The Rush To Russia
Viktor M. Borovsky traveled halfway around the globe to savor one very sweet moment. Standing on the balcony of the New York Stock Exchange on the morning of Jan. 26, the Siberian utility executive beamed as the name of his company, Irkutskenergo, flashed by on an electronic ticker.
Borovsky is one of many Russians trekking to Wall Street these days to see their companies' names up in lights. Fourteen, including Irkutskenergo, have launched issues of American depositary receipts in the U.S., and officials at Bank of New York estimate that an additional 15 are in the pipeline. But that doesn't tell half the tale. In New York, London, Frankfurt, and of course Moscow, investors are swarming to buy Russian equities even in the face of rampant crime, corruption, and a 6% economic decline in 1996. Says Nancy Curtin, head of emerging markets for Baring Asset Management in London: "We are committed to Russia."
Baring and other big global investors have poured $1.2 billion into Russian equities since Jan. 1 alone, and have helped the Moscow market climb 65% this year on top of 127% in 1996 (chart). Investors are snapping up Russian corporate debt as well. What finally persuaded foreigners to dive in was President Boris N. Yeltsin's reelection and Russia's successful $1 billion Eurobond offering last year. Also bolstering confidence was a decision by the World Bank's International Finance Corp. to add Russia to emerging-market indexes many fund managers use as a benchmark. Now, investors are pleased by signs the economy is stabilizing after five years of contraction.
EASY MONEY. Indeed, Yeltsin's decision on Mar. 11 to sack most of his Cabinet and bring reformer Anatoly B. Chubais back into the government was only the latest fodder for the bulls. They say this demonstrates that, despite his fragile health, Yeltsin is serious about the tax reforms and bankruptcy measures Russia needs to restart growth.
To be sure, Russia's sharp gains also are a product of easy money in the industrial world that is pumping up stock prices from Wall Street to Warsaw. Money is beginning to pour into a slew of Russian corporate Eurobonds, too. More than a few money managers now worry that Russia is a bubble that could burst if interest rates rise in the U.S. and investors flee emerging markets. That is especially true for big petroleum, telephone, and utility stocks that foreigners have favored. However, the bulls insist that even a market correction would not dim Russia's prospects. They argue that Russia remains a bargain-priced, if risky, bet on future growth. That allows them to see past everything from impenetrable financial statements to crime. Says Craig S. Sim, chairman of Donaldson, Lufkin & Jenrette Inc.'s international investment banking group: "People are looking at the cheapness of assets. So if there is some corruption in oil? So what?"
Talk like that--as well as a plunge in yields on Russian Treasury bills to 20% from more than 200% last summer--are luring local investors into the stock market, too. As much as 20% of Moscow's trading volume so far this year has been generated by Russians themselves, up from virtually zero a year ago. But for the wealth created by the stock-market boom to trickle down into the real economy, the reforms Yeltsin and foreign investors are seeking will have to speed up. Right now, warns Renaissance Capital Group CEO Boris Jordan: "Production continues to fall in many industries, working-capital shortages are rampant, and there has been no restructuring."
That's the case at Irkutskenergo. Like tens of thousands of enterprises across Russia, it is squeezed in a vise of punitive tax rates and bills it can't collect. A third of its revenues are in cash. The rest are in promissory notes and barter. Gripes Borovsky: "We took in only 27% of the money owed to us in 1996, and were supposed to pay out 26% of our earnings in taxes. If we pay our taxes fully, we have no money for wages."
Irkutskenergo owes its 22,000 employees two months' back wages. Workers have also missed out on the recent runup in their company's share price. When the company was privatized, employees were given 51% of the shares. But most of them didn't understand they might appreciate, and sold them. By the time the company's stock had nearly tripled in January, to 30 cents a share--or $15.75 per ADR--42% of the company was foreign owned. "Workers are complaining," says Borovsky.
But even amid the complaints, the economy is showing early signs of rebirth. Electrical consumption, for example, rose slightly in 1996, a possible harbinger of rising industrial production. Moscow's Brunswick Brokerage predicts that Russian gross domestic product will grow by 2% in 1997 and 5% in 1998, driven by new investment in industry. If Yeltsin is successful in cutting tax rates, companies in the unofficial "shadow" economy, particularly fast-growing service firms, will begin to report earnings, giving another boost to official GDP.
These early signs are leading many investors to focus on Russia not only as a way to buy into natural-resource companies for a song but also as a play on growth. That is leading them to put their money into regional phone and power companies such as Irkutskenergo. By all rights, these companies should bloom if the economy starts to move. Yet their stocks have trailed behind the more established Lukoil, Rostelecom, and Unified Energy System.
The broadening of the market is causing investors to take a closer look at fundamentals. Evaluated on the value of its reserves, Russia's premier integrated petroleum company, Lukoil, trades at a 90% discount to foreign oil firms. Nonetheless, the price-earnings ratios of many blue chips and a few second-tier telecom companies are now double, or even triple, that of their foreign counterparts. The surge of foreign cash has pushed Irkutskenergo's price-earnings ratio, for instance, to an eye-popping 71.5, compared with just 13.8 for the far more profitable Spanish utility Endesa. And Stephen O'Sullivan, head of research for MC Securities in London, estimates that if Lukoil's meager profits were restated in line with Western standards, its price-earnings ratio would be a robust 30, twice that of some Western companies.
Still, as one of the most liquid and best-known Russian stocks, Lukoil will be in demand by big pension and mutual funds that are entering Russia. Telecom issues, especially smaller ones, should also stay hot. Earnings at regional carriers such as Chelyabinsk Svyzainform and Perm Uralsvyazinform are growing at an annual rate of 15% to 20%, even after including the cost of providing social services such as housing, kindergartens, and medical care. Analysts believe these companies will be able to turn such functions over to the government.
In fact, spotting such possible opportunities is becoming key to identifying stocks that are on the verge of taking off. Par Mellstrom, research director at Brunswick, thinks that oil issues just coming to market, such as Yukos, Sidanko, and Sibneft, are valued 40% to 80% cheaper than high-flying Lukoil and Surgutneftegaz and could be among that group.
Bank stocks, meanwhile, are coming into vogue as high-profile lenders such as Inkombank and Menatep, itself the heart of a huge financial and industrial group, launch ADRs. But many analysts save the bulk of their praise for Sberbank, the former Soviet state savings institution, where Russians do everything from depositing their nest eggs to paying phone bills. With 34,000 offices and some 70% of all Russian bank deposits, Sberbank, still 51% owned by the central bank "is an enormous monolith that is making lots of money and investing it," says Taco Sieburgh Sjoerdsma, head of research at Moscow's United Financial Group. Early this year, foreigners began to snap up shares, considering them undervalued at $45. By the end of February, the price had jumped to $150, but it was still trading at a p-e of only 1.
STILL RISKY. Sberbank's spectacular rise shows how artificial Russian stocks can be. The bank's management and big outside shareholders want to maintain control by keeping the stock in the hands of domestic investors. So when foreign investors began hunting for shares, Russian brokerages started buying stock in their own names from Sberbank employees. To stop the practice, the bank has ordered employees not to sell shares. The bank can back that up with action because it controls its own register of shareholders, a common practice in Russia. "There is no uninterested party keeping track of shareholders," complains J. Mark Mobius, president of the Templeton Russia Fund.
Managers who maneuver to keep control are only one of the risks that remain in the market. Disclosure is improving, but Russian accounting still makes it hard to ascertain a company's real worth. The legal system provides insufficient protection for shareholders. Corporate governance remains dysfunctional. There's a shortage of experienced managers. And markets haven't started funneling capital to companies.
For now, global investors are willing to forgive such shortcomings. They may not do so indefinitely, especially if Russia's economic situation doesn't improve by summer. But for now, most are willing to give Yeltsin the benefit of the doubt. Now that Russia has joined the world of Eurobonds and ADRs, the country is becoming more subject to the demands of international capital than the diktats of former commissars. If that message sinks in deeply enough, Russia's bull still may have room to run.