Russia's $50 billion Treasury market and more than $4 billion worth of Eurobonds. But since investor mood has cooled, as much as $10 billion worth of new Eurobond deals have suddenly been placed on hold.

SHAKY SCAFFOLDING. The crisis has refocused attention on Russia's structural problems. Banks are still more interested in speculating than lending. Almost half of commercial transactions are conducted in barter. The bankruptcy law has no teeth. Most important, the government is spending and borrowing too much and not collecting enough in taxes. In this environment, who wants to take big risks in Russia? Says William F. Browder, managing director of Hermitage Capital Management: "Only allocate an amount of money you can afford to lose."

In November, Russian regulators got a hard lesson in just how skittish investors are these days. Reluctant to push up the government's borrowing costs, regulators intervened in the Treasury-bill market to keep yields around 28%. But the ruble was under pressure, and 28% was not high enough to compensate foreign investors for the currency and market risk. Nobody was buying--and Korean and Brazilian investors, who were preoccupied with their own money troubles, pulled out some $4 billion.

On Dec. 1, the government decided to stop intervening and made it clear that it would do whatever was needed to support the ruble. That brought some foreign investors back in, but T-bill yields remain above 30%. Indeed, interest rates will be a key factor in the performance of Russia's equity markets in 1998. If investors can get guaranteed yields of 35% in the T-bill market, few will buy equities. Banks will put whatever money they have in Tresury bills rather than loans. And if there's another crisis, all bets are off. Says Harvey Sawikin, who manages two Russia funds for Firebird Management LLC in New York: "Interest rates are the tail of the dog that wags the stock market."

Still, barring another global meltdown, Russia stacks up pretty well against other emerging markets when it comes to major economic indicators. It still boasts moderate inflation and a balance-of-payments surplus. And foreign direct investment in Russian companies has doubled this year. Assets are tantalizingly cheap, too. The market capitalization of Russia's top oil producers averages less than $1 per barrel of reserves--less than one-fourth the figure for leading Latin American companies.

But getting reliable information on Russian companies is tough. Russian accounting practices mask the barter transactions and unpaid debts that are strangling many companies. Only a handful of companies have been audited according to international standards. And managers aren't always friendly to shareholders. Says J. Mark Mobius, president of Templeton Developing Markets Trust: "When the Russian market was booming, many investors had to lower their guard and buy what was available and exciting at the time. Now, there are many large companies in other emerging markets that are very attractive and cheap."

The safest bet in Russia is still the oil-and-gas industry, with its rich assets and strong export potential. "You can find outstanding long-term value, particularly in these natural resources," says Jonathan Garner, director of emerging-market strategy at Robert Fleming Securities in London. But investors need to shop around more carefully because the industry is in the throes of consolidation. Small publicly traded companies are being merged into bigger holding companies under government privatization rules, and shares in the smaller companies are often diluted in the process. At the same time, many of these holding companies are now part of bank-owned conglomerates that have the power to siphon off assets at will.

Such tangled relationships make it difficult to assess oil companies' performance. Only Lukoil, created several years before the other holding companies, now operates as an integrated oil company in the Western sense. Not surprisingly, it trades at multiples two to three times higher than those of other Russian oil companies.

Electric utilities, another sector that created a buzz with investors this year, now looks hazardous. Because utilities are legally barred from cutting off nonpaying customers, most of them run up huge accounts receivable or accept payments in barter. Fund managers such as Nancy Herring of the U.S.-based Lexington Troika Dialog Russia Fund have sharply reduced their utility holdings.

BARGAINS. Still, the savvy investor can ferret out some good buys. After the steep drop, companies that were expensive two months ago are once again bargains. Some regional telephone companies, for example, are trading at low prices even though they appear to be poised for robust growth, with local governments approving rate increases and vendors ponying up credits for capital improvements. And auto maker Gaz has managed to build a successful light-truck business while other Russian automotive companies have floundered. It recently announced an $850 million joint venture with Fiat to produce 150,000 Fiat sedans per year.

Some fund managers are looking closely at consumer-goods companies, especially food and beverage makers that are holding their own against imported brands. Danielle Downing, chief Russia equities strategist for Salomon Brothers Inc. in London, is keeping an eye on startups such as retailer Seventh Continent and food distributor Soyuzcontract in expectation of their going public in 1998. "You're starting to see consumer-led demand," notes Downing.

Others prefer to wait on the sidelines. Firebird's Sawikin cashed out most of his two funds' holdings shortly before the October crash, and he's in no hurry to get back in. "We're still looking for signs of improvement in the macroeconomic fundamentals," he says. Until that occurs, Russia's raging bull may have to stay in the corral.By Patricia Kranz and Carol Matlack in MoscowReturn to top

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