Roland Nash of Renaissance Capital -

Russian equities have again been underperforming in recent weeks. From being the star performer among emerging market equities since 2000, Russia so far this year has been disappointing, down 5% compared with an average for other emerging markets of up 9%. While it is possible to put the weakness down to a series of coincidences (softer oil prices, Yukos auctions, Russia-US relations, cash raising for recent IPOs), there are longer-term trends that are probably more important. Hydrocarbons have now fallen for the last 12 months. While eventually valuations will reach a level where the investment case is restored, we expect the negative underlying trends to continue.

Since 2000, firms (particularly commodity producers) have enjoyed a set of one-off transfers from the rest of the economy. High oil prices are a transfer from oil consumers to oil producers. An undervalued rouble is both a transfer from importers to exporters, and from consumers to producers. Low wages are a transfer from employees to employers. Under-investment (an economy-wide phenomenon) is a transfer from future and past generations to the current. And the under-paying of tax is a transfer from expenditure benefactors (largely households) to taxpayers (largely firms). The benefit from each of these transfers is gradually being eroded, which should prove to the long-term benefit of Russia, but at the expense of firms, and therefore, shareholders.

The most visible reflection of this is in earnings numbers. One of the major drivers of the equity market since 2003 has been the repeated ability of the hydrocarbon and commodity sectors to surprise on the upside. Analysts over the period have tended to be slower than the markets at raising commodity price assumptions, resulting in revenue numbers that have been consistently higher than expectations. Surprisingly high revenues have disguised any tendency for costs to increase. While oil prices have remained high in late 2006 and 2007, they have stopped rising, and therefore the surprise factor has gone.

Meanwhile, cost pressure is continuing relentlessly. For reasons we have spelled out in detail many times elsewhere, there is a virtually irresistible tendency for the rouble to keep strengthening, raising import costs and domestic costs relative to export revenues. Partly for the same reason (rising money supply) and partly because of emerging labour bottlenecks, wage pressure is also pushing up costs. As the attached figure 1. shows, wages are increasing nearly 20% faster than the average consumer goods that firms are selling. Figure 2. shows the earnings numbers delivered for 2006 relative to expectations. Those companies that have negatively surprised tend to be most exposed to these longer-term trends.

Moreover, valuations are not obviously supportive. Much of the out-performance of Russian equities since 1999 has been due to a combination of decreasing risk perception and the revaluing of assets that were simply mispriced. But with Russian risk now remarkably stable at roughly 100 basis points over US Treasuries, and most valuation ratios at a par with emerging market comparables, the scope for any further multiple expansion is limited. While the Russian market as a whole trades at a relatively benign 11.9 times 2007 earnings (compared with the MSCI EM at 14.6 times), the comparison is a lot less favourable if the market is broken down by sector. On a sectoral basis, most of Russian equity still trades at a premium to EM (figure 3). Underperformance is clearly improving the relative valuation argument for Russia. But so far, it would take an optimist to define them as demonstrably cheap.

In the absence of either earnings growth or the scope for multiples expansion, the potential for general Russian equity to outperform is limited. This is obviously not to say that weakness should be expected across the board. There are still many excellent opportunities to put capital to work in Russia (see below). But for Russian equity inc., the market seems to be digesting that the outsize returns of recent years is over.

On top of the earnings trends, there are also less-tangible fears. Domestic politics is the most clear and present. Until there is consensus in the Kremlin over who will be the next president, what will be the role of Putin in 2008, and, most importantly, how the current elite will protect their interests under the next president, the potential for a nasty surprise remains real, and probably underestimated. Similarly, there is no reason to expect any reversal in the tail-spinning relationship between Russia and the US. Both sides seem to have given up even pretending and the diplomatic pantomime is now being played for domestic audiences, neither of which is particularly open to nuance.

One or two obvious examples aside, domestic and international politics have been largely irrelevant for equities in recent years. When the market is racing higher, it can afford to ignore politics. However, in more bearish conditions, politics tends to become more influential.

Finally, there is the giant bogeyman of international risk-assessment. It is often easy to forget that the trillion dollars of value created in the Russian equity market since 2000 has been made against an ideal international backdrop. Commodity prices are one half of the story. The other is the apparently insatiable demand for risk. By far the two biggest corrections in the Russian market over the last 12 months have both resulted from a (so far) temporary reassessment of that risk appetite. With Russian equity already looking soft, a further shock could catalyse a large sell-off.

So where should capital be deployed amidst these less favourable conditions?

Building opportunities

The good news is that there remain many excellent opportunities. Somewhat ironically, the rising costs and the need to invest are increasing the value of capital in much of the economy. As we have described in other publications, the rebuilding of Russia’s dilapidated infrastructure is a mammoth task which will offer opportunities well into the medium term. While steel, pipes and real estate have all outperformed over the last 12 months, we believe that outperformance will continue.

Similarly, while real appreciation of the currency undermines exporters, it helps dollar investors into stocks with rouble revenue streams. While valuations are stretched in some of the mobile, retail and finance companies, for those with management that is able to hit strategic goals, earnings growth can continue to power outperformance.

Moreover, domestically focused companies in these sectors manage to avoid the two major risks identified above. Their domestic focus decreases exposure to international risk, and they tend to be firmly established in the non-strategic sectors of the Russian economy thereby avoiding much of the political uncertainty. While all stocks would suffer from an increase in risk-perception, domestically focused, non-strategic companies offer the best immunity.

Finally, and more controversially, it may prove a winning strategy to align interests with those of the state. There are signs that the Kremlin has become aware of the concept of market capitalization, and likes what it sees. Providing favourable conditions to national champions in strategic sectors is not an optimum strategy for the Russian economy in general, but it could well enhance market capitalization for the chosen few.

It has long been our view that rouble appreciation and rising costs would undermine the competitiveness of Russian exporters. This has been reflected in the hydrocarbon sector for the last 12 months and in the equity market more widely since the beginning of the year. Figure 4. shows how the equity market is gradually evolving away from hydrocarbons.

While at around 1800 on the RTS, there is some technical reason to expect a bounce, these underlying trends look set to characterize the Russian market into the medium-term. The valuation argument for hydrocarbons is becoming more compelling as the underperformance continues. But from a strategic standpoint, we stick with our view that infrastructure development, real estate, and the better retail, finance and mobile opportunities continue to offer greater longer-term value.

Roland Nash is head of research at Renaissance Capital in Moscow

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