Unflagging faith in Russia stock growth

The Russian equity market has finally started to break out of its period of sideways trading, delivering returns of over 60 per cent since the beginning of the year.

Grant Felgenhauer, investment director at Moscow-based Hermitage Capital Management, speaking at this year’s PIMS International event, said: “We think that Russia is one of the most exciting places in the world”. With over $2bn in assets under management, 60 per cent of this sourced from Europe’s private banks, Hermitage Capital Management prides itself in running the world’s largest public equity fund dedicated to Russia.

The Yukos saga, which scared investors all over the world and ended with the conviction of the oil giant’s former chief and largest shareholder, Mikhail Khodorkovsky, for fraud and tax evasion, had such a demonstrative effect that other Russian oligarchs are now paying their taxes in full, says Mr Felgenhauer. “This shows that a Yukos type of scenario won’t happen again.”

President Vladimir Putin recently supported a series of reforms aimed at restoring confidence in the Russian market. This included an amnesty which reduced the irrevocability of companies’ privatisations from 10 to three years.

Hermitage estimates that in spite of the recent rise, the $410bn (?339bn) Russian equity market is still one of the cheapest stock markets in the world, and with valuations accompanied by higher earnings growth.

The main drivers of the market are all directly linked to oil, responsible for a quarter of the Russian GDP and over half of the country’s exports. First is the increase in domestic liquidity, driven by petrodollars inflows.

The second driver is external liquidity, fuelled by forthcoming inclusion in the MSCI index of Gazprom, the state-owned gas and oil company and largest in the world. “The liberalisation of Gazprom shares is a huge catalyst to bring more external funds,” said Mr Felgenhauer. “We anticipate a lot of buying fund managers to keep their weight in Russia in accordance to the MSCI index”. The third catalyst is represented by earnings upgrades and reserve growth at Russian oil companies.

INVESTMENT PROCESS

The Hermitage Guernsey-domiciled hedge fund, started in April 1996 by William Browder in partnership with the late Edmond Safra, has delivered euro-based annualised returns of 35 per cent. It has returned 66 per cent over the last 12 months, versus 57 per cent for the sector. But over three and five years returns are below average. Favoured stocks are those with low valuations, found predominantly in the gas and oil sector, which accounts for 90 per cent of the fund’s assets.

The fund’s fight for better corporate governance in Russia has helped reduce the scale of stealing and waste at various companies including Gazprom – its largest position – and helped the stock appreciate six times in four years.

Lukoil is the second largest holding. “One of the reasons we like Lukoil is because it has always been compliant with tax law, very close to the Kremlin”, explained Mr Felgenhauer. Given the centralisation of power in Russia, his team likes to invest in companies that “have good relations with the State, because on balance, these are safer investment cases”. Mr Felgenhauer said that several companies in Russia have “oligarch risk”, meaning that their beneficiary owners have a very high-risk profile. “A company has to be, in our minds, either attractively valued or if it has this kind of [oligarch] risk, be cheap because of this”.

Daily volatility of up to two per cent is fairly standard in Russia. In October 2005 the RTS, the Russian index, took a nose-dive by 15 per cent in only 20 days.

Hermitage says, the main market risk revolves around the transition of power in 2008 from president Vladimir Putin, whom Mr Felgenhauer defines “an incredibly dynamic performer of laws”. Other risks include the deterioration in the general risk appetite, given the high correlation between the Russian equity market and other risky assets, an oil price fall to less than $20 a barrel, a rise of equity risk premiums all over the world or major changes in central banks’ currency policy.

Another risky factor is, according to Oussama Himani, head of emerging markets at UBS Wealth Management Research, the heavy dependence of the Russian economy on oil. “The market is influenced heavily by one single factor which is oil, so structurally Russia is going to be more risky than other more diversified economies”.

Unlike Mr Felgenhauer, Mr Himani sustains that compared to other emerging markets, Russia was extremely attractive a year and half ago but this relative valuation advantage has largely gone now. “A couple of years ago Russia was a bargain, now it seems to be in line with the market”, he says.

Felgenhauer: Kremlin funds safer bet