Vladimir Putin’s invasion of Ukraine has turned Russian companies into pariah investments on the international stage — but before then, their stocks were priced way too high, according to Chris Brown, founder of Aristides Capital. 

“From an investment perspective, the most shocking thing to me about Russian stocks is how expensive they were before this unjustified war,” Brown wrote in his monthly letter to investors, which Institutional Investor has obtained.

“I looked last week at a Russian oil and gas stock, that, like all Russian stocks, had already fallen 80 or 90 percent-ish. I was stunned to see that even after crashing, it still yielded only about 17 percent free cash flow to enterprise value,” he wrote. “Every Russian stock I browsed was the same story; they had all been priced, pre-crisis, at least double what people should have been willing to pay for them given the embedded risks.”

Brown said the experience investors are facing with Russian stocks is nothing new: It has happened in other countries with risks that investors were ignoring. And it has happened in Russia previously.

When Putin first came to power in 2000, Russia had a terrible reputation with investors who had just been burned by the Russian debt default of 1998, as well as the high levels of corruption and crime, Brown noted. This wariness towards Russia continued for years.

“For many years after the 1998 crisis, Russian stocks traded at a massive discount to developed world markets. This made perfect sense to me, as when a nation has no rule of law, and investors’ attorneys can be jailed and murdered (e.g. Sergei Magnitsky, 2009) people are rightly a little spooked,” Brown said, in reference to the lawyer for former hedge fund manager Bill Browder, who died in a Russian jail. (Browder has waged an international campaign to create laws to punish Russian oligarchs and state actors responsible for these actions.)

When Putin took over as president, allegedly bringing stability to the country, Russia’s Corruptions Perception Index ranking was 82nd out of the180 countries ranked by Transparency International. It has since gotten much worse.

“Putin’s regime annexed Crimea in 2014, intervened in Syria on behalf of dictator Bashar al-Assad in 2015, poisoned leading opposition figure Alexei Navalny in 2020, and made nearly 10 million Russians ineligible for political office in 2021,”  Brown said. All this resulted in the country’s ranking on that index falling to 125th place — and that was before it invaded Ukraine last month.

Brown attributed investors’ willingness to continue investing in Russia to a phenomenon called the “peso problem,” a term that’s often attributed to Milton Friedman. 

In the 1970s, the Mexican peso had been stably pegged to the dollar for more than two decades.“For an observer with a knowledge of only this ‘short-term’ history or ‘short-term’ charts, it might seem anomalous that Mexican deposit interest rates were persistently higher than those available in the United States,” Brown wrote. “The difference, of course, was due to the possibility of a large, sudden discontinuous move in prices, especially a sudden devaluation of the peso were the peg to break, which of course, it eventually did.” The peso fell suddenly in December of 1994, eventually losing half of its value and leading to a contagion event throughout the emerging markets and in the U.S. fixed income markets.

The same thing is going on in Russia, Brown said. “The 23 years of relative prosperity (sans the 2008-2009 global financial crisis) in Russian equity markets, followed by sudden collapse, shows that you can let the institutions of civil society gradually degrade in your country and, at least from a market valuation perspective, get away with it for a surprisingly long time,” he wrote. “Eventually, however, core institutions and the rule of law matter.”

As Brown says, "Ukrainians are dying, Russians are dying, millions of lives are being torn apart, and investors are losing a ton of money. The last phrase there is the least important in the grand scheme of things, but it is part of the reason why even hedge fund managers should care about politics.”