by Ivan Martchev | April 5, 2012 8:37 am
This is part of a four-article series discussing the outlook for and ways to invest in the BRICs countries.
“We wanted to do better but it happened as always” are the famous words of the late Russian statesman and Gazprom (PINK:OGZPY) founder Victor Chernomyrdin regarding the initially disastrous transition to a market economy in the 1990s.
The early years of transition to a market economy in the former Eastern Bloc were not easy — I lived through part of that period in the region — but by now, all agree that Russia is a major economic force to be reckoned with.
Much of the credit for the steadier economic course in the past 10 years is given to (again!) President-elect Vladimir Putin. Not to take away from Putin’s accomplishments as president, but it has to be noted that Boris Yeltsin’s resignation at the turn of the millennium that originally put Putin into office coincided with the beginning of the biggest bull market in oil in a generation, which gave Putin the necessary financial resources to (begin to seriously) reform the Russian economy.
In trying to quantify how much help Putin got from the surge in oil prices, I came upon a paper from Katsuya Ito from Fukuoka University in Japan, “The Impact of Oil Price Volatility on Macroeconomic Activity in Russia.” Ito looked at the period between Q1 1994 and Q3 2009 and found that “a 1% increase (decrease) in oil prices contributes to the depreciation (appreciation) of the exchange rate by 0.17% in the long run, whereas it leads to a 0.46% GDP growth (decline).” I did not bother running his math as I knew from experience the economic leverage was huge — the price of oil and the Market Vectors Russia ETF (NYSE:RSX) track each other closely.
The benchmark MSCI Russia Index is 59.8% weighted in energy and 10.5% weighed in materials — one reason why it is currently valued at a forward P/E of 5.8 with a par valuation to book. For comparison, the benchmark MSCI Emerging Markets Index has a forward P/E of 10.4 and a price/book of 1.8. The Russian market is the most exposed to natural resources of any BRIC market, and for that it has paid the price of having the most depressed valuation.
Given the leverage to natural resources, the Market Vectors Russia ETF has the volatility of a stock as opposed to a diversified ETF. Last year, the same ETF sponsor issued the Market Vectors Russia Small-Cap ETF (NYSE:RSXJ), which is more balanced than RSX as it has a third lower weight in energy and materials. The volatility still is high, as the average weighted market cap is $2.7 billion — compared to RSX’s average weighted market cap of $42.4 billion — but since there is only one available ADR among the top 20 holdings, it is a great way to invest in the “real” economy of Russia, looking past the energy and materials sectors.
Still, the valuation discount has reached unseen lows in some cases. Russia’s largest company by market capitalization is Gazprom, which holds the largest undeveloped reserves of hydrocarbons in the world of any publicly traded energy company. For that, investors pay a trailing P/E of 3.5 and a forward P/E of 2.8 — no, this is not a typo. (And the multiple to book value is 0.59.)
I don’t think a Putin discount is to blame in this case, as the record share prices of many Russian companies were achieved on his watch way after the infamous Yukos affair. In this case, it might be the market fearing the ultimate dissolution of the euro and how that would rub off on Russia as a large European trading partner. The valuations of the local shares are compressing while the European situation remains far from certain.
Whether from the Putin discount or European fears, depressed valuations are a theme across the Russian market. Although Lukoil (PINK:LUKOY) trades at a heftier forward P/E of 4.2 and a smaller discount to book value of 0.70 than Gazprom, it still is below that of the MSCI Russia Index. The company is the third-largest non-state publicly traded oil company worldwide by proven reserves of hydrocarbons (1% of world total) and is the sixth-largest non-state publicly traded oil company worldwide in production of hydrocarbons (2.2% of global oil production). Lukoil prides itself on being more open than most Russian companies, and the only Russian oil company whose share ownership is dominated by minority shareholders; senior management does own a large (but not controlling) stake.
Because of the disproportionate reliance on energy and minerals’ prices for economic prosperity, Russian leadership has made it clear they understand the need to rebalance the economy toward more services, as well as develop a more vibrant industry sector. I know they have the money — in the past 10 years, GDP/capita has doubled and the country has racked up half a trillion dollars in foreign exchange reserves — so the only thing remaining is the implementation of those publicly stated wishes.
With or without this coming to fruition, if Victor Chernomyrdin were with us today, he probably would have been smiling while discussing Russia’s economic progress: “We wanted to do better, and as impossible it is to believe, we did it.”
Other BRICs reports:
Ivan Martchev is a research consultant with institutional money manager Navellier & Associates. The opinions expressed are his own. Navellier & Associates holds a position in Lukoil Oil Company for its clients. This is neither a recommendation to buy nor sell the stocks mentioned in this article. Investors should consult their financial adviser prior to making any decision to buy or sell the above mentioned securities.
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