The Alternative Investment Management Association

Alternative Investment Management Association Representing the global hedge fund industry

Who's afraid of the bear?

Stephen Cohen

Troika Dialog

Q4 2007

Global investors seem to have a thing about Russia. They seem to expect that a country 15 years old and where memories of the Soviet communist system are only too vivid should behave like a Western European country and operate to the same standards. Too often the phrase “Russia risk” is quoted as a reason not to consider investing in the region.

On closer examination, many of these purported risks turn out to be a garbled legacy of memories from the 1990s or just the normal risks one might expect in any emerging market. Investors blithely allocate to China and India, where standards of corporate governance, access to the legal system, administrative transparency, state involvement in industry, protectionism and democracy deficits, etc., are all live issues, not to mention corruption and, in China’s case, a mercantile policy that tends to reduce return on equity.

Investors are happy to turn a blind eye to the problems in Romania and Bulgaria, even post EU accession, in the expectation that these will be favourably resolved over time.

However, Russia is different; it is bigger, brasher, not wholly European, an ex-superpower and still largely a natural resource economy: And it did go bust in 1998. When coupled with a seemingly relentless news flow, such as we have seen in the last 12 months, then investors’ minds focus on the risks not the opportunities.

There are, of course, risks of investing in Russia but they are not the ones that most investors focus on. In 2007, Russian real GDP growth may exceed 8 percent in rouble terms and this may reach 25 percent in US$ nominal terms, depending on the amount of rouble appreciation. This is impressive, even by Asian standards. Foreign exchange reserves exceed US$400 billion. The current account surplus this year may be around 7 percent of GDP. The Russian government has no net debt and will enjoy a fiscal surplus even if the oil price falls back to US$40 per barrel. Macro-economic risk is not only minimal but the economic outlook is excellent based on domestic demand led growth. Consumption is growing at 10-12 percent real and capital investment by 15-18 percent real. This growth is not especially dependent on commodity prices. Wealth is spreading out. The Gini co-efficient is improving and real wage growth is significant.

A few other myths are worth demolishing. An owner of Russian equities today has good title, can settle a trade and will enjoy reasonable disclosure as 75 percent of major companies now publish IFRS data. The relative importance of foreigners (and thus their skittishness) has much diminished as over 80 percent of trading is by domestic investors. Turnover averages around US$3.5 billion per day or better. There is a thriving and liquid derivatives market. Over 50 names can be borrowed for shorting in reasonable size and price.

While natural resources are still over 65 percent of market capitalisation, the new issue flood has vastly increased the investable universe in terms of sector diversification, numbers of names and liquidity. Attractive exposure to the consumption theme can be had via the financial sector, where bank balance sheets are growing at 50 percent rates given the prevailing low levels of debt in the economy.

Russia did assert its legal authority to regain control of Sakhalin-2 and the Kovytka field. The process was not elegant and the PR handling was poor in the extreme. The Strategic Assets Bill will become law later this year and as in many emerging (and developed) economies this will exclude foreigners from controlling key assets. This is not so much a nationalisation process but rather a final sorting out of the immediate post-Soviet era.

It is not unreasonable to ask neighbours to pay a commercial price for their gas and to object when they steal some. Switching off the pipeline to Western Europe was clumsy but produced the desired result.

While Russia is no longer a super power, it still has plenty of missiles and there is a sense of a loss of empire. Russia’s conventional forces are not a threat but Russia does seek to make clear its own foreign policy and one that is distinct from NATO or G8, as Russia has very different strategic concerns. It is likely that Russian foreign policy will continue to raise hackles in Washington, as Russia pursues its own interests and asserts its sovereignty. It seeks respect from the G8 and to be accepted as an equal partner for negotiations. Russia will make its views felt, wherever it perceives its interests to be affected, such as Kosovo.

Thus, further incidents should be expected as NATO continues to move East (missiles in the Czech Republic) and Russia resists. Economically, Russia is on a path to converge with the mainstream global economy and capital markets over the next 5-10 years and is well aware of the rules of the game. Expect more tail-tweaking (Chavez, Hamas, etc.), and maybe even repeats of the cyber attacks on Estonia but little of real consequence. The diplomatic tit-for-tat over Berezhovsky and Lugovoi should die down in time. Russia has learnt in the last 9 months that there is still some housekeeping to do. Deputy central bankers should not get shot in capital cities. Lethal radioactive materials should not be available for freelance foreign assassinations.

Compared with the 1990s, lawlessness has vastly improved and big city streets are mostly as safe as in the West. Russia is busy making money and in many cases travelling to the West to spend it. It is brash, rich and getting richer. The West just needs to get used to this.

President Putin enjoys 80 percent popularity ratings. Aggressive statements on foreign policy do not hurt him or the United Russia Party, especially ahead of upcoming elections. In fact, the strict content of his notorious Munich speech – telling the Americans that unilateralism in world affairs was a non-starter - was not materially different from comments made by Chirac or even Blair. Putin’s delivery was a little harsh and the reporting of his remarks was worse.

Putin’s policies have generally been good for the Russian economy and for the stock market. It is unlikely that the next President could be elected without at least tacit approval from Putin. This means it is very likely his successor will be someone whom he has selected and elevated and who will pursue similar policies. Political risk to the stock market in Russia does not appear to be material. The constraints on democracy in Russia may on some occasions not be attractive but by comparison with most Asian countries in the 1980s and several today, Russia is considerably more open.

The risks that investors should perhaps be considering are different. In the short term, there are still corporate governance risks at individual companies. Both Securities and Company law still have lacunae which some companies exploit. The risks to investors can often be on the upside as management come to understand the benefits that derive from better governance and change their behaviour. Some aspects of Administrative decision making are not perhaps as transparent as they could be. Access to the legal system for redress can sometimes be difficult. Again, these are on a par with other emerging markets. Even corruption, when surveyed by the World Bank and by Transparency International, is not dissimilar from many Asian countries and for the man on the street bribery in Russia is apparently less of a problem than it is in Greece or the Czech Republic.

So, in the short term investors should worry more about interest rates, inflation rates, growth and earnings. They should focus on the oil price, Chinese demand and the US consumer, etc. In the medium term, it is worth keeping in mind some other concerns. Is the longer term trend towards more or less democracy? Will the creation of very large state champions (Gazprom, Rosneft, etc.), lead to inefficient allocation of capital and suppress entrepreneurial activity elsewhere? Will the decline in state spending on education be reversed? Will the size of the state bureaucracy continue to grow rapidly?

Overall, Russia seems to have chosen an economic model which is relatively investor friendly, provided that the position of minority shareholders receives reasonable respect. There are risks, certainly, in particular companies. However, while the Russian market is no longer obviously cheap, it is not yet expensive and the economic background is excellent. Investors might do well to learn to conquer their fears of the Bear.

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