25th July 2013
Russia is proving to be one of the more problematical and underperforming emerging markets leaving investors wary of devoting even a small proportion of their cash to it and tarnishing that other once popular investing concept that of the BRICs (Brazil, Russia, India and China).
Jupiter’s Emerging European Opportunities fund manager Elena Shaftan has returned from a recent trip to Russia and suggests the market has problems and opportunities, just not the ones you would expect.
In a note to investors, she also poses some interesting questions looking at what might trigger a re-rating in this country’s unloved stock market.
She admits that there is a dearth of investors in Russia at the moment but this begs the question: is there a silver lining?
“In the environment of emerging markets outflows, it is some comfort at least that there is not much to flow out from here, which made this market relatively resilient in the recent emerging market sell-off. When risk appetite does return, it is this abandoned and unloved market trading at absurdly low valuations of Price to Earnings Ratios (PER) of 4.5x (lower than when we launched the Fund in 2002) that, in my view, has the potential to deliver strong returns,” she writes.
Asking what might trigger a re-rating, she sets out the key questions –
When will growth start to pick up?
When will we see improvement in corruption and corporate governance?
What should investors make of the lack of reforms and baffling politics? What should one invest in?
Below are the rest of Shaftan’s thoughts.
“I thought I misheard the deputy Minister of Finance when he said that in his view the economy was overheating. With 1.6% growth so far this year that hardly made sense. However, he was referring to the fact that, with the jobless rate at just 5.5%, Russia effectively has full employment, pushing labour costs up with a lack of corresponding productivity gains. Thus the Ministry of Finance is resisting pressure to loosen the fiscal policy that was largely responsible for the economic slow-down as it wants to encourage productivity gains.
“Notwithstanding that, there are also some measures being adopted to stimulate growth: a part of the National Welfare fund will be released as infrastructure spend, while the central bank is set to extend maturities for loans to the banking system, which should de facto loosen monetary policy.
“This should drive the economic growth in the second half of the year to finish the full year close to 3%. Secular growth of 3%-3.5%, however, is not enough to meet Putin’s objectives. The only way to accelerate this sustainably is to embark on a course of structural reforms.”
“Putin’s approach to managing the economy in the past year has been a piecemeal one, a constant compromise between the liberal economic team that argues for reforms and tighter spending and the hawkish lobby who want protectionism and spending. How long will this muddle-through carry on for? The answer was provided by one of the oligarchs from the liberal group with direct access to Putin. The President has made it clear that he is prepared to embark on a course of reforms aimed at one single target – to stimulate the economy enough to meet his social obligations and make himself popular again so that he can win the next election in 2018. This may sound less than inspiring, but is at least honest, and not too dissimilar to many other countries where the same approach is taken but not voiced.
“One of the significant contributors to that economic recovery would have to be foreign investments. Goldman Sachs was hired to advise Putin on what investors need to hear and his recent speech at the economic forum in St Petersburg was his best effort to date to woo them. He has realised that he is going to need them after all.
“While the words “Russia” and “reform” in the same sentence understandably cause many to roll their eyes, we should not forget that over the last two years we have seen progress on many issues that had been stalled for decades, from WTO entry to bringing stock market settlement procedures in line with western norms. And we are likely to see more. It is no coincidence that a reemphasis on reform should happen at a time when oil prices have taken a breather from their decade-long upward trend. When the price of its main export quintuples, it is easy for a government to kick the can down the road, but when prices stabilise, the elite is forced to take hard decisions and make better policies in order to survive.”
Corruption, corporate governance and state interference
“The attitude to this subject could be best illustrated by the emotional reply from a CEO of one of the consumer companies we met. As I pressed him to reflect on the risk of higher social taxes, he said: “You don’t understand – we have simply never had it this good! We live in a city that is cleaner than London or New York. We don’t have to give bribes anymore. We can afford everything we want within reason. We can say whatever we want within reason. We run some of the most profitable companies in the world. And we pay 13% tax. How much better can it get? If the taxes go up a little, it’s hardly going to affect us that much.”
“He was right about the city. Moscow certainly looked clean, but more strikingly, despite the +30C temperature, the air did not feel as oppressive as usual. Growing consumer wealth has finally translated into a modern car fleet, which combined with refinery upgrades has resulted in cleaner air – and more butterflies!
“He was also right about corruption. Putin’s anti-bribery drive has accelerated in the past six months with a lot of high profile heads rolling. But this trend began some time ago. In the past three years, prosecutions for bribes increased by 83% compared to 10 years ago.
“And most importantly, he was right about profitability: Russian food retailers, mobile operators, internet and IT companies command some of the highest margins globally. As of last year, they also started increasing the pay-out ratios. Dividend yields are now above 4.5%, among the highest in emerging markets.
“Russian business still suffers from state interference, and corporate practices often leave a lot to be desired, but in this respect it is not that different from other emerging markets. The reason Russia is being penalised so heavily is because it is assumed to be “European” and is judged by European standards. But in reality Russia has never been quite the same as other European countries, shaped by very different history and geography. The important point is that it is changing, perhaps painfully slowly, but changing nonetheless and, in my view, for the better.”
What to invest in?
“On this trip, I focused in particular on consumer-orientated, privately owned firms (which largely reflect the current make-up of the portfolios). Food retailers have been a consensus safe-haven of late. With a robust consumer and unconsolidated markets, you can see why the bigger and better managed operators can command superior margins. While there are still plenty of opportunities for expansion, the tight labour emerged as an area of concern with migrants comprising as much as 30-50% of staff. Those with a strong corporate culture are able to cope with this level of staff turnover, but the weaker ones clearly suffer from substandard service as a result. In general, competition among food retailers in Moscow is fierce and clear differentiation is required in this crowded trade.
“In my view the most interesting companies proved to be the internet and software ones, some of which have been too expensive in the past (often trading on PERs of well over 35x) or too illiquid. However they have since been de-rated, have increased their free floats and at current levels present an interesting opportunity of 30+% sustainable earnings growth at PERs in the high teens for 2014.
“We continue to be impressed by a high end maternity hospital group that has outperformed the Russian index by 33% since October 2012. The top management team are qualified medical doctors and are extremely engaging and intelligent. A key factor in their success has been their ability to put across the case for investing in a sector that is highly attractive, but completely new to portfolio investors in Russia.
“Similarly a well-run consumer electronics retailer with a western CFO who presents the company effectively to foreign investors has beaten the Russian index by some 35% over the past three years and is another example of how good communication, in combination with good results – can help a stock outperform.”
“This highlights the importance of good PR, not only for companies, but for the country too. A polished, western-friendly tone goes a long way towards making a company and a country appear safe, attractive and understood. In this risk-averse environment, we search for safety in familiarity, we as investors prefer to deal with people who speak the same language, not just literally, but metaphorically. A good public image will not do it alone; there needs to be a good story behind it, but it is one controllable factor that could help to close the discount.
“The discussions with many of the companies we met and Putin’s efforts at the economic forum made me feel optimistic that at last Russia is beginning to get what it takes to woo western investors: first and foremost speaking the same language, a language which they first needed to learn and understand. It feels like this process is finally underway.”