COMMENT: The butterfly effect

By bne IntelliNews March 9, 2007

Chris Weafer of Alfa Bank -

"Float like a butterfly, sting like a bee." Muhammad Ali

We may not yet know if a butterfly flapping its wings in China could indeed cause a hurricane on the other side of the planet or if every Chinese person jumping in unison result in a tidal wave hitting America. But after last week we know a 9% drop in the Shanghai stock index most definitely can cause a rolling financial tidal wave that swamps the rest of the world.

As with all momentous events, it's all in the timing. After four harrowing days in global markets, the fact that Chinese equities fell, in response to what is basically a good proposal to better regulate a highly speculative market, is no longer the issue. The value of Chinese equities is similar to the total in Russia, ie. just over $1 trillion, or less than 3% of the total value of global equities. But what it has done is allowed US economic concerns and the fear of a sudden unwinding of the yen carry trade to take centre stage.

It is now clear that these concerns are not going to disappear quickly, and global markets are facing a very uncertain and likely very volatile March. For Russian equity investors, the fact the economy is fiscally sound and growing above the global average, and that the current-year earnings multiple is barely into double digits does not matter over the short term. What does matter, as it does for emerging market equities as an asset class, is that global investors are facing a period of uncertainty and high risk. The longer that lasts, the higher the perception of asset-class risk and the greater the temptation to pull money out of risk assets, regardless of local fundamentals. Should that happen, we could find ourselves in the sort of "death spiral" that dragged the market almost 30% lower last May and June when redemptions led to forced selling, declining prices and further redemptions.

Last week, the RTS fell just over 7.0%, which is nothing more than a blip in an index that is up over 150% in the past 24 months. And by Tuesday it broke its the five-day losing streak by finishing up 1.5% to 1,764. The local Moscow bourses were closed on Thursday for a national holiday and will re-open today.

For relative return investors, the safest equities to be exposed to are those with mainly domestic drivers and less vulnerability to a possible global slowdown. On the export side, the more prudent "bets" are in stocks that have the cheapest earnings-based valuations. These are also those that offer the best upside should either global growth worries abate (metals) or should the threat against Iranian oil exports increase.

The price of zinc has been the real laggard in the metals sector in recent months due to demand worries against rising supplies, so Chelyabinsk Zinc falls into the category of "cheap for a good reason." The electricity, banking, fixed-line telecoms and consumer sectors represent the best domestic themes with greatest isolation from external contagion. The mobiles are also a strong consumer theme, but are highly correlated with the high-risk Nasdaq.

Gazprom is particularly risky, partly because it does not have any obvious drivers this year (quite the opposite - its strategic direction is seen to be wrapped in political and structural issues) and also because it is the most liquid, cheapest and easiest of all the global emerging market stocks to "short" as an asset-class insurance. Rosneft is the most expensive of the oil majors, and while it may benefit from the YUKOS auction, that event is already "in the price."

Otherwise, the stocks and themes that offer the best mix of safety and upside are the following:

Electricity: Momentum is continuing in industry reforms, and a sizeable part of the equity to be raised will come either from strategic investors or domestic sources. UES is still the best proxy for these changes, but it is also one of the most liquid blue chips and, therefore, will not buck a major sell-off. Moscow City and Moscow United Distribution are the cheapest in P/E terms, while OGK-5 and UES both have good upside based on DCF target price.


Banks: Growth in the domestic economy will mostly be unaffected by any global problems, or at least not in 2007. Sberbank is now in a strong position having secured almost $9bn of additional capital recently, so it has enough funding to sustain strong growth via lending expansion this year. Sberbank (+30% to target price) and Vozrozhdenie (+27%) are the best valued sector plays.

Fixed-line telcoms: Siberia Telecom, Volga Telecom and Uralsvyazinform are all trading at a cheaper 2007 P/E than the market average. Volga (+45%) and Siberia (+41%) also have amongst the highest upsides to target price. A good "hedge strategy" would be to go long both Volga and Siberia while shorting the most expensive stock in our coverage universe, Rostelecom.

Consumer: Because this "domestic consumer" theme was favoured through most of 2006, the pure consumer stocks, such as food producers and retailers, are now expensive. None have 2007 P/E ratios below the market average, and only Lebedyansky (+27%) has upside to the 12-month DCFbased target price greater than the market average. X5 Retail Group is the next best with 14% upside.

Extractive industry exporters feature on both valuation lists, but of course this is the theme most exposed to any negative investor reaction to a global slowdown. In that event, cheap commodity stocks will only get cheaper as investors expect downward earnings revisions.

But four stocks do stand out as candidates for when investors see the market settling, especially if growth expectations remain intact.

Norilsk Nickel: A 2007 P/E of less than 5x and upside to DCF target of 33% leaves a lot of room for any downgrades and adequately pays investors for the risk. But nickel is the only major metal to have survived last week's sell-off in commodities and actually hit yet another price record. There is a very tight inventory position in the metal and supply is not expected to rise in 2007.

Mechel: The cheapest of the metals with a P/E of just over 8x. It also has a growing coal business that is becoming more attractive as the government pushes for growth in the sector as part of its efforts to diversify fuel sources for the electricity industry.

LUKoil: The best diversified and least complicated of the oil majors with a P/E of less than 10x (half that of Rosneft) and DCF upside of 31%. Best way to play the "oil spike" threat and should have reasonable support not far from current levels because of valuation.

TNK-BP Holding: The cheapest of the oil majors on both 2007 earnings multiple and DCF target upside. That is because of the perception of political risk and the uncertainty facing major projects. But it is assumed that these issues will be resolved, and the current valuation is pricing in almost the worst-case outcome. Anything better will see the valuation catch up quickly.

Chris Weafer is chief strategist at Alfa Bank in Moscow


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