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September 1, 2008updated 01 Feb 2016 12:07pm

Another Country

By Christopher Silvester

It is a little over ten years since the Russian state defaulted on its sovereign debt, an event that practically all Russians remember with shame and certainly all foreign investors remember with anxiety. Yet the ensuing decade has witnessed dazzling growth.

Spear’s WMS has spoken with four witnesses to this process, who remember the trough but are bullish about the country’s future as an investment market. ‘The ’98 crisis was severe and very tough indeed,’ recalls Sergey Bubnov, a Muscovite who started out in London in 1994 as a research analyst for Credit Suisse First Boston ‘There were some positives that came out of it, though. A significant depreciation of the rouble made the local exporters very competitive overnight and laid the ground for the growth we have seen over the past ten years.

‘Also, of course, oil was ten dollars, so it was quite hard for the government to maintain the fiscal balance. Few people anticipated how low the oil would go in the late ’90s. It was a dismal year. But it did help the producers a lot and the oil price started going up.’ After CSFB, Bubnov worked for Merrill Lynch and the European Bank of Research and Development before joining investment bank Renaissance Capital in the summer of 2005.

Peter Halloran, CEO of the Pharos Financial Group, has been involved with the Russian capital markets since their inception in 1994 and had previously built Credit Suisse First Boston’s equity and fixed-income brokerage businesses in Russia and the CIS. ‘It was the end of ’97, the market was red-hot,’ he recalls. ‘Most of the money that came out here was from people I had known from my days in New York, whom I [introduced] to Russia, such as George Soros. The idea was to set up a fund to take a few hundred million of CSFB’s prop [proprietary] money, so I set up Pharos.

‘Soros and all these large hedge funds and large investors that were already in Russia put money into my fund with a mandate to go out and be creative. So I could do private equity, public equity, fixed income, any kind of structured product that I could come up with. Everything changed when ’98 came along. Valuations got wiped out, we were back to where we’d started, and suddenly it was a question not of being clever or creative, it was a binary decision — either you’re in the market or you’re not in.’

Matthias Siller, now an investment manager for Baring Emerging Europe, first went to Russia in 1997 for the Austrian bank Raiffeisen, then the largest non-Russian bank in Russia. ‘There could hardly be a bigger contrast between the state of affairs back in ’98 and the economic development today,’ he reflects. ‘Russia has huge currency reserves that have been accumulated over the last few years actually stemming from taxation of the resource sector.

‘Secondly, we now have a political situation where you can again interpret the motivation and long-term goals very well. Talking about whether this regime is autocratic, semi-autocratic, democratic or whatever is not so important for doing business in Russia. What is important is that the average Russian has more faith in the political elite than at any time in the last 25 years.’

Marina Akopian, like Bubnov a native Muscovite, started her career as a fund manager with Pictet Asset Management in London, working on its First Russian Frontiers Trust. She has been following the Russian story since the beginning of the stock market there and now manages the Hexam EMEA (Emerging Europe, Middle East and Africa) Absolute Return Fund.

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‘The Russias of ’98 and 2008 are like two completely different countries,’ she says. ‘They called it democracy in ’98, when really it was complete and utter anarchy — the fact that the country was left literally without any budget because it was privatised for pennies and a dozen or so powerful figures bought all the country’s assets and were not paying taxes.’ She believes that Prime Minister Putin is not given enough credit for what he achieved during his presidency by making business people pay taxes.

‘The Russia of 2008 has a very strong macro-economic picture. You have a budget surplus, you have a current-account surplus. People say it’s mainly because of high oil prices. Well, I disagree, because the majority of industrial production comes now from manufacturing, construction and services rather than from the extraction industries. That shows two things. Firstly, that corruption on the government level is negligible. Putin is not putting this money into offshore accounts and transferring it to Switzerland. This money actually belongs to the Russian people, just in case it’s needed. Secondly, the country has managed to diversify away from being a resource-based economy to one that is actually manufacturing, is growing due to the domestic factors, and is not purely dependent on high commodity prices.’

‘There are certain sectors where foreign expertise and know-how is definitely sought after in Russia and these sectors have nothing to do with commodities — technology and consumer-related goods, where the Russians understand that they lack expertise, yet at the same time have buoyant consumer-demand growth.’

Indeed, the bulk of the growth in the past few years has not been coming from the extraction industries, but from the domestic market. ‘About ten years ago, the proportion of the market given over to the oil and gas sector was 90 per cent,’ says Sergey Bubnov. ‘Now it’s nearer to 70 per cent.’

Peter Halloran sees this switch as indicative of the fact that Russia is an industrial nation which went into sharp decline and is now making a comeback. ‘The difference between Russia and China is that China’s growth has been fuelled through export-led demand and what it is trying to do is create domestic-led demand,’ he explains. ‘If you look at infrastructure, the story is the re-industrialisation of the country, with plant and equipment being upgraded and modernised, and you get efficiency gains.

‘I think it’s unprecedented that Russa’s had 10-per-cent-plus productivity gains for approaching ten years, and it comes on the back of a lack of spend before. That’s the untold story of Russia, but that’s where a lot of these growth numbers are coming from, increased productivity, and the domestic cycle that’s feeding on itself.’

Marina Akopian has figures given to her by one of the Russian telecom companies that show that the profit contribution to global conglomerates from Russia is phenomenal. ‘First of all, we only have a twelve per cent tax rate in Russia, so your bottom-line earnings are fantastic.  And the Russian market is such an unpenetrated market in many ways. On the genie coefficient [an index that measures the ratio of income between the top 20 percent of a society’s income earners and the bottom 20 percent], Russia falls between the US and the UK in terms of the per capita disposable income. It’s much higher than what you have in China or Brazil, so despite the fact that the population is much smaller than in China they have much more to spend.’

Russia is becoming one of the most important consumer markets globally. In 2004 it became the largest European market for mobile usage. In 2005 it had the largest sales volume in Europe for washing machines and in 2009 it is expected to overtake Germany in car sales.  Peter Halloran points out that something like 28 million people have disposable incomes of $1,000 a month or more: ‘That’s a lot of spending power and it certainly supports a lot of consumer concepts. That’s compared to ten million who were at that level three years ago. The headline numbers reach down reasonably broadly into the general population, so it’s become a wealthier country.’

While we’re on statistics, Matthias Siller of Baring Emerging Europe believes Russia’s emerging middle class could reach 50 or 60 million within the next two years and 80 or 90 million within the next decade.  Moreover, a Russian opinion poll conducted by the Public Opinion Foundation in June of this year showed that 73 per cent of respondents ‘know’ or have ‘heard’ of foreign investments in Russia. The share of negative attitudes towards foreign investment has declined since 2000 and that of indifferent attitudes has increased, while the share of positive attitudes is stable.

‘On the marketing side,’ argues Peter Halloran, ‘European investors are far more savvy when it comes to Russia than American investors, who have been slower to shake the legacy of the Cold War. Once you get out to America, the level of comfort falls off rapidly because there’s not a lot of depth of understanding. Aggressive hedge funds, they’ll go and look at everything, but when you go a level below that, high-net-worth or ultra-high-net-worth-type investors, who don’t have the time or necessarily the motivation, then it’s very different. They’re just as happy to look at Asia or Latin America. Russia is the next big opportunity for the US markets to figure out.’

If foreign investors are wary, argues Marina Akopian, it is at least partly the fault of ‘those of us who invest in companies without doing maybe enough due diligence. If I were running a purely Russia fund I probably would be investing in companies that are very transparent historically and where we have already seen that there is no way that transfer pricing is going on or tax not being paid — companies like Gazprom, Rosneft and Sverbank.

‘I’ve seen a lot of investment houses coming out and saying the country-risk premium of Russia has increased, when what in fact has happened is that over the years we stopped doing enough due diligence on companies, in terms of their corporate governance issues, what they’re doing in terms of transparency, and how honest they are as corporates. What should change is the level of due diligence that fund analysts and fund managers do on taxpaying and transfer pricing. To focus on the bottom line and earnings per share obviously isn’t enough. We need to dig deeper and see if companies are behaving in a legal way and paying taxes, and not just focus on EPS grosses.’

Nonetheless, Akopian has currently reduced her fund’s exposure to the country. ‘It is not because I think the Russian risk premium has increased or that I think the government is going to go after business — I think that’s rubbish. Quite the opposite. I think that the government is trying to restrain corruption and show business that it has a social responsibility for paying taxes.

‘As is always the case, the Russian market is quite misunderstood, so there might be redemptions. And purely because of the outflow and the liquidity, the market can underperform other markets in the region, but when I think the major outflows happen, I will definitely look to go back into Russia and use this weakness as a buying opportunity.’

For Pharos’s Peter Halloran, there are still things to be done with the extraction sector — gas distribution, and supply and service companies. Agriculture, too, is a hot theme. ‘We have long plays and short plays. You have to be as careful about agriculture as you would oil, for similar reasons. We’ve actually got investments in companies that have a lot of agricultural land but they’ve been at it for quite a while with grain silos and have expanded into land ownership.

‘What you’ve had with the opening up of land over the last few years is financial investors going out and paying $400 per hectare to line up farmland, then flipping it off into public markets at $4,000, and in between doing a little bit of work. We’re short some of those names, because we see that more than half their land is at risk of falling away from their control. In American historical terms, they’re the carpetbaggers. The math is so compelling and that’s where the markets misprice all of this.’

Raven Russia, a Guernsey-registered company founded in 2005 that is listed on London’s AIM market, invests in warehouse and logistics properties in Russia, as well as Ukraine and Belarus, and its executive deputy chairman, Anton Bilton, whose international property company Raven Mount manages the Raven Russia portfolio, had more than $1.4 billion of logistics properties in Moscow, St Petersburg, Rostov on Don and Novosibirsk at the end of last year. Raven Russia has continued to expand rapidly, fuelled by the consumer-driven retail boom.

Russian and European retailers, such as IKEA, which has opened 10 Mega Mall developments in Russia, need distribution space, and Raven Russia is able to use debt financing to leverage its portfolio and undertake leasing based on occupier demand. Coupled with leverage, this can produce yields of 13 per cent, which Glyn Hirsch, Raven Russia’s CEO, has described, in a deft soundbite, as ‘property sex’. The company has announced its intention to seek a main listing by early 2009 and to enter the FTSE 250 later in the year.

Baring Emerging Europe is investing in supermarket chains. The market is very fragmented and will benefit from consolidation. There is a large amount of unorganised retail — kiosks, open-air markets, street traders — and Matthias Siller believes that the organised retail sector will gradually take this over. He likes companies operating throughout the different regions of the Russian Federation, especially those that are investing a lot in brand recognition. For example, he points to supermarket chain X5 and food processor WimmBillDann.

Marina Akopian is a little more sceptical about the Russian retail sector. ‘You have to look at the individual companies’ valuations. Yes, the retail sector is still in a stage of consolidation. Having said that, it is almost playing a speculation game, buying stocks with a view to getting some M&A exposure. I think valuation-wise there are only a couple of companies that are attractive in the retail sector.

‘What I think is very surprising and counter-intuitive is that two very large companies in the mobile telecoms sector, VimpelCom and MTS, which are trading at probably the cheapest valuation they’ve had in a long while, are not getting any interest from investors. This is despite the fact that they’re not in the extraction industry and at the same time it is the sort of industry that is exposed to domestic growth. Their [share] performance year-to-date has been really poor and they don’t seem to be getting any bounce from the market either. So I think there is some mispricing in the market in general.’

As for the Russian stock market itself, our interviewees are remarkably happy with how it has developed. ‘You have a lot of liquidity,’ says Peter Halloran. ‘On normal days, it’s trading about $5 billion a day and there’s a future that trades about one or two billion dollars a day. Of all emerging markets, it’s one of the most liquid by far. There are structural issues with settling and clearing that need to be streamlined, and with offsetting derivative contracts, but it’s a very liquid and a very deep market, with a lot of commitment out of the London market makers.’

Matthias Siller is also impressed by the liquidity of the market, especially with regard to the blue chips. ‘The two Moscow-based bourses, RTS and Micex, combined with London and some stocks that are listed in New York, now account for two to three billion dollars in turnover every day,’ he notes. ‘Also, a very liquid derivatives market has been developed, which is entirely based in Russia. Futures trading in Russia is definitely more liquid inside than outside Russia. That tells me, as an investor, that there’s a significant base of local investors and speculators in Russia.’

Marina Akopian points out that the Russian stock market is one of the largest emerging markets in the world. ‘Companies are liquid and trading is very good, so there are no issues from a stock-market point of view which should discourage investors,’ she observes. ‘The number of private investors has grown significantly, she points out, but middle-class retail investors are mainly day traders. ‘They are very similar to retail investors in China, and Turkey, very newsflow sensitive, and their time-horizon is basically a few hours. It does provide, for long-time investors like us, some interesting entry points, but at the same time it does add to the general market volatility.’

Like Akopian, Peter Halloran is relaxed about Russia’s day-trading phenomenon: ‘It’s not what you saw in Japan, a lot of people with online accounts. The day trading that we see is more institutional, which makes it more bizarre. You have these pockets of corporate and institutional money that are managed by these young kids who are day trading. A lot of that’s fallen away over the last six months because the lending rates have gone up, so it’s more expensive to do your day trading. It didn’t get out into the general population. It’s not a situation where your taxi driver’s got an online account.’

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