Smart Money Has `Train Wreck' at Top of BRIC League: Eric Kraus
Time and again, we hear dire warnings about Russia and its place among the BRIC nations. That’s great news for investors.
Most of us aren’t smart enough to reliably outperform a rational, fully arbitraged market, so we avoid the crowded trades and seek to profit from mispricing by trading against misinformation, bias and sheer pigheadedness, none of which is in short supply when it comes to Russia.
While the casual reader could be excused for imagining Russian markets as an ongoing train wreck, the data may surprise. Although Russia was widely written off as a failed state in 1998, the country’s long-dated Eurobonds returned 20 times your investment over the ensuing decade. That almost matched the returns on the equity market, which gained 2,500 percent, and handily outperformed any peer group you choose.
Since then, it has been a wild ride, but once again, after a nasty sell-off during the global credit crunch, Russia has bounced back. The benchmark Russian Trading System Index has risen 63 percent over the past year, trouncing the remaining members of the BRIC quartet: Brazil (up 30 percent), India (up 29 percent) and China (down 21 percent).
The story is only half played out, and much like the beginning of the last decade, Russia is again one of the cheapest emerging markets. The smart money is betting it won’t stay that way; this year the inflows into Russia funds have topped the BRICs league.
Clearly, there are serious problems such as corruption, property rights and governance, but Russia doesn’t exactly have a monopoly here. Take property rights: Yes, BP Plc had a spot of bother getting into an ill-advised fight with its Russian partners, but a light touch of the Kremlin’s magic wand, and hey presto, everyone was friends again. The oil company continues to enjoy bounteous cash-flows from its investment in TNK-BP Ltd., its deal of the century.
It wasn’t quite so lucky in the Gulf of Mexico, although BP assumed itself to be protected by legal limitations capping its liability at $75 million. When an oil well it had commissioned blew out, the U.S. government retroactively tore up the rulebook with nary a hint of judicial process or recourse. The oil giant was crippled with potentially unlimited liability, a $20 billion down payment was extracted, along with a freeze on asset sales. Worst of all, terrified of Washington, BP rolled over without a fight. Just imagine the press coverage had it been Russia.
So, why is the RTS trading with a forward price/earnings ratio of about six? Besides the negative coverage in the Western press, the discount is attributable to three main things:
First, there is still a hangover from the sell-off during the global 2008 credit crisis, which triggered a major liquidity squeeze for Russian businesses, which were dangerously dependent on international bank finance. Russia sacrificed $200 billion in reserves to provide liquidity to its domestic market. Unlike its peers in the Group of Eight nations, it used savings, not borrowed money, to do so. Two years later, the corporate sector is a net foreign creditor to the tune of $40 billion; given gross sovereign indebtedness of less than 10 percent of gross domestic product, many European finance ministers must wish they had Russia’s problems.
Second, the RTS is largely comprised of large oil companies, plus a couple of major state-owned enterprises. Like every major oil exporter from Norway to Venezuela, Russia has decided that subsoil resources belong to the nation. The Finance Ministry captures the lion’s share of export revenue, leaving the companies to function by a “utilities” model -- modestly profitable whatever the oil price, but with limited upside.
Buying state-owned behemoths such as OAO Gazprom or the oil-transport monopoly OAO Transneft is akin to acquiring shares in the Education Ministry: worthy undertakings, but don’t imagine investor returns to be their main priority.
Oddly enough -- this makes asset allocation fairly easy -- anyone owning a diversified Russian portfolio, minus the oil blue chips and state-controlled companies, has done very well this year.
Finally, trading on global risk tolerance, European debt concerns, Chinese growth scares -- everything but its own fundamentals -- the Russian equity market gives a whole new meaning to the term “high-beta.” For as long as global markets live in terror of a generalized G-7 sovereign-debt crisis, Russian shares will remain something of a gamble.
Fortunately, debt markets are a bit less hysterical than equities. Russian sovereign credit-default swaps are performing better than those of several European Union member countries, as well as a half-dozen U.S. states. The bonds of the top Russian banks are doing better than some of their European peers.
Russian markets aren’t for the fainthearted, nor for the impatient. Financial markets eventually converge with the underlying economics, and the “decoupling” between the G-7 and the emerging markets is for real. But so far it has involved the economies, not the financial markets. Russia is no exception, with GDP growth of about 5 percent, less than such paradigms of free-market orthodoxy as China and Argentina but great by Western standards. With low debt levels, it is a rerating just waiting to happen.
Russian markets are fashion victims, and are currently both unfashionable and cheap. You can own them now, or wait and buy the next time they surge back into vogue. And I will be selling out just about then.
(Eric Kraus is a special adviser on global strategy for Moscow-based Otkritie Financial Co. The opinions expressed are his own.)
To contact the writer of this column: Eric Kraus at firstname.lastname@example.org