Dmitry Mikhailov of Renaissance Asset Managers -
Russia is cheap. It has always been cheap. Currently, the price/earnings ratio is 5-times. That should come as a shock, because it is less than the 7.5-times when the RTS was founded in 1995 and Russia has changed out of all recognition since then: every macroeconomic indicator has gone up at least 10-fold over the period and the RTS Index is up 16-fold. Yet despite the visible progress, Russian stocks are deemed to be worth less now in proportion to company earnings than they were during the political uncertainties of the Yeltsin-era. That might be about to change.
There are many factors contributing to the low valuations - the disconnect between how the world views Russia and the reality on the ground, the Cold War stigma, as well as the nascent nature of corporate governance, a weak judiciary and obsolete regulation - but most of these are starting to change.
One major change concerns Russia's poor dividend payout, the lowest of all 45 countries in the MSCI Emerging Market Index. Why do Russian companies pay out so little to shareholders?
One reason is the high concentration of stakeholders in companies. Most Russian companies have a majority shareholder with a 50% stake or more, whereas in most developed countries the largest shareholders own at most stakes in the teens.
Moreover, in many of the biggest companies the Russian state is the controlling stakeholder or, if a company is indeed private, ownership and management are not separated, which is unusual in more developed markets.
The upshot is an obvious conflict of interest between majority and minority shareholders in respect of dividends, as the owner manager has little incentive to forgo growth in favour of paying out dividends.
This situation is understandable if you consider the evolution of the Russian market. Almost all of today's major companies were created in the last 20 years. The current owner/managers are the first generation of businessmen and their companies are very much personal property, in that they built them with their own hands so they have both a material and emotional connection to them.
The same was true of American companies created a century ago. Names like John D. Rockefeller, Andrew Carnegie, J.P. Morgan and other tycoons also didn't pay high dividends, as they ploughed their profits back into growing their empires. It is only two generations on after the ownership of these companies passed to shareholders that dividends appeared. Indeed, Microsoft didn't pay dividends in the first 20 years of its life; it's only since Bill Gates more-or-less moved on that the company has begun to pay out anything at all.
The low valuations are also a function of the lack of a domestic investor base in Russia. The stock market is large and vibrant, but the Kremlin has failed to put through reforms that would encourage retail investment into things like pension schemes or mutual funds. At the same time, despite a decade in operation, the Russian pension and insurance industries are still in their infancy.
With so few Russian minority investors, the job of investing in Russian shares is largely left to foreign investors. And given the weakness of the judiciary system in Russia, the temptation to abuse these outsiders is overwhelming for some managers/majority stakeholders. In general, the smaller the company, the less inclined management is to respect minority shareholders' rights.
Ironically, Russia's rapid economic growth of recent years has also led to stocks underperforming. High growth rates in the past led to the expectation of high growth rates in the future, which only reinforces managements' inclination to reinvest profits into the company, rather than pay out dividends.
Finally, the cost of equity capital is high at about 15%, whereas the most that can be earned on cash on deposit is about 5%, so there is little motivation for taking capital out of the company unless the owners have a specific need.
Nevertheless, today Russian companies are awash with cash after the state pumped liquidity into the economy to lend support during the worst of the 2008 crisis. As most companies remain the private property of their owners or the state, there has been little motivation to reward shareholders by paying out dividends, but that is starting to change - especially amongst the state-owned companies. Dividends are likely to become the 'it' theme of 2012 and beyond.
The state is one mover. Although the state remains a majority shareholder in most of the large companies, once Russian President Dmitry Medvedev re-launched the privatisation programme earlier this year, many of these companies have become more interested in increasing their dividend payments as a way of boosting valuations ahead of being sold off.
At the end of November, management at Russia's state-owned oil pipeline monopolist Transneft, which is due to be privatised in two years' time, confirmed that it would boost dividend payouts next year.
Transneft is usually oblivious to shareholder value, but faced with privatisation management have suddenly discovered the concept of shareholder value. The company reported a three-fold increase in income in 2010 due to a change in accounting methods that moved profits from the subsidiaries to the holding company, and management has decided to return some of that money to shareholders. Management said it believes the company's valuation would re-rate significantly by 2014 when all the major investment projects should be completed. Management's stated goal is now a stable share price and reliable dividends, and that the decrease in price volatility and the expansion of the shareholder base would lead to a surge in market capitalisation.
Amongst private companies, the owners/managers are also becoming more interested in the share price as they turn to their equity as a means of raising additional investment capital. The slowing global economy and the moribund credit markets means equity as a source of capital has become increasing appealling, as share prices are likely to underperform for the next few years even though earnings will continue to grow, particularly amongst the natural resource companies.
Indeed, over the last decade Russian stocks have been the best performing in the world - including the 2008 sell-off when the stock market lost some 75% of its value - on the back of earnings growth alone. Despite the fact that the P/E ratio of the Russian stock market has yet to re-rate like that in China, Brazil and India, the MICEX index still grew four-times more than the second best performing market in the world over the same period, which was China.
But perhaps the biggest reason for change is simply down to the fact that Russia's first generation of owner/managers is getting older and will soon start retiring. Once the likes of MMK's Viktor Rashnikov, NLMK's Vladimir Lisin, and Lukoil's Vagit Alekperov leave their jobs as chairman of their companies and hand over to the next generation of managers, they will likely want to continue benefitting in the form of dividend payments.
Currently, Lukoil's dividend policy sets a 15% payout of its GAAP profits, but the 2005-14 strategy calls for this to be increased to 40% of consolidated earnings by 2014. So far, the company has paid weighted average dividends of 15% between 2006 and 2009, peaking at 20.86% two years ago even if nominal dividends in 2010 were higher.
But the most exciting development concerns reports that Gazprom is looking to double its dividend payment. At the start of November, Gazprom's management reportedly agreed to set next year's dividend payment at RUB180bn ($5.9bn), or RUB7.6 per share, and a 4% annual dividend yield based on current market prices. Long one of the worst dividend payers in Russia, the change of heart at Gazprom suggests strongly that there has been a change in the government's attitude to dividends.
Russian Minister of Economic Development Elvira Nabiullina explained recently the philosophy behind this change of heart: "There is the need to keep investments growing during the absence of oil price increases. The budget does not have the resources to support investment growth at previous levels, that is why the emphasis needs to shift to private investments."
Both the Kremlin and private owners of companies are slowly developing a new mentality. Traditionally, business has been the private domain of the owners. But as the Russian economy develops, the idea of sharing profits and success with shareholders as allies and partners is creeping into the Russian mindset. A combination of age and necessity is driving this change.
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