Emerging markets rallied 37% in 2017, making that the best-performing sector of the year. But one significant laggard within the group was Russia, surprising, considering the strength of the oil price.
The Russian stock market and the oil price are tightly correlated, but diverged last year. Russian equities eked out minimal gains as investors worried about further international sanctions.
But now Russia is being tipped for a recovery, and with valuations so incredibly cheap this could be the perfect time to buy. Robin Geffen, manager of the Neptune Russia and Greater Russia Fund, says the market currently trades at 0.8 times price/book compared to a historic high of 2.5 times. That’s a 55% discount to emerging markets generally.
Russia currently trades at 7.5 to 8 times price/earnings compared to a historic high of 20 times. While Geffen does not expect these highs to be re-visited, he sees scope for the market to trade at 1 times price/book and 12 to 15 times price/earnings.
That’s supported by a dividend yield of 5% and an “incredibly low” pay-out ratio of 20%, compared to 40% for emerging markets as a whole – meaning companies could return more cash to shareholders.
Warning: Could This Be a Value Trap?
Cyrique Bourbon, portfolio manager at Morningstar Investment Management, likes Russia, but accepts some may worry about the market being “perpetually cheap”.
He says that a long-term deterioration of the oil price could lead to a downward shift in fair value, but notes that the index is transitioning away from being overly dependent on the large oil firms. Gazprom, for example, used to account for 35% of the MSCI Russia index. It now represents 15.5%.
“The first element of the Russian puzzle is to realise that it is not reasonable to just look at the evolution of the price/earnings ratio and declare that Russia is cheap,” Bourbon continues.
Russia is volatile, though, and not for the faint-hearted. “The Russian opportunity could experience a very wide range of outcomes, from negative annual returns to strong double-digit returns,” he adds. “But the probabilities are skewed to the upside.”
How Russia Responded to the Oil Price Crisis
Winston Churchill in 1939 said he could not “forecast you the action of Russia”. Well, it’s certainly easy to forecast March’s Presidential election. “Russia has the strongest and most secure President and the most capable central bank Governor,” says Jan Dehn, head of research at emerging markets specialist Ashmore.
This helped Russia weather the storm when the oil price crashed in 2014 and 2015. Inflation shot up to 17% by early 2015 and the country entered a recession. The reaction was “textbook how to get yourself out of a crisis”, according to Naomi Waistell, investment manager at Newton.
The Russian central bank hiked interest rates from 5.5% in 2013 to 17% the following year. It also managed to keep a current account surplus, which stands at 2.5% of GDP today. “Russia really is the poster child for how to do a crisis right,” says Waistell.
Now, inflation is down to 2.5% – well below the 4% target – and the interest rate is at 7.75%, giving a real interest rate of 5.25%. “That gives them huge scope for rate cuts,” says James Dowey, chief investment officer at Neptune.
Currently, 100 basis points are expected to be cut from the headline rate in 2018, but Dowey reckons that’s too conservative. “We think 150 basis points is really do-able.” This would take it to 6.25%, lower even than the 6.3% priced in by the end of 2019.
Elsewhere, consensus forecasts for real GDP growth is currently 1.8% for 2018. Dowey thinks 2.5% is realistic, giving a positive macro backdrop for the Russian market.
Energy Matters to Russia
Many contrarian commentators are bullish on the outlook for oil prices, which is ultimately what really matters to Russia, according to Colin Croft, manager of the Jupiter Emerging European Opportunities Fund.
He likes Lukoil, the most widely owned Russian oil company, and owns preference shares in oil and gas firm Tatneft, which have outperformed the ordinary shares by 40%.
Croft shows analyst expectations for Lukoil’s net income at ₽440 million. Two analysts have calculations based on oil at $60 a barrel and forecast significantly higher income for Lukoil. “If oil stays at $70 for the rest of the year, Wall Street will have to upgrade their income forecasts for Lukoil by over 20%, which is pretty big,” Croft concludes.
He also recently bought into natural gas company Gazprom because “it had just got too cheap”. “Everything has a price, even the companies you might not like,” he says. While the dividend is not growing, this will change in the future once it reaches the end of its capital expenditure cycle.
“In 2006 all these Russian oil companies were trading on quite high multiples, yet they were paying no dividends,” continues Croft. “Nowadays they are paying fantastic dividends and nobody’s paying any attention. As soon as they start paying some attention, these things will go through the roof.”
Geffen does not hold state-owned Gazprom and Rosneft, but he likes gas producer Novatek. He says management has an excellent track record of execution and value creation. It’s delivered 20% return on equity consistently and grown free cash flow considerably over the past three years.
What About Financial Stocks?
The second largest portion of the index, financials is an area both Ulle Adamson, manager of the T. Rowe Price Emerging Europe Equity Fund, and Croft like. State-owned Sberbank is the largest holding in both managers’ funds.
Croft points out that the company’s net income has increased from ₽106 billion in 2007 to ₽740 billion today and is expected to hit ₽1 trillion by 2020. Further, its pay-out ratio has increased from 8% to 50% in that 10-year period. “That is just mid-boggling,” he says.
Croft holds Sberbank’s preferential shares, which have beaten its ordinary shares by 20% since the start of 2017. “The prefs tend to trade at a discount but quite often you get exactly the same dividends,” says Croft.
“The fact you don’t have voting rights doesn’t really matter when you’re dealing with an institution that’s controlled by the central bank.”
Adamson says she’s positive on domestic names, particularly fast-growing market leaders. This has led her to own regional group Bank Saint Petersburg, which focuses on the smaller and medium sized businesses and retail markets.
Unloved Tech
Technology has been a huge driver of equity market performance in recent years. That’s been characterised by the efforts of the major tech stocks FAANGs in the US and the BATs in China.
The MSCI Russia Index has zero weighting to technology stocks. This is something that Geffen believes works to his advantage. He owns internet service providers Yandex and Mail.Ru.
The US giants are not allowed to enter the Russian market, Geffen notes, which means Yandex and Mail.Ru have a Google, Amazon and Facebook-free marketplace in which to compete. This gives them the ability to earn “supernormal profits”.
“Not only that, they also have a very good relationship with the Government so are not in any way going to be threatened by legislation going forward.”
Lesser Known Opportunities
On the two big supermarkets, Croft prefers X5 to Magnit. The latter is a former stock market darling but has recently seen a real deterioration in earnings due to its regional bases. X5, meanwhile, is based in Moscow and Saint Petersburg, which gives it more durable earnings. It’s also less owned and cheap.
Ewan Thompson, manager of the Neptune Emerging Markets Fund, says that mobile phone penetration in Russia is actually over 100% because most people have more than one phone. Geffen adds it’s the strongest market for luxury mobiles in the world.
“Mobile phones are an essential tool,” says Geffen. “Even in the hard times when people were cutting down on their food baskets, they were not cutting down on their phone usage.” He has smaller positions in mobile telecoms provider Mobile TeleSystems.
How to Play Russia
No pure play Russia funds are rated highly by Morningstar analysts. Geffen’s fund was downgraded from Bronze to Neutral in February 2017 due to “heightened analyst team turnover and the fund’s risk profile”.
For his part, Geffen says he “makes no apology for taking a defensive position when everybody was far too euphoric” in the first half of 2016.
Of the Morningstar Silver Rated wider emerging market funds, Lazard Emerging Markets has the largest net weighting to Russia at 8.79%, followed by the Robeco Emerging Stars Equities Fund with 6.71%. Both hold Sberbank and Lukoil amongst their top holdings.
