Roland Nash of Renaissance Capital -

Perception of Russia risk is a curious phenomenon. The connection with reality is often glimpsed, but only in passing. The swing from safe haven to pariah in the summer of 2008 was exceptionally painful, even by the standards of the crisis. The swing back from pariah to legitimate investment destination is proving analogously lucrative. Optimism is necessarily now a more crowded position, but we remain confident that the grafting of the "R" back into BRIC will drive the next leg of Russia's re-rating, and potentially plough straight through the fundamentals.

Russia sits in the sweet spot between liquidity and economic recovery. A consensus international commitment to hold interest rates low for long enough to ensure growth in the structurally challenged economies of the developed world provides a boost to Russia through simultaneously tending to decrease the price of risk and increase the price of dollarised commodities. Likewise, the recovery of demand in the developing world provides a medium-term, demand-side underpinning to commodity prices, while improving the risk-reward trade between the low-growth developed world and high-opportunity emerging markets.

We already see reasons to be cautious about equity valuations. Using a risk-free rate of 8%, an equity-risk premium of 5-10% and an average oil price increasing from $59/barrel this year to $80 into the medium term, our aggregate discounted cash flow valuation of Russian equities provides only 6% upside potential to our fair value. A 6% undervaluation will not set pulses racing after a 100% market re-rating.

But while the correction back from sharply oversold is now largely complete, we think the improvement in the fundamentals will drive further appreciation.

Reasons to be cheerful

The cost of capital is still falling ahead of the equity market. Having risen to levels above 11% at the end of last year, Russian sovereign yield is now at 6.1%, just 50 basis points above where it was before the crisis. Domestically, interest rates are being pushed lower. Reserves are again being built up as the Central Bank of Russia (CBR) defends the rouble at RUB30/USD. We expect CBR base rates to move another 50-75 basis points lower before the year-end.

Growth is beginning to return. As interest rates drop towards inflation, the same incentive to build inventories will likely drive a new wave of investment. The government stimulus package now looks likely to be less aggressive than we had originally expected, but only because private-sector demand is coming back more strongly. Our 4% growth target for 2010, while still slightly above consensus, no longer looks particularly outlandish.

The final potential positive is the improving rhetoric surrounding both a government reform programme and the relationship between Russia and the US. As the political focus shifts away from the minute-to-minute management of the crisis, it is becoming increasingly clear that President Dmitry Medvedev is intent on burnishing Russia's image as an investment destination and a reliable partner in the international arena. Prime Minister Vladimir Putin seems happy to stand out of his way. While both ambitions deserve to be treated with some scepticism, we note that even a change in rhetoric has, in the past, proved a powerful catalyst for the equity market.

The biggest risk remains the oil price. With inventories and spare capacity so high, we readily admit that Russia's whole investment case rides on the Saudis continuing to keep Opec in line. While this risk remains, Russian assets should continue to trade at a significant discount to emerging market peers.

Top-down stock picks

Our stock-specific conclusions fall out of the top-down discussion. Much like in the second and third quarters of this year, as risk appetite returns, the clear investment conclusion is to move down the liquidity curve and into riskier assets. We continue to favour domestically oriented stocks, despite their outperformance in the past three months. Some, like Sberbank (BUY, TP $2.72), are now among the most crowded trades in Russia. But fundamentals still support the stock, and we now regard it as the cleanest liquid exposure to returning economic growth, rouble appreciation and lower interest rates. Similarly, we continue to favour VTB (BUY, TP $4.64/GDR) as a less crowded alternative in the financial space. In the same vein, we would also recommend looking at the less liquid opportunities both in Russia, as well as in Kazakhstan and Georgia.

The reform rhetoric is best played, in our view, in the utilities space. Electricity distribution companies have had a tremendous run over the past few months, but we think their fundamental upside potential remains impressive. As we have seen in the past, utilities can move several times higher as enthusiasm returns. It seems like the increase in valuations may even be backed up by the realisation of reforms this time around. In particular, we like MRSK Holding (BUY, TP $0.17) as the most liquid opportunity among the regional utilities, and the one with most to benefit from tariff changes.

Real estate is another theme that is working well. Real estate companies remain among the most beaten-up in Russia, despite their recent run. With finance - both private and public - returning to the space, we think PIK (HOLD, TP $1.45), Raven Russia and LSR (BUY, TP $5.60) should all run further.

On the more cautious side, we note that both Rosneft (HOLD, TP $4.36) and LUKOIL (HOLD, TP $45.2) are now trading above our target prices. At reasonable oil-price assumptions, we are cautious about more fundamental value at current levels. Moreover, even if the oil price does rally, we believe a better way to gain exposure is through names that benefit from economic recovery, a decreasing cost of capital and rouble appreciation, rather than through the liquid oils. We would, therefore, remain underweight these two names against the benchmark.

Our official DCF target for the RTS at the end of 2009 is being raised slightly from 1,200 to 1,350. But we believe that this is just the beginning of a medium-term rerating of Russian stocks, and are lifting our end-2010 RTS target from 1,600 to 1,800.

Roland Nash is head of research at Renaissance Capital, Moscow

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