Ben Aris in Berlin -

Ian Hague, co-founder of Firebird Management LLC will be speaking at the Adam Smith conference on Russian alternative investment in London on February 21-22

Russia is being roundly attacked on an almost daily basis by Western editorial writers for its backtracking on democratic reforms and allowing the concentration of presidential power. But investors have little to complain about: Russia's leading index, the RTS nearly doubled in 2004 and 2005, and despite a sharp correction in emerging markets around the world in May last year, it still finished the year up nearly 70%.

With parliamentary elections slated for the end of this year and crucial presidential elections in March 2008 - President Vladimir Putin has promised to stand down - there is no doubt the Kremlin is taking control of media and crushing nascent opposition groups in preparation for the handover of power to Putin's successor.

The politics are grim, but the economy is sparkling. Russia's economic growth was up an unexpectedly strong 7% in 2006 year-on-year, while inflation fell into single digits for the first time in modern history and was inside the government's self-imposed 9% target. And with petrodollars flooding the country, the economic fundamentals are the stuff of most Western European central bankers' dreams.

The increasingly vibrant domestic growth has pulled in billions of dollars of direct investment as international firms from retailers to carmakers try to get a piece of the consumer spending bonanza.

"It's a paradox," says Hague. "At the start of this decade, Russia was an economic basket case, but enjoyed very good relations with the West. By the end of the decade, it is an economic powerhouse with terrible relations with the West."

The four funds

Hague, together with Partner Harvey Sawikin, manages Firebird's four Former Soviet Union equity funds: Firebird Fund LP, Firebird New Russia Fund LLC, Firebird Republics Fund LLC, and Firebird Avrora Fund LLC.

The Firebird Fund and Firebird New Russia Fund have returned 60.8% and 50.4% respectively over the last year and are 90% invested into Russian equities. The biggest funds are the Firebird Republics Fund and Firebird Avrora Fund (which is only one of the four funds still open to new investors), with over $650m under management in each. Like most investment in Russia, these two funds are hunting for opportunities in the regions and returned 69.1% and 50.5% over 2006.

However, Hague says that in the fast moving Russian economy it is important not to marry yourself too closely to any one idea; there is opportunity everywhere and there is overlap in the Russian exposure of all of the funds, and overlap in the regional allocation as well.

The Firebird funds had a total of $2.8bn under management as of the end of 2006. About $1.9bn of this is in these four funds, but Firebird also has two global funds – Firebird Global Fund I and II – which Hague manages with his other partner James Passin and Amber Trust, a joint venture in private equity in the three Baltic States, which it runs with Danske Capital Finland.

"We invest in the emerging equity markets and companies of the former Soviet Union and the 'still emerging' portion of Eastern Europe; namely Bulgaria and Romania," says Hague.

"This can mean trading on local-currency denominated exchanges, over the counter, ADRs in London and New York or even London- or Canadian-listed companies whose businesses are dedicated to the region. Our portfolio is dominated by the larger liquid names, but some of our biggest gains have always come from buying things when they are good value but illiquid, and holding on to them through the process of creating liquidity," he says.

Secret of success

Emerging markets are notoriously volatile and the Russian market in particular has the habit of being either the best or worst performing market in the world. Hague says the secret to Firebird's success is to hold onto investments for a "very long time." Keeping an eye on the economic and political turning points that precede a rapid decay in fundamentals is essential, but Russia has yet to disappoint.

"Since 1998 we have not seen conditions that would justify [reducing our exposure to the CIS], but our working assumption is that, at least in the cases of Russia and Kazakhstan, economic growth that relies so heavily on the prices of hydrocarbons is not sustainable over the long term and that eventually there will be a crisis; we just know that it is very unlikely over the next 18 months," says Hague.

The question on the minds of Russia's investors right now is whether the economy has finally reached one of these turning points. The RTS has been bolstered by huge amounts of international liquidity and the extraordinarily high price of oil. But as Russian traders went back on January 9, the market sold off sharply on concerns of worsening conditions, falling from the record high of 1,922 set on the last day of trading in 2006 on December 29 to 1,755 by the time of writing on January 10.

Hague says Russia's prospects are mixed. The high oil prices have been an obvious fillip for the Russian economy coupled with the phenomena of "Putinism" - the overarching authority of the president that has brought political stability to a Russia wracked by a series of crises since the end of the Soviet Union in 1991.

"For the well being of Russian people Putinism is probably a bad thing. And for the efficiency of Russian companies and the overall valuation of the Russian stock market it is also bad - but try telling that to a Russian," says Hague alluding to Putin's sky-high popularity rating among a population grateful for the end to the chaotic Yeltsin years.

Hague argues that Russia has made a lot of progress in developing its economy, but the soaring stock prices are as much driven by external factors as internal progress.

"The compression in credit spreads and the impact of the fundamental growth lifted the whole country," says Hague. "No one remembers when overall volatility in financial markets has been this low. The result is that a lot of people went into emerging markets who were not there three years ago. And in Russia the effect was multiplied by the fact that stocks are the only instrument in Russia that can yield positive real yields."

After two years of about 100% gains, some funds are starting to switch out of the plain vanilla strategy of buying Russian blue chips simply because they are undervalued. The string of interest rate hikes in America last year took the wind out of the sails of commodity producer and caused a massive switch out of traditional blue-chip stocks and into companies with exposure to the domestic consumer story.

"The switch into retail stocks was dramatic and probably over done. The IPO prices were excessive and the first to be hit by the sell-off [in May 2006]. Russia is a big country and beyond the extraction industry there are lots of interesting businesses being run by entrepreneurial people, but it is tough being a Russian manager.

"There are some blue chips with good fundamental upside but the 20 biggest stocks are at fair value or even passed it. Firebird is going into a lot less liquid stocks as well as doing some private investment deals to get a non-correlated [to the index] return. If the monetary conditions remain supportive of stocks then the blue chips will continue to do well, but we are also looking at the consolidation story in things like paper and pulp. And in every region of Russia has at least one bank with local franchise that is growing like a house on fire. It is maybe the purest and deepest play on Russia's financial recovery."

Send comments to Ben Aris