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EScroogeJr (< 20)

Thoughts on Russian stocks - I.



September 07, 2007 – Comments (3)

Recently I looked at some Russian ADRs and was surprised to see that they all received 4 or 5 stars. This unmitigated optimism has prompted me to look into this unlikely success story to see if they can help me improve my score.

First, I looked at valuations. Here are some forward PEs: WBD - 23, MBT - 12, VIP - 15, MTL - 8. That's not bad. On the face of it, most companies look slightly undervalued to fairly valued. But now, here comes the disappointment (this is Russia, of course). Those PEs are pretty meaningless for at least three reasons:
1. The PE can go up should the company choose to report its real earnings.
2. Many companies are working on outdated Soviet equipment and still have a lot of potential for an increase of productivity.
3. The government may remove price controls, or help the company in some other way.

The downside, as you've already guessed, consists of the above-mentioned points 1, 2, and 3. Russia's distinguishing feature is that while in most of the world, true earnings reports help you stay out of jail, in Russia, such reports often get you to jail (just ask Khodorkovsky).  And because the more profits you report, the sooner you attract attention, the way to avoid confiscation is to improve your performance little by little, making the government hopeful that you will improve it still further if allowed to run your company for a little longer. Finally, any preferences from the government can be removed just as easily as they were bestowed.

To see what trecherous ground you must tred when making a valuation, you need look no farther than Gazprom. It is still selling 2/3 of its gas in Russia at around $50 for 1000 cubic meters. Remove price controls, and you're looking at a company with 3 times the current revenue. Now, will these controls be removed or not, and if yes, how fast, will depend on WTO negotiations, exchange rate of the rouble, global gas market, and a thousand other factors. The other piece of the puzzle is how much gas can be saved and used for export when and if Russian consumers became energy-efficient  (rumors have it that such a development would double the export capacity at current production levels). Yet another aspect is the issue of how much that notorious "social responsibility" can cost Gazprom (to put it in simple terms, the government wants Gazprom to run a gas pipe to every remote village with 3 houses and 5 people).

And yet, when you look at how well publicly-traded Russian companies have grown their earnings through modernization, mergers and acquisions, rendering the old PEs obsolete, it is easy to feel that they could pull that trick one again, leaving the current PEs in the dust. I am inclined to believe that's the case. Another thing to consider is the overall potential of the Russian market. The American GDP is $14 trn. I see no reason why Russia could not have the same GDP per capita, for the total of $7 trl - all the necessary prerequisites are there. That's a long way to go from the current figure of 730 bln! A growth like this should be enough to take the RTS index from 2,000 to 20,000. Think along these lines, and it becomes clear why people believe Russian stocks to be a good investment.

However, upon a second look, there are more than sufficient reasons to moderate such optimism.

First, if you consider the historical context, any bullish case for Russia will look very much like subprime mortgage paper. Russian history is cyclical, and, unfortunately for everyone, it goes in circles, not in a spiral. The typical cycle looks like this. At the first stage, the tsar realizes that he and his cronies are poor by Western standards and begins to wonder what he can do about it. The answer, of course, is to let his subjects show initiative, develop new industries, and make some money for themselves, enriching the state treasury in the process. So liberalization is initiated, which immediately makes things worse because of the clumsy attempts to relax controls without actually relaxing them. At the second stage, the pig-headed rulers finally realize the need for some compromise with reality. So they put harliners on a short leash, and, for a while, everyone seems to be going OK. At the third stage, the ruling elite looks at the continuing economic growth like a hungry dog watching a piece of red meat going past its mouth. For a while, apprehensions about slaughtering the hen that is laying golden eggs delay the inevitable, but finally, the dog's patience snaps, and the confiscation machine is set into motion. It is at this stage, however, that outside observers, who are always too late to realize what is going on, feel the most optimistic and predict an unprecedated future prosperity just as the house of cards is about to fall. At the fourth stage, having confiscated every ruble in the entire country and anxious to reward itself for all those years of suffering, the ruling elite loses its head altogether, pulls some old ideology from a dusty drawer, and squanders away everything, typically, on expensive new military toys and even more expensive territorial acquisitions. At the final stage, everything falls apart. All initiative is eradicated, all resources are depleted, expropriators turn out to be disastrous managers, and eventually 100% of the shrinking pie once again looks like pocket change in comparison with a small share of a much larger Western pie. It is then that reformers are called to the rescue, and the new cycle begins. The point that investors looking for Russian Microsofts should remember is that there was never a time in Russia when that hen laying golden eggs would not be slaugtered after reaching a certain size.

Putting such philosophical arguments aside, there are serious macroeconomic objections to the theory that you could find many ten-baggers among Russian stocks. True, the RTS index itself has been a 20-bagger since 1999. However, most of that growth is simply a result of the appreciating ruble: in real terms, the rouble is at least 5 times stronger now than it was in 1999. And, of course, the barrel of oil has jumped from $10 to $70, which explains today's capitalization of the commodities sector. Both should be treated as one-time events. With this adjustment, growth has not been that spectacular. To be sure, the index still tripled or quadrupled in real terms over these 8 years, but such returns are not without precedent here in the US, and they are no match for the Chinese market. A comparison with China points to another restraint on future performance. The Russian stock market is represented by the commodities and services sectors, with a smidgeon of manufacturing. It is in vain that you will be looking for stocks like the Chinese STP, NTES, MR, and CTRP. Such companies are not listed, and, truth be told, they don't exist - yet. While Russian GDP could double or quadruple from here, if you buy what's being offered today, you're not getting any of the companies that could make it happen. That's a limited upside. On the other hand, should commodity prices tumble, you're left with a very unimpressive selection of stocks and are also exposed to the weakening ruble.
There is the silver lining, though: in the short-to-dedium term, the commodities boom and the ruble both seem to have some more legs to run.

Finally, Russian stocks always seem to be a little ahead of themselves. Russia has the greatest income disparity among moderately developed countries, meaning that the share of GDP available for investing is far greater than what we are accustomed to here in the US. At the same time, high barriers to entry and lack of competition allows for fat profit margins of the corpotations. Unfortunately for foreign investors, the optimistic economic scenario for Russia implies, among other thing, a more competetive environment, where you get a combination of shrinking profit margins of corporations and less discretionary income with which to buy the stocks of these corporations. In addition, Russian investors should soon get more access to foreign stock markets, further reducing domestic demand for Russian assets. This won't stop the market from growing but will put a restraint on that growth.

Plus, don't forget about the ongoing M&C - Mergers and Confiscation activity. Most of it is hidden from foreigners, Yukos and BP being the sole visible exceptions. While it is true that Russia has always treated foreigners better than its citizens, one would be foolish to rely on such chivalry from the people who specialize in taking what is not theirs. (Remember, foreign investors did get get burned in 1917, and for all the prefrential treatment of foreigners, they recovered one kopeck on the ruble, and 70 years later). I wonder, for instance, what arguments Goldman Sachs, which reportedly will be the underwriter for Rusal's IPO in London, will use to convince its clients to buy a stake in the aluminum smelter, whose founder and main owner says that he will surrender his stake to the government the moment he is asked to. Yes, when that happens, people who own 1 share will be the last in line, but common sense tells us that once such process is initiated, it must come to its logical conclusion. After all, confiscating something halfway is always an awkward arrangement for all parties involved.

To conclude, it is unlikely that Warren Buffett will ever buy a Russian company - any  Russian company. The potential is more limited here and the risks are greater than most people realize. The risk/reward ratio points to India, China, and Brazil as better investments than Russia (personal note: as a native Russian speaker, I would rather prefer to make a different conclusion; sadly, the rules of logic give me no choice).

So, why did I put "outperforms" on several companies such as MBT, VIP, ROS, MTL, and NILSY.PK? I must confess these are purely speculative picks based entirely on my sort-term bet that the combination of some commodity-driven growth with greed and stupidity of foreign investors will provide for yet another leg of the rally. My thesis hinges on 4 points: a)  Commodities still look very strong, b) Even if prices retreat a bit, the ruble may keep appreciating as long as the balance of trade is still positive, c) The planned opening of a ruble-based commodity exchange in St. Petersburg could be important. Hopes to make the rouble a reserve currency alongside the dollar, the pound, and the euro (very small chance of that actually happening. Just my opinion.) might cause a small mini-bubble in ruble-denominated assets, d) 8 years of continuous growth have created an era of good feeling. The accumulated momentum is strong enough for the market to overshoot before the pendulum swings back. Note, however, that this is only what it is: a very short-term gamble. In any case, until we know the name of Puin's successor (yes, I know, you will be right to suggest that his name has five letters, starts with "P" and end with "n", but I don't think that's the only possibility  here) (hint, hint: Rosneft might hold the key to the puzzle), our time horizon does not stretch beyond 2007, and I wouldn't entirely rule out the chance that the fair market value of all these picks will go down to zero immediately afterwards.
Meanwhile, I'm putting an underperform rating on Lukoil, and would put underperforms on Surgutneftegaz, Bashneft and Tatneft if Caps allowed me to. Private oil production is the one part of the market that has no appeal, either long-term or short-term. These companies will eventually merge with Rosneft,  on terms which minority shareholders are not going to feel very happy about.

If I have time, I'll try to compile a full list of Russian stocks with their valuation metrics. Watching them will be a fascinating exercise - after all, Russia has never failed to frustrate every single prediction, gloomy or optimistic.

3 Comments – Post Your Own

#1) On September 10, 2007 at 1:31 PM, floridabuilder2 (99.34) wrote:

i will give you your props on the thoughtful analysis, but your still wrong on homebuilding....

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#2) On September 10, 2007 at 1:49 PM, EScroogeJr (< 20) wrote:

Thanks for the props,

I see where you're coming from with regard to homebuilders, but I can also see you're being too emotional on these stocks, and emotions are usually bad advisors.

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#3) On September 10, 2007 at 3:30 PM, floridabuilder2 (99.34) wrote:

this is what makes caps great, it is an incubator for seeing what ideas work and what ideas dont work... to see what advice people have on sectors and their track record on sectors...  people are all down on the top fools because of their red thumb performance but in an up market where there wasn't a housing issue, where would these guys find their red thumbs... eventually all of us will see how our theories play out..

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