As part of Managing Risk week and following our previous article on political risk, we take a short trip to Russia as a case study to look deeper into country risk. In many ways, investing in Russia is a classic example of accepting both market and country risk in the hope of gaining a higher return.
Between the stock market collapses of 1998 and 2008, Russian equity indices have multiplied in value several times over. Pictet Asset Management estimates that Russia’s corporate earnings growth will reach 23.2%, in 2011 exceeding that of companies in Korea, Brazil and Taiwan. Yet, according to Pictet’s calculations, 70% of Russian stocks still look cheap relative to emerging market peers.
But what of the investing environment in which these opportunities are set? In 2010, Transparency International ranked the country’s corruption levels at 154 out of a possible 178, where a low number signals a more transparent political and business environment, putting Russia roughly on an equal footing with Venezuela and the Democratic Republic of the Congo. (Incidentally, Denmark ranks number one.) In addition, the country’s economy is heavily reliant on the production and export of commodities and is thus highly correlated with the volatile prices of oil and natural gas. What’s more, the energy sector is heavily controlled by the state through direct government participation in the biggest oil and gas producing enterprises as well as commodity price controls.
Investors who have set their eye on Siberia’s vast energy reserves would be right in feeling uneasy about the opaque business practices and centralised political power in the country. That said, because concerns with Russia’s high level of risk are common and largely priced in, fund managers find Russian equity valuations appealing. To reconcile these views, we've decided to evaluate the impact of politics on the Russian market and ask dedicated Russia investors about their approach to seeking opportunities in the country.
Political Risk in Russia
Even though private market players can engage in corrupt practices among themselves, a high level of corruption is a political risk as it marks a failure of a country’s legal and regulatory system. “Corruption is a major risk in emerging economies,” says Michael Denison, Research Director of Control Risks’ Global Risk Analysis Team, adding that this requires companies operating in these markets to be well aware of the relationships between key corporate and political decision makers. International companies operating in Russia run into corruption “from day one”, says Denison, noting that there is a history of companies “running into the sand due to the associations they have had.” Such risk is more pronounced in strategic economic sectors, such as defence and energy, and less extreme in sectors such as retail, Denison clarifies. While there has been an awareness in both the public and the private sector that lack of transparency and grey-area business practices discourage foreign investors, “corruption is still clearly an issue,” when doing business in Russia, Denison argues.
According to Peter Jarvis, a Senior Investment Manager in Pictet’s Emerging Markets Equities Team, acknowledging the prevalence of corrupt practices in the energy space is not necessarily a threat to the day-to-day operations and profitability of Russia’s commodity champions. That political power in Russia is heavily centralised is a known issue and one needs to invest “with these entities and not against them,” says Jarvis. Buying into a natural resource company that has a poor relationship with the Kremlin has “no value”, according to him, though this does not imply that investors should focus solely on companies in which the state owns a significant share.
Beyond being aware of this key Russian market feature, however, Jarvis sees little role for political considerations in constructing a portfolio of Russian equities. The Yukos affair aside, Jarvis can think of very few instances where political interference has actually tripped corporate growth. In his view, the misfortunes of Mikhail Khodorkovsky, the oligarch who was in control of Yukos and was subsequently sentenced to 14 years imprisonment, sent a signal to Russia’s rich list that they should stay out of politics. The separation of business and government, Jarvis argues, is a concept even UK companies would not oppose.
Control Risks’ Denison takes a slightly different view of the Yukos case. He calls it a “watershed” that started an era of government capturing the business sector, following the early 1990s, when it was very much the other way round.
The Danger of Risk Perception
The divergence in Denison and Jarvis’s interpretations of political risk captures a key aspect of Russia’s risk profile – that the country’s market is highly susceptible to risk perceptions. This can, and has, given rise to substantial market volatility. While policy changes, such as enforcing price controls on a staple food product, may have little overall impact on the relevant markets, dramatic headlines and market noise has the power to scare investors in the short term, Jarvis explains. Overall, Pictet takes the view that Russia is being over-penalised for risk due to a historic bias against the country, which western investors have still not shaken off.
Because Russia, like many emerging markets, is highly reliant on foreign capital, such a perception-driven flight of foreign investors can give rise to substantial volatility. In addition, unlike Chile or South Africa, where large pension funds invest domestic capital in the local market, Russia has no sizable domestic investor base which can “mop up the stocks foreign investors are selling” in a downturn, says Jarvis.
The need to compensate for short-term downside risk is one of the key reasons why Pictet recommends an investment horizon of seven years for holders of their Russian Equity Fund. Foreign capital has a tendency to exit quickly and return in a gradual manner, points out Jarvis, which explains his team’s long-term investment strategy in the country.
To Own a Single Country Fund
Investing with a long-term horizon is one way to curtail downside risk when buying into a ‘risky’ region such as Russia. Another common strategy is to diversify country risk by holding assets in regions with little correlation to the local politics. Clearly, this approach is not available to managers of a single-country fund such as Pictet’s Russian Equity Fund. When you invest in a single country, you simply “accept the risk”, says Jarvis. No doubt there are individual investors whose risk appetite is sufficient to gobble up this proposition. However, as Plamen Monovski, Chief Investment Officer at Renaissance Asset Managers, says, investing in single country funds is an exercise of timing a single market. Monovski takes a stance against investing in single country funds, because, he says, fund flows in such vehicles are usually correlated to lagging market performance, that is to say that investors jump into a region in response to market noise, when it is already too late to gain the best of the region’s performance.
Morningstar Associates’ Stoyan Angelov explains that Morningstar consultants also do not allocate clients’ resources to single-country emerging market funds. Angelov, however, does not discount the value of such funds for particular exposure within a more broadly diversified portfolio. “Single-country funds are also particularly useful for taking short term tactical asset allocation bets on a country or region,” he says. From Morningstar Associates’ perspective, single-country funds have a limited role in a global diversified portfolio created with no particular country bias in mind. In such a portfolio, typically a total of 20% of the asset pool will be assigned to emerging markets investments.
In summary, Morningstar’s Senior Analyst William Samuel Rocco says single-country emerging-markets offerings are inappropriate for everybody but very bold investors who already own a diversified mix of overseas funds, who are big believers in the target market in question, and who are intent on owning an investment that has a risk/reward profile like that of an aggressive stock.
