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Russian stocks, fueled by a booming energy industry, have outperformed most markets, but fundamental economic problems remain.

Russian stocks, fueled by a booming energy industry, have outperformed most markets, but fundamental economic problems remain.

By Charles Keenan
January 2003
Institutional Investor Magazine

Although most economies around the world are ailing, Russia's GDP was expected to rise about 3.5 percent in 2002, following a 5 percent gain in 2001 and a 9.1 percent increase in 2000. Similarly, most global stock markets are reeling, yet Russian equities returned 39 percent for the 12 months ended December 19. The Standard & Poor's 500 index, by contrast, fell 22 percent, and the Morgan Stanley Capital International Europe, Australasia and Far East index was down 19 percent for the period.

"Russia is a place where almost all of the fundamentals are positive," says William Browder, CEO of Hermitage Capital Management, a Moscow-based private equity firm with $750 million under management.

Don't overlook the word "almost." The strengths of the Russian economy are undeniable: political stability under the three-year-old regime of President Vladimir Putin, a firmer alliance with both the U.S. and the European Union, booming oil and gas exports in a market of $30-a-barrel petroleum, a fast-growing telecommunications sector and a fiscal and current-account surplus. To boot, there is also apparently improved corporate governance, including the adoption of international accounting standards by a handful of Russian corporations, such as Yukos and Norilsk Nickel Mining and Metallurgical Co.

But Russia's weaknesses are equally plain: a barely functioning banking system hobbled by corruption and fraudulent accounting, a dearth of direct foreign investment, inadequate financial transparency and a Byzantine, overstaffed civil service.

Of course, Russia has come a long way since the crash of 1998, when the government defaulted on its debt, the ruble collapsed, and foreign investors suffered massive losses. "The landscape is radically different," says Donald Elefson, portfolio manager of the $27 million Excelsior Emerging Markets Fund. "It has improved a lot, and now I believe we have come to a plateau of improvement that is going to last a while."

"Russia is attractive right now," says Michael Calvey, co­managing partner of Baring Vostok Capital Partners, a private equity firm in Moscow. "The growth rates that companies are achieving in Russia today are among the highest in the world." Calvey is especially bullish on consumer-products companies. He's helping finance two privately held firms: SladCo., the third-largest confectionery in Russia, and Borjomi, a mineral water company based in Georgia. In Calvey's view these companies boast well-known brands, dominant market positions and strong management.

One striking symbol of the country's resurgence: Russia is now pumping out nearly as much crude oil as Saudi Arabia, the world's top producer -- 7.9 million barrels per day, versus 8 million for the kingdom. The United States ranks third, with daily production of 5.5 million barrels per day, according to the International Energy Agency in Paris. Last month the government sold off a controlling stake in Slavneft, a state-owned producer, for $1.9 billion to a joint venture run by Tyumen Oil and Sibneft, two leading Russian oil companies.

Not surprisingly, public and private funds have invested heavily in oil and gas companies. The $39 million-asset Acadian Emerging Markets Fund keeps 11 percent of its portfolio invested in Russian firms, with the lion's share -- 75.6 percent -- in oil and gas. Its holdings in Yukos rose 71 percent last year through mid-December, selling at a multiple of 6.4 times 2003 estimated earnings. Gazprom, another position, is up 17 percent, trading at multiple of 4.9. In addition to the relatively cheap valuations, these companies offer liquidity, with market caps of $19.9 billion for Yukos and $27.3 billion for Gazprom. "Oil and gas companies are at the forefront of the beneficiaries of reform," says Charles Wang, a senior portfolio manager at Acadian Asset Management.

Although the stocks of Russian oil and natural-gas companies have enjoyed substantial run-ups in recent years, to many money managers they still are reasonably priced, compared with their U.S. counterparts. Hermitage Capital's Browder estimates that oil reserves in Russia trade at about 95 cents a barrel, versus $10 a barrel for U.S. producers.

Excelsior's Elefson is bullish on the country's largest producer, Lukoil, which he's owned since 1994 and which now accounts for 1.5 percent of his portfolio. Lukoil stock, trading at 6.6 times estimated 2003 earnings, was up 26 percent last year through mid-December. Elefson likes Lukoil's two-pronged strategy of drilling in the Timan-Pechora region in the north and in the Black Sea in the south. He thinks Lukoil can become a major exporter in the next few years.

The telecom sector is also inspiring keen enthusiasm. Just 40 percent of all Moscow households own cell phones; nationwide the figure is 10 percent. That leaves plenty of room for expansion. (In the European Union penetration rates range from 60 percent to 80 percent.)

On the consumer side, buoyed by increased purchasing power among Russia's workforce, telecoms with a retail focus, such as Vimpel Communications and Mobile TeleSystems, dominate the cellular market. Mobile reported third quarter net income of $84.3 million, up 7.5 percent over the same period a year earlier. Its subscriber base was expected to jump to 6 million by year-end 2002, up from 2.7 million in 2001; in November the company announced its plan to buy a controlling stake in Ukrainian Mobile Communications, giving it access to a new market.

VimpelCom's performance also has been impressive: it earned $1.06 per share in the third quarter, up from 42 cents over the same period last year.

With a strong foothold in the Russian market for voice and data services to business, Golden Telecom appears to some investors to be a promising turnaround play. Baring Vostok teamed up with two other partners to buy a 60 percent interest in the company, which was losing money and had seen its share price decline 90 percent over the last three quarters of 2000. After slashing costs and focusing on organic growth, Golden earned $7.8 million in the third quarter ended September 30, compared with a loss of $1.9 million for the same period in 2001. Golden now controls 40 percent of Moscow's business market.

Pointing to the company's debt-free balance sheet, Calvey estimates that Golden will have generated $90 million of cash flow in 2002, up from $27.4 million in 2001. In December the price-to-book ratio was 1.28.

"That is an absurdly cheap valuation," Calvey notes.

Such success stories -- coupled with last year's passage of a flat 13 percent personal income tax and a 24 percent corporate tax rate -- are helping to line government coffers. Russia's budget surplus last year was expected to hit 1.4 percent of GDP, and the current-account surplus 8.1 percent of GDP, says Peter Westin, a senior economist at Aton Capital Group, a Moscow brokerage. With sustained surpluses, the government, once in arrears with military and civilian workforces, is now current with its payroll and debt payments. For September, the most recent month for which statistics are available, real wages were up 17 percent over the same period a year earlier.

Still needed: an overhaul of Russia's civil service, whose complex regulations thwart worthwhile business development. "You have this bureaucratic thicket that small- and medium-size companies have to wade through," says Stephen Jennings, CEO of Renaissance Capital Holdings, a brokerage in Moscow.

And for the moment, financial transparency also remains a distant goal. The government would like companies to make the switch to international accounting standards by January 1, 2004, but has yet to issue specific criteria for companies to follow.

The lack of transparency is one key reason why foreign direct investment in Russia lags well behind other transition economies in Central Europe. Foreign investment totaled $160 per capita from 1994 through mid-2002, according to research by Aton Capital. That compares with $2,000 in both Hungary and the Czech Republic over the same period. "The investment climate is bad," says Westin. "Investors are worried about bureaucratic and legal obstacles."

To many foreign investors, Russia's greatest asset -- its powerful oil and gas industry -- is also a potential weakness if energy prices fall. "We have a market that has been a phenomenal performer and a strong economy that has been driven by one sector," Excelsior's Elefson says. "And that's risky."