The Russian stock market is, by conventional measures, one of the cheapest in the world — with a trailing price-earnings ratio of only 6. The big question is: Given geopolitical, economic and governance problems besetting Russia, is this price low enough for investors to make it worth entering?
Moscow’s MICEX index hit an 11-week low on Monday, closing at 1,361.94, the lowest since May 6. The exchange’s all-time low since the start of 2014 was on March 13, when it closed at 1,237. It recovered steadily for the next few months, hitting a high this year on June 24, but has since fallen more than 10 percent from that peak. Even after July price declines on the back of fears of political repercussions from the destruction of Malaysian Airlines Flight 17 over eastern Ukraine, many international investors have, in recent months, seen the low valuations of the underlying stocks as a buying opportunity.
The market has been buoyed by investors such as the €49 billion ($65.8 billion) French investment management firm Carmignac Gestion, which decided at a point near the March low to increase existing weightings, in particular Russian stocks that in the firm’s opinion had favorable long-term stories. “From an economic standpoint, the consequences of this crisis were pretty limited,” says Jean Médecin, a Paris-based member of the investment committee at the firm. “The panic movement of the market was an opportunity for us to add to our investment.”
Many investors are still wary about the Russian market even at these low metrics. Their greatest fears are not about the short-term effects of the Ukrainian crisis, including likely tougher sanctions against Russia. Médecin says that the dispute between Russia and Ukraine has had little impact on the Russian economy because it is relatively closed, and because Western sanctions have targeted individuals rather than corporations. Rather, the main concerns dogging investors about Russia are over long-term structural problems that stand to impair earnings, including sluggish economic growth and ongoing dissonance between the priorities of shareholders and those of government.
“To be honest, the economic outlook for Russia is not very good,” says Manolis Davradakis, Paris-based senior economist for emerging markets at AXA Investment Managers, part of the French AXA financial services group. AXA Investment Managers has progressively revised downward its forecast for 2014 gross domestic product growth to a scant 0.4 percent, from 4.1 percent at the start of the year, in part because of the negative effect of worsening domestic sentiment stemming from the U.S. and European Union sanctions and in part because of high inflation, which has hit purchasing power.
Looking to the long-term outlook, Davradakis predicts that Russian economic growth will remain below global GDP growth for the foreseeable future — a discouraging statistic for a country whose modest GDP per capita suggests strong growth potential. To make the Russian economy more efficient, there is a clear need for reforms, he says. Vested interests make him pessimistic about the country’s ability to do this, however. For example, the Russian government has talked about further privatization in energy, because “there is a stream of rent coming from the energy sector,” says Davradakis. “Everyone, including the security forces, is flirting with that stream of rent.” This creates an incentive to keep energy companies in state hands.
What does this gray forecast mean for the equity market? “It looks deeply undervalued,” says AXA Investment Managers senior equity strategist Mathieu L’Hoir, who calculates that after adjusting for its sectoral makeup, the Russian market is about 50 percent below that of emerging markets as a whole. He says that there are good reasons for this, however. First and foremost, he expects earnings to fall rather than rise this year and next, largely because of the weak Russian economy, as they did last year — a situation which, he says, is “rare for emerging markets.” According to L’Hoir, the state of Russia’s government also justifies its low price-earnings ratio.
Many other investors agree that Russia’s low valuation ratios make sense. “In my view there are some good reasons why Russia is cheap,” says Carmignac’s Médecin. “It has a very strong concentration in a few sectors in which political interference can be quite high, such as energy, materials and financials.”
Carmignac’s solution is to invest in Russian stocks with strong fundamentals in sectors farther removed from governmental intervention. The firm’s investment in Russia is concentrated on two companies. One, Yandex, Russia’s largest search engine, benefits from the linguistic barrier to Google posed by Russia’s Cyrillic alphabet. Yandex stock is not cheap, with a 2014 price-earnings ratio of 26. Yet Carmignac sees it as likely that the company will achieve more than 20 percent annual growth in earnings per share between 2014 and 2017. Yandex, listed on Nasdaq, has been almost unchanged in the prior 52 weeks, at $30.16 as of market close on July 28.
The other, Globaltrans Investment, a railway freight company, is much cheaper, with a trailing price-earnings ratio of only 10. It is, says Médecin, “underappreciated by the market,” given its ability to generate cash, with a 20 percent free cash flow yield. Government policy could provide an extra boost to earnings, given possible future liberalization of the sector. But Médecin is not relying on this. “The liberalization is like an options contract,” he says. Globaltrans Investment, listed on the London Stock Exchange, closed at $9.75 on July 28, up 15.1 percent from its 52-week low on March 17 of $8.47.
The long arm of the Russian government is often bad for stocks, but it can be extremely good for bonds. Jan Dehn, head of research at Ashmore Investment Management, a London-based firm with $75 billion in assets under management that specializes in emerging markets, cites the case of Russia’s energy companies. Interference by the government to keep prices low for consumers, for example, means that “they cannot necessarily produce very big surpluses and therefore pay big dividends.” At the same time, government involvement also means that energy company bonds are what Dehn calls “quasi-sovereigns.” And given Russia’s debt-to-GDP ratio of about 13 percent, Dehn says, “Russian sovereigns have some of the strongest credit profiles on the planet.”
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