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The All-Russia Research Team

Investors identify the leading analysts at Moscow brokerage firms who help them navigate an alluring but treacherous bull market, in our inaugural survey of Russian research.

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In the Communist-era Soviet Union, consumers famously lined up to buy eggs and meat. Now, in capitalist Russia, they've gone off-line -- clamoring for cell phones. In 2003, 36 million citizens owned mobile phones, twice as many as the year before.

Many appear to be calling their stockbrokers. Local shares have soared 66 percent since January 2003, bolstered by strong oil prices and relative political calm. The benchmark Russian Trading System index has more than quadrupled since the start of 2001, while Russia's overall market capitalization has surged from $70 billion to $201 billion, with free float growing from $12 billion to $40 billion. Russian Eurobonds have also delivered fat profits, and a domestic corporate bond market has sprung up out of nowhere in the past two years. Since 2001, as measured by Morgan Stanley Capital International, Russia's stock market has posted the best dollar-based performance of any emerging-market country, save the much smaller Colombia.

Investors remain optimistic. "Even after all the gains, the Russian market is trading at eight times earnings," says William Browder, who manages $1.5 billion at Moscow-based Hermitage Capital Management. "If that goes to 20, I might think it's overvalued. Not now."

Underlying the market bullishness is Russia's booming economy, which grew 7.3 percent last year. President Vladimir Putin, reelected in March by a landslide, has brought much-needed order to the country, restoring state finances to impeccable condition with nearly $90 billion in reserves and a debt-to-GDP ratio of less than 30 percent. That performance led Moody's Investors Service to upgrade Russia's country ceiling from Ba2 to an investment-grade Baa3 last October. The outlook continues to appear strong: Oil, which along with gas accounts for 20 percent of Russia's GDP, traded above $40 per barrel in May and could remain above $30, thanks to improved OPEC discipline and rising demand as the world economy recovers.

Another bullish factor: Russian companies are far more investor-friendly today than they were in the '90s, the dawn of the age of oligarchs. Now firms like Vimpel-Communications and Mobile TeleSystems, the top two cellular phone carriers, offer Level 3 American depositary receipts, which require that issuers report their financials with a transparency nearly on par with U.S. companies'. That, in turn, has enticed giant global institutions like AIG Global Investment Group, Deutsche Bank, Pioneer Investment Management and Franklin Templeton Investments to buy into the market. "The transparency of Russian companies and the quality of information available to us have improved dramatically from five years ago," says Alexander Schwarzkopf, a vice president at Deutsche Bank's equities special situations group in London.

To be sure, the Russian market can still be treacherous. After embattled energy giant Yukos Oil Co. said in late May it might not be able to avert bankruptcy if forced to pay more than $3 billion in taxes the government says it owes, its shares dropped 10 percent. That put further pressure on the RTS index, which fell 29 percent in April and May, in part because of concerns about higher U.S. interest rates. And despite all the progress Russia has made since its 1998 debt default, company disclosure and minority shareholder rights still generally trail Western standards. One of Russia's top oil companies, Surgutneftegas, last year stopped giving investors financial figures that complied with U.S. generally accepted accounting principles, keeping them only for management. In the metals sector, recounts Renaissance Capital analyst Robert Edwards, analysts typically endure "having somebody from the company sit in a meeting with a CFO and jump up any time you raise a question that's not deemed appropriate to the meeting. Those questions tend to be anything that affects potential tax liabilities, ownership or the true profitability of the business."

For investors this volatile combination of investment opportunity and riskiness makes insightful securities research more valuable than ever. With this in mind, Institutional Investor set out this year, for the first time, to determine which analysts are doing the best job covering Russia's rapidly growing -- and challenging -- capital markets. To do so, we surveyed more than 200 global and domestic institutions managing about $24 billion in Russian stocks (60 percent of the market's free float) and $11 billion in Russian fixed-income to find out which stock and bond analysts they turned to first for insights and information. In past years we have presented investors' views on analysts in a single Russia country category in our All-Europe Research Team (and this year as part of our new Emerging EMEA Research Team). The new stand-alone All-Russia Research Team allows us to look at research coverage in unprecedented detail across 11 sectors: Consumer, Financial Services, Industrials, Metals & Mining, Oil & Gas, Telecommunications, Utilities, Economics, Equity Strategy, External (Foreign-Currency) Debt and Internal (Ruble-Denominated) Debt.

One firm stands out for the depth and breadth of its coverage: Renaissance Capital. The nine-year-old outfit, founded by veterans of Credit Suisse First Boston's Moscow office, comes in first by a wide margin, placing in all categories and winning a total of 15 team positions, including eight first-place finishes. United Financial Group is No. 2, with ten team positions; followed by Brunswick UBS in third, with seven team positions; Troika Dialog, with four slots; Aton Capital Group, with three slots; and Alfa Bank, with two team slots, both of them runners-up.

Dozens of brokerage firms track Russia or Russian securities to some degree, and analysts at 40 firms received at least one vote in II's survey. Among them are global brokerages such as Citigroup, CSFB, Dresdner Kleinwort Wasserstein, Goldman, Sachs & Co., HSBC, Merrill Lynch, J.P. Morgan and Morgan Stanley, as well as emerging Europe, Middle East and Africa regional specialists such as CA IB International and ING Financial Markets. Some of the global firms pulled out of Russia after the 1998 default and have reentered the market in the past two years but have not built Russian research departments on the same scale as the local brokers. None of the analysts at these global brokerages garners sufficient votes to make the first All-Russia team.

"The best house on Russia is Renaissance," sums up one London-based Russia investor. "You feel like you are on the ground with them."

Individually, the analysts at Renaissance and other All-Russia firms also excel. Last year's 58 percent market rally made it easy enough to pick winners, but the top analysts distinguished themselves by identifying outperformers. Renaissance's Edwards, who takes top honors in the Metals & Mining category, recommended Norilsk Nickel -- the world's largest nickel producer, with a growing exposure to gold -- in early 2003 at $22 per share. Edwards thought favorable commodity prices, competent management and a growing gold mining business would boost the shares. He was right; by mid-May they were trading near 70.

Renaissance's Utilities first-teamer, Hartmut Jacob, warned investors away from Unified Energy System and toward regional power companies called energos that offered, he says, the same exposure to the reconstruction of the power sector at more-favorable valuations. His favorite, Volga regional Samaraenergo, rose from 0.03 in September to 0.108 in mid-May, or 260 percent.

Edwards and Jacob are but two of dozens or so sell-side analysts -- 30 of whom place on our team -- who are doing their best to raise the research in Russia from its roots in hunches, rumormongering and potboiling for house positions to work that today approaches world standards. Some skeptics still question Moscow analysts' independence. But their work is inarguably growing more incisive and professional as native Russians get business degrees and training abroad and expatriates forsake lukewarm markets in London and New York for the adventure of Moscow. Many are young: All of our first-teamers are under 40, and No. 1 Industrials analyst Elena Sakhnova of UFG is just 27. Like their counterparts in other markets, Russian analysts excel by providing their clients with detailed information on their companies and industries. Clients praise Dmitry Vinogradov of Brunswick UBS, who ranks No. 1 in Financial Services and No. 3 in Consumer, for a September 2003 report in which he argued that Sberbank was cheap compared with its peers in Eastern Europe. "This type of cross-country analysis helps global emerging-markets players identify relative value easier," says one investor.

Such broad industry knowledge is much in demand among investors. We asked respondents to our All-Russia survey to rate analysts in each category on six attributes of service: access to management, financial analysis, ideas, independence from investment banking, industry knowledge and written research. (Macro analysts were rated on accessibility/responsiveness, ideas, market knowledge and written research.) In the seven industrial categories, winners generally scored highest on industry knowledge, written research and financial analysis.

But covering the Russian markets still takes much more than a spreadsheet and a shoeshine. Politics -- national, regional or international -- can matter more to a company's future than profit margins, as investors in Yukos found out when the government arrested oligarch Mikhail Khodorkovsky, who was CEO. Struggles for influence take place behind closed doors or are aired in public through coded gestures that an inexperienced observer might misread or miss altogether. "You can't work in Russia as just a financial analyst," warns UFG utilities analyst Derek Weaving, a second-place finisher. "You've got to synthesize your analysis with politics, business culture and even history."

Politics permeates most Russian business, and analysts can be drawn personally into the political fray. In 1998­'99, when former Finance Minister Anatoly Chubais had become Unified Energy System CEO, he "made his dramatic call for liberalizing the power sector, and I commented that this was a good thing," UFG's Weaving remembers. "This led to my being tagged as a supporter of the 'Chubais plan,' which I never was, and playing some role in the industry I was supposed to be analyzing dispassionately."

Russian analysts must still contend with plenty of executives who cling to Soviet-era notions of disclosure. "My sector is still very much affected by the traditional reluctance to divulge information to outsiders," says Renaissance's Edwards. He points out that even Norilsk Nickel, where Harvard University­trained lawyer Leonid Rozhetskin heads what's regarded as the metals industry's most transparent investor relations effort, can offer just one year of audited financials.

That said, the dozen or so most-liquid companies in Russia have followed Yukos's lead and Westernized their investor relations in recent years. They've increased transparency as they tap Eurobond markets. International executives, like Yukos CFO Bruce Misamore, often sign off on the books in much the same way that the Sarbanes-Oxley Act requires in the U.S. And some companies are pursuing more demanding ADRs than the Level 1 receipts that three dozen Russian companies have issued. Level 1 ADRs impose the lightest U.S. disclosure requirements on foreign issuers and trade in the pink sheets or on the OTC Bulletin Board; Level 2 requires fuller, U.S.-style disclosure, with financial statements reconciled to U.S. GAAP and allows issuers to list their ADRs on major U.S. exchanges or Nasdaq; Level 3 permits issuers to raise new capital in the U.S. markets if they satisfy Level-2 disclosure requirements and file a full prospectus for their U.S. offering.

"The blue chips are producing enough information now to do serious analysis at a global standard," says Petru Vaduva, chief of research at Nikoil Brokerage Co.

Second-tier companies have made improvements, too. Although limited free floats, murky majority-ownership arrangements and hard-to-shake tendencies toward management truculence scare off many foreign investors, nearly all publicly traded Russian companies now issue financials that meet at least basic international accounting standards. Companies that court the financial community well enough to break out of second-string status reap considerable benefit. Juice maker Wimm-Bill-Dann Foods, one of three Russian companies to attain a Level 3 ADR, sports a market capitalization of $737 million, a cool 23 times forward earnings. By contrast, Gum, the former state department store chain famous for its Red Square emporium, is valued at $113 million, a 7.2 price-to-earnings ratio, in part because of its small free float and allegedly spotty communication with outsiders.

Economic research is another challenge for analysts in Russia. Anyone who walks the streets of Moscow can see that the country's economy is growing, but no one knows just how fast or in what ways. The Soviet-holdover statistical agency Goskomstat simply adds 25 percent to measurable economic activity to account for the gray economy when estimating GDP, Renaissance's chief strategist, Roland Nash, notes. A more realistic premium might be 40 percent, he thinks. Charting performance in Russia's vast interior involves still more guesswork. "I recently compiled a series of reports on regional economies," recalls Nash, who takes the top spot in both the Economics and Equity Strategy categories. "I got as much information going to the sauna with local officials as I did from the State Statistics Committee."

Nash's employer, Renaissance, and the other three brokerages that lead this year's All-Russia survey -- UFG, Brunswick UBS and Troika -- share relatively long histories in the market. All were founded between 1992 and 1995 and nurtured by expatriate managers. The founders of Renaissance, led by Boris Jordan, came from CSFB's Moscow office. Jordan, an American of Russian descent, became the media star of the 1990s boom but left Renaissance after the 1998 Russian default. Two of the four pioneering firms have now found multinational partners: Brunswick UBS, which was created in Moscow by Scandinavian capitalists shortly after Communism crumbled and is 50 percent owned by the Swiss banking giant; and UFG, in which Deutsche Bank agreed to buy a 40 percent stake last year.

Naturally, research managers extol the benefits of their new big brothers. "Being part of Deutsche's worldwide standards improves our professionalism," says Stephen O'Sullivan, II's third-team Oil & Gas analyst. He co-heads research at brokerage UFG, whose founding partners are American banker Charles Ryan and former Russian Finance Minister Boris Fyodorov. "There's a true Chinese wall here. I literally don't know what goes on in corporate finance."

Rivals who remain unattached just as naturally tout their independence. "Our analysis shows that this market is where Brazil's was ten to 15 years ago," says Stephen Jennings, CEO of Renaissance Capital. "What happened there was that independent partnerships with the freedom to be idiosyncratic were very successful."

Alongside these internationally minded Russian brokerages are the truly global investment banks that usually follow Russian stocks as part of their European or EMEA industry coverage. At Merrill Lynch, for example, EMEA financials analysts Zekeriya Öztürk and Paul Tucker cover Russian financial services, while oil analysts Anatoli Kaminov and Irina Boudnikova spend 90 percent of their time on Russian names. But none of these firms garners sufficient votes to place on the All-Russia team this year, even as a runner-up. (Although they fall short of making the team, global brokers fared relatively well in two of Russia's biggest industries, Oil & Gas and Metals & Mining.)

A third, and rising, force consists of homegrown investment banks like Alfa, Aton and Nikoil Brokerage, founded and managed by natives, with a smattering of hired Western expats. The banks' initial difficulty in attracting Western institutional clients caused them to cultivate the Russian investors whose bankrolls and tastes are increasingly driving the market -- or so they claim. "Our basic franchise is with Russian high-net-worth individuals," says Nikoil Brokerage research chief Vaduva, a Romanian-American who is one of a handful of expats at the firm. "Those are very different investors than Western professionals. They don't care about overperforming or underperforming. They like to trade and take risks, and only absolute return counts."

Those Russian retail clients are playing a much more important part in the current bull market than they did before the 1998 default. In 1997­'98, 90 percent of the cash flowing into Russian stocks was foreign, Moscow brokers say. Today that's down to half or less, raising the hope that funds won't quickly flow out again at the next bump in the road.

It's not only locals who prefer the work of the analysts at the homegrown brokers. "I like the research that comes from the Russian houses," says Harvey Sawikin, co-founder of New York­based Firebird Management, a hedge fund firm that has about $350 million invested in Russia. "It may not be as 'professional' as the slick stuff the other guys are putting out, but it has a better feel for qualitative issues, which are very important in Russia. Alfa has a very good feel."

For their part, Westernized banks Renaissance and Troika get 50 to 60 percent of their brokerage volumes from freewheeling native investors. This can make the Moscow researcher's life complicated. "Research for the institutions is becoming much less gut feel and much more mathematical, with discounted cash flow analysis and the rest of it," says James Fenkner, chief of research at Troika. "Then you've got Russians calling up and asking, 'How cheap is this?' or 'Is this hot?'"

Russian institutional investors, who might one day provide a bridge between local investors in search of tips and Westerners interested in long-term cash flow projections, have only lately begun to flex their muscles. A pension reform law that requires the state to begin doling out retirement money now run by the Treasury to selected private firms just took effect last year. So did compulsory liability coverage for Russia's drivers, a measure expected to kick-start the insurance industry.

"Russian institutions are growing fast but from a tiny base," says Renaissance's Nash. "I'd be surprised if they attain the status they have in the West even within five years. What we're seeing now is wealthy individuals investing their money."

Capital repatriated by Russian investors last year helped create the nation's first capital-account surplus since the 1998 default, bolstering the development of the Russian bond market. Russia's external, or foreign-currency-denominated, debt market has enjoyed a powerful rally, with the yield on the benchmark Russia 2030 Eurodollar bond falling from almost 20 percent in May 2000 to 8.2 percent in mid-May 2004. Meanwhile, Russia's internal debt market for ruble-denominated bonds, which opened in 2000, now includes about $5 billion of debt issued by some 100 companies (Institutional Investor, April 2004). The ruble market also includes OFZ federal government securities and municipal debt.

Even though the bond market is flourishing, Russia still lacks its own IPO market. Only six Russian companies have launched initial share offerings; these include such familiar names as Wimm-Bill-Dann, VimpelCom and MTS, which offered shares in the U.S. market through their Level 3 ADR programs. For equity brokers, too much cash is chasing too few stocks, and much of it is concentrated in natural-resources shares that will be vulnerable at once in the next falling commodities cycle.

"The main weakness of this market is that you've got the same brokers and many of the same people chasing the same stocks for the past five years," UFG's O'Sullivan says. "We're hoping, with the election out of the way, to see a wave of IPOs at last."

The absence of IPOs has spared the Russian market some of the research-related scandals that have tarred investment banking houses in the U.S. and, to a lesser extent, Europe. But investors worry whether analysts' opinions are truly independent. Moscow financial houses have relied on brokerage and trading, leading to higher fees and wider spreads than prevail in more-developed, more-competitive markets. The concern is that brokers might bend research to the needs of the trading book or to flatter a much-needed banking client. "I'd be out of business by now if I acted on Moscow brokers' buy-sell recommendations," says Hermitage's Browder.

Charles Tennes, who runs $130 million as chief investment officer of Alfa Capital, the investment management arm of Alfa Bank, is more diplomatic, asserting that sell-side professionalism has increased. "A lot of the number-crunching and modeling is of very good quality," he says. "The trouble comes when they reach a conclusion and make recommendations. It's hard to tell what might be happening behind the scenes."

To some extent, competition forces transparency: With up to ten rivals avidly covering the same small market space, it's hard to blow too much hot air under a favored stock. And an increasing number of researchers are chartered financial analysts, subject to supranational licensing requirements and sanctions. "The Russian research market is still not entirely clean," acknowledges Troika's Fenkner. "But the fact that many of us are CFAs, and can have that certification withdrawn by an international body, is a big help."

Honest sell-side research alone isn't enough to sustain Russia's bull market, and given the events of 1998, it's fair to wonder whether this new bout of prosperity can continue. The good news is that overall conditions are much better now than in 1997­'98, when, as UFG's O'Sullivan says, "the real economy wasn't doing anything." In 1998 oil crashed to $10 per barrel and production was at its nadir, the economy was shrinking, and Boris Yeltsin's cabinet shake-ups kept the political elite in chaos. Investors who poured into Russian shares and bonds that year were betting not that the country would succeed but that the International Monetary Fund and the U.S. government would deem it too big to fail. When the IMF and Washington drew a line under their lending to Moscow, the Kremlin defaulted on $70 billion in domestic debt and the equity market collapsed, ultimately leading to the near-failure of U.S. hedge fund Long-Term Capital Management, which threatened the world financial system.

The Federal Financial Markets Service -- a regulatory agency created by Putin in March and headed by Oleg Vyugin, a respected Finance Ministry and Central Bank official who was briefly Troika Dialog's chief economist -- still has to prove it can keep Russian companies from reverting to the bad old days of disappearing treasuries and backroom share dilutions. "Improvements in corporate governance have come because owners saw they could make more money by attracting investors than through revenue transfer," Renaissance's Nash says. "That lasts as long as the stock market keeps going up. I'm not sure Russia has the legislative infrastructure to police it if the incentive is lost."

The next chapter in the development of Russia's markets may bring far greater liquidity to equities. Investors and analysts hope that the government will abolish the "ring-fence" that has kept non-Russian investors from holding direct shares in natural-gas monopoly Gazprom. Foreigners can trade Gazprom ADRs, but domestic shares are reserved for Russian nationals. Researchers point to a thickening trail of signs and portents from the Kremlin as evidence that 2004 could be the year the long-dangled measure comes to pass. The senior economic planner in Putin's cabinet, Minister of Economic Development and Trade German Gref, promised in April that the fence will topple "soon."

"This will be the biggest indexation event in emerging-markets history," exults Nash. At present a mere 3 percent of Gazprom's equity is owned by global investors through ADRs. The "domestic" free float is 30 percent. Because of their scarcity, the ADRs trade at a 65 percent premium, implying a market capitalization of $75 billion for the state-controlled company -- making it the second-biggest emerging-markets company by market cap after Petrochina. Once the fence is down, Nash reasons, global funds will pour into Gazprom as it takes its place in more emerging-markets indexes, pushing domestic shares higher than the ADRs' current level.

Investors are more skeptical. Alexander Branis, who helps run $650 million in Russian equities as a director at Moscow-based Prosperity Capital Management, is staying out of Gazprom. First, he's not convinced that the fence is really coming down. Even if it does, the colossus remains "an inefficient state company with no free cash flow, whose main purpose is to serve a public function," that is, to provide fuel at a loss to Russian consumers and industry.

Quibbling and point-scoring of this sort is inevitable within a tight financial community like Moscow's, where anyone who has been around for a year or two knows everyone else. But for the moment, it sounds like spats within a happy family. The Khodorkovsky affair, which last fall seemed to threaten the great Putinian prosperity, looks increasingly like a footnote as rival oligarchs go about their affairs unmolested and the president enters his second term. Young reformers appear to be dominant in both Putin's cabinet and the Kremlin administration. Mikhail Fradkov, a virtual unknown whose last job was as Russia's emissary to the European Union, was a puzzling choice for prime minister. But the two top economic liberals from Putin's first term are back -- Gref at the Economic Development and Trade Ministry and Finance Minister Aleksei Kudrin. The presidential administration also looks more progressive, with Putin's old St. Petersburg associate Dmitry Medvedev replacing Yeltsin-era holdover Alexander Voloshin as its boss.

Signs from the oil market are relentlessly positive -- more chaos in Iraq, more demand recovery in the U.S. -- and Russia anticipates a repeat of its $39 billion 2003 current-account surplus. The expectation of higher U.S. interest rates has cooled Russian equities, along with other emerging markets', by sucking some capital back into the West. But a crash on the order of 1998, when the Kremlin was borrowing three-month funds at 70 percent, still seems far-fetched.

"What could go wrong with this market is an oil price collapse," concludes UFG's O'Sullivan. "But it doesn't look like we're heading for one at the moment."

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